Diminishing Investment Returns: Why Investors May Need To Lower Their Sights by McKinsey & Co
Buoyed by exceptional economic and business conditions, returns on US and Western European equities and bonds during the past 30 years were considerably higher than the long-run trend. Some of these conditions are weakening or even reversing. In this report, we attempt to quantify the impact on future investment returns. Our analysis suggests that over the next 20 years, total investment returns including dividends and capital appreciation could be considerably lower than they were in the past three decades. This would have important repercussions for investors and other stakeholders, many of whom have grown used to these high returns.
- Despite repeated market turbulence, real total investment returns for equities investors between 1985 and 2014 averaged 7.9 percent in both the United States and Western Europe. These were 140 and 300 basis points (1.4 and 3.0 percentage points), respectively, above the 100-year average. Real bond returns in the same period averaged 5.0 percent in the United States, 330 basis points above the 100-year average, and 5.9 percent in Europe, 420 basis points above the average.
- A confluence of economic and business trends drove these exceptional investment returns. They include sharp declines in inflation and interest rates from the unusually high levels of the 1970s and early 1980s; strong global GDP growth, lifted by positive demographics, productivity gains, and rapid growth in China; and even stronger corporate profit growth, reflecting revenue growth from new markets, declining corporate taxes over the period, and advances in automation and global supply chains that contained costs.
- Some of these trends have run their course. The steep decline in inflation and interest rates has ended. GDP growth is likely to be sluggish as labor-force expansion and productivity gains have stalled. While digitization and disruptive technologies could boost margins of some companies in the future, the big North American and Western European firms that took the largest share of the global profit pool in the past 30 years face new competitive pressures as emerging-market companies expand, technology giants disrupt business models, and platform-enabled smaller rivals compete for customers.
- As a result, investment returns over the next 20 years are likely to fall short of the returns of the 1985–2014 period. In a slow-growth scenario, total real investment returns from US equities over the next 20 years could average 4 to 5 percent—more than 250 basis points below the 1985–2014 average. Fixed-income real returns could be around 0 to 1 percent, 400 basis points lower or more. Even in a higher-growth scenario based on resurgent productivity growth, we find that returns may fall below the average of the past 30 years, by 140 to 240 basis points for equities and 300 to 400 basis points for fixed income. Our analysis shows a similar outcome for Europe.
- Most investors today have lived their entire working lives during this golden era, and a long period of lower returns would require painful adjustments. Individuals would need to save more for retirement, retire later, or reduce consumption during retirement, which could be a further drag on the economy. To make up for a 200 basis point difference in average investment returns , for instance, a 30-year-old would have to work seven years longer or almost double his or her saving rate. Public and private pension funds could face increasing funding gaps and solvency risk. Endowments and insurers would also be affected. Governments, both national and local, may face rising demands for social services and income support from poorer retirees at a time when public finances are stretched.
Over the past 30 years, financial investors have had to contend with two equity market collapses, in 2000 and 2008; the steepest one-day decline in history on the New York Stock Exchange, in 1987; an emerging-market crisis that erupted in Asia in 1997 and spread to Russia and Brazil in 1998; and a worldwide financial meltdown and banking crisis. Despite these challenging episodes, financial markets in the United States and Western Europe still delivered total investment returns to investors between 1985 and 2014 that were considerably higher than the long-term average.
These returns were lifted by an extraordinarily beneficial confluence of economic and business factors, many of which appear to have run their course. Consequently, investors may need to adjust their expectations downward.
In this report, we discuss the changing economic and business conditions that will determine the future investment returns earned by US and European equity and fixed-income investors and attempt to size the magnitude of the potential shift. Our analysis finds that even if GDP growth rates were to return to the trend rate of the past 50 years, other factors could dampen annual returns over the coming decades by 150 to 400 basis points compared with returns earned in the past 30 years.1 We also discuss what it would take—such as sweeping technological change that lifts corporate productivity and profit growth—to bring returns back to the same level investors enjoyed between 1985 and 2014.
This report has several important caveats. First, we model investment returns only on US and Western European traded equities and bonds. For reasons of simplicity, we exclude performance of real estate and alternative investments. We also do not assess the past or future performance of emerging-market investments. All of these could lift average returns for investor portfolios in the years ahead, and indeed in future iterations of this work we may expand our analysis to include them. Finally, the analysis in this paper is not meant to be a forecast of future equity or bond returns. Our goal is to help investors, governments, and individuals understand the drivers of returns and the trends that could dampen future investment performance, the potential magnitudes involved, and their implications, so that they can reset their expectations.
1985 To 2014 Was A Golden Era For Investment Returns
The period from 1985 to 2014 produced equity and bond returns far above long-term averages for both the United States and Western Europe (Exhibit 1).
Real total returns on US and Western European equities both averaged 7.9 percent. In the United States, this was 140 basis points above the 100-year average and 220 basis points higher than the 50-year average. Western European equity returns in the 1985–2014 period also exceeded the 100-year and 50-year averages, by 300 and 220 basis points respectively.
Fixed-income investments, as measured by total real investment returns on government bonds, were also considerably higher on both sides of the Atlantic in the 1985–2014 period than they had been in 1915–2014 and 1965–2014. Total real US government bond returns of 5 percent were 330 basis above the 100-year average and 250 basis points above the 50-year average, while real returns on European bonds averaged 5.9 percent, which was more than triple the 100-year average and 150 basis points above the 50-year average.
Most investors today have lived their entire business and professional lives during this golden era and many have grown used to expecting that future investment returns will match those of the past. Many public pension fund managers in the United States,