How big is the equity risk premium?

It is one of the most important questions in the investment world and one of that is permanently debated. How big is the equity risk premium vs. safe assets? I am not going into the theoretical debates and the pros and cons of different approaches. For that, I recommend you read the fantastic compendium edited by Larry Siegel and Paul McCaffrey for the CFA Institute Research Foundation. I find myself going back to that time and again. Instead, I want to discuss what practitioners use in their asset allocation models.

The go-to resource to find out what investors use as risk-free rate and equity risk premium is Pablo Fernandez annual survey (the 2024 edition is available here). But Magnus Dahlquist and Markus Ibert have done something interesting on top of the Fernandez survey. They collected equity risk premia and credit risk premia used by institutional investors and their advisers and compared them by type of investor. Plus, they analysed how these risk premia change over time.

First, the good news. Unlike retail investors, institutional investors do not simply extrapolate past returns into the future. They are quite rational and sensible. When equity markets decline, they increase their risk premium and thus their expected returns. When equity markets rally, they reduce their risk premium and thus their expected future returns. Similarly with credit and long-term bonds.

Where things are getting a bit dicey is when you compare the expected risk premium for equities between different types of institutional investors. Below is a chart of the equity premium for US equities. The chart shows the distribution of assumptions as well as the average (blue diamonds) and the median (horizontal white line).

US equity risk premium used by different institutional investors

Source: Dahlquist and Ibert (2024)

Here is the same chart for developed market equities.

Developed market equity risk premium used by different institutional investors

Source: Dahlquist and Ibert (2024)

Note that there are systematic differences in both the average risk premia used and the dispersion of assumptions.

When it comes to the average risk premium, pension funds use consistently higher values than the rest of the institutional investor world. This is probably a reflection of the accounting pressures for pension funds. Pension funds need to show their liabilities are covered by their assets. A simple accounting trick to reduce the funding gap is to assume higher returns for the assets.

Asset managers and wealth advisers, meanwhile, are more on the conservative side with wealth advisers particularly pessimistic about US equities. Investment consultants who serve both asset managers and pension funds try to split the difference and position themselves somewhere in the middle.

When it comes to the dispersion of assumptions, we can see that pension funds and investment consultants are a pretty homogenous bunch with little difference between the different providers. The dispersion among asset managers, meanwhile, is large.

The paper by Dahlquist and Ibert generally does not provide details about the expectations for individual asset managers except in the case of the average equity risk premium used for US stock markets by different providers.

And here, GMO stands out as by far the most pessimistic asset manager of all with an average risk premium on US equities of -2.9%. No other institution comes even close with MFS the second lowest at -0.7% and Fidelity the third lowest at +1.2%. The highest equity risk premium on average came from Columbia Threadneedle at 5.4% followed by Wells Fargo Investment Institute at 5.1% and Pioneer Investment at 5.1% as well. Read through Table 6 in their paper if you want to know if your advisor or fund manager is particularly optimistic or pessimistic and find out which long-term CAPE they use for the US equity market (again, GMO stands out as particularly pessimistic).