The Market Equity Risk Premium

Abstract:     
The New Zealand Superannuation Act 2001 requires the Treasury to state each year the required capital contribution of the New Zealand Government to the New Zealand Superannuation Fund. This paper examines a key assumption made in that calculation - the level of expected long-term premium of return on equity market investments over return on long-term government bonds. Over the past seventy-five years, US capital markets have provided an equity risk premium over long-term bonds in the region of 7%. The traditional view has been that these historical results provide an unbiased estimate of the expected future long-term equity risk premium. This view has given way over the past few years to a consensus that the future expected risk premium is actually somewhat lower. This consensus rests on a range of recent empirical evidence and theoretical analysis. It draws on both the historical records of market returns, dividends and reported earnings, and on forward-looking information through surveys of market experts and from the expectations implicit in analysts' earnings forecasts. On the basis of this analysis, we believe that the long-term annual (arithmetic) expected equity risk premium sits in the range of 3% to 5%. For the purpose of calculating the required capital contribution to the New Zealand Superannuation Fund, the Treasury is adopting the assumption of a long-term expected future equity risk premium of 4%.

Number of Pages in PDF File: 39

Keywords: Expected returns, risk premium, investments, pension funds

JEL Classification: G10, G23, H55

working papers series