Revisiting Willis Towers Watson s asset assumption setting ...Willis Towers Watson has for many...

Revisiting Willis Towers Watson’s asset assumption setting processSeptember 2016

Revisiting Willis Towers Watson’s asset assumption setting process September 2016

Table of contents

Executive summary.................................................................................................................................... 2

Introduction ......................................................................................................................................................... 3

Setting asset class assumptions ..............................................................................................4

Key drivers of an assumption setting process ..............................................4

Key principles for setting asset class assumptions ...............................4

Changes to our assumption setting process at June 2016 .....................6

Why consider a second calibration of the model? ...................................6

Inflation and interest rate outcomes under the two model calibrations..................................................................................................................................................7

Equity return outcomes under the two model calibrations...........9

Impact of model calibration on asset class assumptions .......................10

Expected nominal returns....................................................................................................10

Expected real returns ................................................................................................................10

Our preferred calibration for the asset model .......................................................12

Linking asset class assumptions to our capital market views 12

Determining which calibration to use .....................................................................13

Risk and correlation assumptions ........................................................................................ 14

Conclusion ..........................................................................................................................................................15

1 Asset assumption setting process

2 willistowerswatson.com

Willis Towers Watson has for many years developed a stochastic asset model and a set of associated asset class assumptions, which are in turn used for a range of purposes, most of which are related to strategic asset allocation advice. These assumptions and the assumption setting process itself are regularly reviewed as market conditions and our own views evolve over time.

As part of the review of our asset class assumptions at 30 June 2016 we have decided that, going forward, we will release two sets of assumptions labelled Yield Reversion and Lower for Longer. The Yield Reversion set is based on our existing assumption setting process which most of our clients will be familiar with. The Lower for Longer set represents a new asset model calibration that is now our preferred calibration for most purposes. In this paper we discuss the rationale for and basis of these two sets of assumptions and why an investor might use one over the other:

�� There is a range of plausible long-term assumptions and there is no single ‘correct answer’. For this reason we have maintained an ‘Alternative’ in-house calibration since 2011. Historically we have placed a low level of conviction in this calibration as a likely representation of the future and have therefore not used this to model client portfolios. However, since then our level of conviction in what until now has been the ‘Standard’ calibration of our model as a representation of the

most likely long-term evolution of economies and capital markets has reduced significantly.

�� The main difference between the two model calibrations is the level at which variables such as inflation, interest rates and equity returns settle in the long term. Compared to the Yield Reversion (previously Standard) calibration, the Lower for Longer calibration assumes that, in 20 years’ time, inflation and interest rates settle at levels that are 0.5% pa and 1% pa lower than our existing normative assumptions. In addition, the equity risk premium (ERP) is assumed to be 1% pa lower than our normative assumption.

�� The impact of adopting the Lower for Longer calibration is to reduce expected real returns over the next 10 years for a typical ‘growth’ portfolio by around 1% pa.

�� A medium-term view on an asset class implicitly contains some view on long-term outcomes. The economic views implied by the two model calibrations are:

�� Lower for Longer – inflation and economic growth will be muted for a prolonged period and implied forward interest rates are a reasonable representation of the future path of cash rates. Inflation and cash rates take longer than 20 years to reach normative levels, and

�� Yield Reversion – economic growth expectations are at the higher end of the recent historical range and inflation and cash rates revert to historical norms over a 10-15 year horizon.

Executive summary

�� We now have a preference for the Lower for Longer calibration as the economic views implied by this calibration are more consistent with our own views than those implied by the Yield Reversion calibration. This said, we believe that both calibrations represent plausible scenarios for long-term outcomes and the most appropriate calibration for use by a particular investor will be determined by the context and the usage of the model as well as the investor’s specific investment beliefs and views.

�� An investor who uses the Yield Reversion calibration would be one who:

�- believes that it is difficult to predict which regime will apply over the long-term (and that historically driven assumptions are a reasonable estimate of the ‘average’ regime)

�- has a very long, multi-decade timeframe, and/or

�- has a relatively optimistic view of medium to long-term economic outcomes.

