Problems with Constant Compound Interest (2)

I had many good comments on part 1 of this series.  One was particularly good that focused on the economy as a whole, and how the promises made by the government were unlikely to be fulfilled with Social Security and Medicare.  Our government attempts to finance programs on the cheap by relying on future growth, which does not always happen.  They move up spending rapidly if growth is large, and small if growth is negative.  In either case, the government grows as a fraction of the economy.

But let me consider asset allocation projections.  It is really difficult to consider average projections of asset returns, whether in real or nominal terms.  Asset returns vary considerably, and the number of years from which average returns are calculated are few relative to the volatility of returns.

We have created an industry of asset allocators, many of which have allocated off of foolish long-term historical assumptions, as if the past were prologue.  Even if they use stochastic models, the central tendency is critical.  What do they assume they can earn over long-dated investment grade debt?  The higher that margin is, the more they lead people astray.  Stocks win in the long run, but maybe by 1-2%, not 4-6%.

Consider defined benefit pension funds — after all, it is the same problem.  What is the right long term rate to assume for asset performance?  Alas there is no good answer, and with private DB plans continuing to terminate because of underfunding, the answer is less than clear.

Scoundrels use the mechanism of discounting to their own ends — they make future obligations seem smaller than they should be, magnifying profits, and minimizing capital needs.  Cash flows are inexorable, though.  There are few ways to avoid the promises from pensions.

Investors, be aware.  Realize that long term investment assumptions are probably liberal.  Also realize that long term assets and liabilities that rely on those assumptions have liberal valuations as well.  After all, who wants to under-report income when the accounting is squishy?

Now, for my readers, what have I missed?