Is Today's Price-Earnings Ratio Too High?

More than half of households’ retirement savings are invested in stocks. During the recent financial crisis, stocks lost more than one-half their market value from the fall of 2007 to their lows in the spring of 2009. Since the trough in the market, stock prices have risen to nearly 85 percent of their former peak. Despite this rebound, savers remain relatively wary about holding stocks, and many experts expect weak returns on stocks in coming years. According to one time-tested standard, the 10-year trend in companies’ reported earnings, stock prices may have risen too rapidly to offer pension funds and other investors attractive returns in coming years. In the past, when prices have been high relative to this measure of cyclically-adjusted earnings, stocks have generally paid investors subpar returns. This brief takes a closer look at stock prices and companies’ earnings. Although some analysts have proposed alternative ways of measuring cyclically-adjusted earnings, this brief uses the traditional 10-year trend for smoothing reported earnings. It finds that the relationship between stock prices and the traditional trend in earnings has shifted recently as a result of the two recessions since 2000. As this temporary shift reverses, cyclically-adjusted earnings will likely grow sufficiently rapidly in the next several years to bring their relationship to prices back to the long-term average. The first section of this brief discusses the case for comparing stock prices to the trend in cyclically-adjusted earnings, instead of current earnings. The second analyzes the relationship between the two price-earnings measures. The third section examines the outlook for cyclically-adjusted earnings and stock prices. The final section concludes that the distribu­tion of future returns for stocks currently is aligned with their historical average returns.

Equity Returns in the Coming Decade

The majority of retirement savings is invested in cor-porate equity, attracted by the historically high average returns offered by stocks. But substantial risk also accompanies investments in stocks, a risk that seems especially costly after the recent financial crisis. Not only did the value of equity plunge, but many fore-casters also expect subpar returns from stocks over much of the coming decade as the economy recovers slowly from the recent recession. They point out that stocks in recent years have paid shareholders lean dividends, and now the sluggish recovery will limit the growth of corporations’ earnings and stock prices. This brief discusses a broader way of viewing the prospect for equities. The return on stocks will depend on corporations’ profitability. Companies’ earnings have recovered strongly since the recent re-cession, and the valuation of those earnings reflected in current stock prices is near its historical average. If companies maintain their profitability, stocks are likely to pay returns that match their historical aver-ages over the coming decade, even if the recovery of the economy is weaker than average. This brief is organized as follows. The first section reviews the history of returns since 1950. The second explains how corporations have used their earnings to support a pace of capital gains on stocks that has exceeded the rate of economic growth. The third sec-tion discusses why earnings, more than capital gains or dividends, matter most in determining the return on stocks. The fourth describes the outlook for the real return on stocks. The final section concludes that the outlook for stock returns may be better than many forecasters anticipate.

How Important Are Inheritances for Baby Boomers?

Due to a changing retirement landscape, many baby boomers are likely to have insufficient resources for a secure retirement.1 One potential source that could improve their situation is inheritances. This study quantifies the aggregate amount of inheritances that baby boomers – those individuals born between 1946 and 1964 – can expect to receive over their lifetimes, and the distribution of past and prospective receipts by household type. The discussion is organized as follows. The first section quantifies the aggregate amount that boomers will receive. The second section investigates who will receive how much. The third section considers the impact of the recession on inheritances, specifically the declining values of equities and housing. The final section concludes that, while inheritances will augment the resources of aging baby boomers, they will be insufficient to ensure secure retirements.

Reducing Costs of 401(k) Plans with ETFs and Commingled Trusts

Increasingly, employers who provide their employees with a retirement plan are relying on 401(k) and similar defined contribution plans instead of defined benefit plans. As a result, participants are paying more of the cost of managing their pension plans, which can take a substantial toll on their retirement savings. Over a 30 year career, for example, an annual fee of 0.7% of assets reduces the purchasing power of a participant's balance at the time of retirement by more than one-eighth.

How Important Are Intergenerational Transfers for Baby Boomers?

Due to a changing retirement landscape, many baby boomers are likely to have insufficient resources for a secure retirement. One potential source that could improve their situation is inheritances. Using data from the Survey of Consumer Finances and the Health and Retirement Study, this study quantifies how much boomers can expect to inherit. Our best estimate is that boomers’ will inherit $8.4 trillion. Of this amount,$2.4 trillion has already been received, while the remaining $6.0 trillion is anticipated. We estimate that two-thirds of boomer households will receive some inheritance over their lifetime, with a median amount of$64,000. The estimates are based on data obtained before the economic crisis, so our analysis explores how the collapse in the stock and housing markets might affect the picture. Evidence from the previous economic crisis in the early 2000s suggests only a temporary reduction in prospective inheritances, which will be reversed as the economy recovers. However, given the severity of the recent crisis, we also considered a scenario in which inheritances fall proportionately with the decline in housing and stock values between 2007 and 2010. In this case, anticipated inheritances would fall 13 percent – from 6.0 trillion to $5.2 trillion. In any case, any prospective inheritance is uncertain. Parents or grandparents who expect to leave a bequest may revise their plans based on fluctuations in their asset values. Or they may exhaust their wealth due to medical costs or long lifespans. In short, boomers should not count on an anticipated inheritance to eliminate the need for increased retirement saving.

Fees and Trading Costs of Equity Mutual Funds in 401(k) Plans and Potential Savings from ETFS and Commingled Trusts

As the role of 401(k) and similar defined-contribution plans continues to expand in our retirement system, plan participants are paying more of the cost of financing their retirement income. This study analyzes the trading costs and fees of the 100 largest domestic equity mutual funds held in defined-contribution pension plans for the years 2004 through 2008. The pricing of the actively managed funds in this sample cost the average plan 0.70 of a percentage point or more in annual returns. By shifting investment options from managed mutual funds to exchange-traded funds (ETFs) or commingled trusts, 401(k) plans can align the fees they pay more closely with the expense of the services they use. This realignment can allow an average plan to reduce its administration and management fees between 0.20 and 0.40 percent of assets. In addition, the shift to ETFs and commingled trusts that hold ETFs can reduce average trading costs 0.50 percent of assets or more for participants holding managed equity mutual funds. The fees and trading costs of the domestic equity funds in this sample are not correlated with the performance of the funds. The funds with the greatest expenses tended to divide evenly between those funds that outperformed and those that underperformed the market by the largest margins.