�� An investor who uses the Lower for Longer calibration would be one who:

�- believes that the future state of the world will be materially different to the past (e.g. due to headwinds from shifting demographics and debt levels)

�- places more emphasis on current market conditions than historical data, and/or

�- believes that economic outcomes are likely to remain muted over the medium to long term.


A major theme that has been present across all of our major capital market and investment strategy publications in recent years has been a view that returns across all asset classes are expected to be ‘low’ compared to historical norms for an extended period of time.

This issue was first discussed extensively in our February 2015 paper, Investing in a low return environment and the case for a lower return outlook was further explored and re-affirmed in our Five Year Capital Market Outlook dated February 2016. In particular, our outlook for economic outcomes and capital market returns has progressively worsened in recent years driven by, amongst other factors:

�� A maturing economic recovery which is now largely being supported by extraordinary monetary policy, including negative interest rates in many major economies

�� Continued falls in discounted risk-free interest rates at medium to long term horizons

�� Asset class valuations which have remained relatively elevated (and which have in fact increased in the case of both sovereign bonds and equities), and

�� Increasing downside risks, both economic and political.

Consistent with a deteriorating forward outlook, the asset class return assumptions used by Willis Towers Watson to support strategic investment advice provided to our clients have also fallen meaningfully in recent years, largely driven by reductions in expected future cash rates. An important characteristic of our historical asset class assumptions has been an assumption that inflation and interest rates revert to values which are broadly in line with historical norms, over around a 10-15 year horizon – but this assumption is increasingly at odds with market pricing.

Over time, our conviction in the assumption that yields will revert to historical norms over the next 10-15 years has decreased and we now believe that this is an appropriate time to review the process by which we set our asset class assumptions and the long-term expectations that are incorporated into our asset model.

However, we recognise that there is a range of plausible scenarios for long-term future outcomes and going forward, we will be communicating two different calibrations of our asset model and two resulting sets of asset class assumptions. In this paper we discuss the rationale for and

implications of the two different calibrations of our model, and we:

�� Set out the key factors and principles that go into setting asset class assumptions

�� Describe the two calibrations of our asset model and the expectations for long-term economic outcomes implied in each

�� Quantify the impact of adopting the two model calibrations on expected asset class and portfolio returns, compared to our previous assumptions, and

�� Consider the various purposes for which assumptions might be required and how this might impact which calibration would be most appropriate.

Introduction


averages, or alternatively to simulate future returns using a ‘bootstrap’ methodology1. We believe that historical analysis can be very useful for informing certain assumptions, in particular assumptions for risk (standard deviations) and correlations.

�� This said, markets do move through cycles and therefore it is important to analyse data over a long time period, looking across multiple countries and time periods. The main point is to understand the key trends underlying the data and to overlay judgment to set assumptions that are both realistic and which compare sensibly across economies and asset classes.

There are (at least) two general approaches that could be applied to move from current market conditions to long-term assumptions:

�� Extrapolation – an appropriate ‘curve’ is drawn between current and normative assumptions, with the timeframe for reversion to normative levels informed by historic market cycles and economic theory.

�� Expert forecasting – research is carried out and used to forecast the economic cycle, its impact on the cashflows provided by investments and the present value placed upon these by investors.

Key drivers of an assumption setting process

At a high level, there are two key elements of any process for setting asset class assumptions:

�� The basis for setting short and long-term economic and capital market expectations, and

�� The approach to setting the path by which expectations for key variables trend from the short-term to the long-term or ‘normative’ values (we refer to the long term values under equilibrium market conditions as ‘normative’).

There are two obvious and objective anchors to any process for setting future return expectations:

�� Current market pricing

�� Asset prices contain information about current market conditions/return expectations and how the market anticipates that these will evolve over time.

�� Over the very long-term we believe that, on average, the market is equally likely to be ‘right’ or ‘wrong’ about future outcomes (and by similar magnitudes).

