The authors contend that most of the institutional investing community is expecting far higher returns than are realistic from current market levels. Extrapolating the past is the easiest, and worst, way to forecast the future. Unfortunately, most investors' return expectations are shaped by a simple extrapolation of either recent or long–term past returns. If, instead, the constituent parts of equity market returns are examined, we find that it is remarkably difficult to make a case for a positive equity risk premium (the premium of future stock market returns relative to bond yields) from current market levels. None of this analysis is contingent on any assumption that market P/E ratios or dividend yields should return to historical levels. If market levels are fair and are fully sustained in the years ahead, there is still little or no room for a positive equity risk premium. If there is not a positive risk premium, then actuarial return assumptions are likely to be too optimistic, with far–reaching implications for pension funding ratios, corporate earnings, future pension contributions, and appropriate asset allocation policy.
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