�� Long-term history

�� The simplest way to set future return expectations (in particular real returns) would be to set these in line with long-term historical

Setting asset class assumptions

1 Also known as ‘resampling’ or historical simulation – these approaches draw random outcomes from the historical data set and use these as simulations of future returns.2 Wilkie, A. D. (1986). A stochastic investment model for actuarial use. Transactions of the Faculty of Actuaries, 39, 341–381

Key principles for setting asset class assumptions

Willis Towers Watson has been carrying out asset allocation studies and developing long-term asset class assumptions for over three decades, starting with the development of the Wilkie Model2 in the 1980s. As with any assumption setting process, the steps used to set our asset class assumptions (and also the asset model itself) are periodically reviewed and updated as both the external environment and our own views evolve.

The key principles that underpin our assumption setting process are set out below:

�� Our asset class assumptions should be forward-looking and be informed by a combination of history, theory and judgment. It is desirable that our assumption setting process is defensible, realistic and does not result in long-term expected returns that exhibit a high degree of variability over time.

�� The primary purpose of our stochastic asset model and the underlying asset class assumptions is to inform (but not dictate) the strategic asset allocation advice that we provide to our clients. As a result, having sensible relativities across assumptions for different asset classes and economies is as important as our assumptions being realistic in absolute terms/in isolation of each other.


�� An increase in the timeframe over which yields and inflation are assumed to revert from current (or starting) to normative levels.

�� There is a need for our assumptions to be fit for purpose for a wide, primarily institutional, client base that includes defined contribution and defined benefit superannuation funds, insurance funds, public sector funds, endowment funds, etc. with diverse views and possibly different requirements for asset class assumptions.

�� The main focus of our strategic advice is to demonstrate the impact of adopting different asset allocations and the beneficial impact of diversifying away from a portfolio consisting mainly of traditional bonds and equities. It is therefore more important that our model captures a wide range of asset classes at a broad level rather than a narrow range of asset classes at a granular level of detail.

Over time, our approach to both setting our long-term expectations and also the path of outcomes has evolved, with the key changes being:

�� Greater incorporation of the current economic environment and market pricing.

�� The adoption of a set of normative assumptions that are informed by long-term history which has improved the stability of our long-term assumptions (notwithstanding the above).

�� The adoption of an extrapolation approach to setting the path of inflation and interest rates, with expected equity returns set as a fixed ERP over cash, thereby increasing the objectivity (and arguably the defensibility) of our long-term assumption setting process, and


As noted above, we first introduced (mainly for internal use) an Alternative calibration of our asset model in 2011 – at this time the Alternative calibration was viewed by our Global Investment Committee as being a possible, but relatively unlikely representation of the likely range of outcomes, compared to our Standard calibration which has been used as the basis for our long-term asset class assumptions to date.

From June 2016 onwards, we will be formally developing and communicating two calibrations of our asset model and two resulting sets of long-term asset class assumptions which are based on different scenarios for the future state of the world. We believe that both model calibrations are now quite plausible representations of future outcomes and have named the two calibrations to reflect their key characteristics and the fact that different calibrations may be suitable for different clients and purposes:

�� The Yield Reversion calibration will be consistent with our previous calibration process and assumes a scenario where inflation and interest rates revert, albeit gradually, to our existing normative levels which are broadly consistent with historical norms.

Changes to our assumption setting process at June 2016

�� The Lower for Longer calibration will assume a scenario where inflation is below central bank targets and interest rates remain suppressed compared to historical norms for an extended period of time and broadly in line with forward rates implied by current yield curves.

We discuss below the rationale for considering different calibrations of our model, the basis for the two calibrations and how the two resulting assumption sets compare to each other and also our previous asset class assumptions.

Why consider a second calibration of the model?

We believe that there are a number of good reasons for us to revisit the long-term parameterisation of our stochastic asset model at the present time, including:

�� The fact that there is ‘no single right answer’ when setting assumptions and that there is a range of plausible long-term outcomes (this was an important driver of the development of the Alternative model calibration in 2011).

�� The gradual extension of the period over which interest rates return to normative levels in our model, as well as a one-off reduction in our normative cash rate assumptions at the end of 2014, reflecting a belief that the future will likely be materially different to the past.

�� The continued fall in risk free interest rates at all durations which has meant that for some time now the long-term path of forward interest rates implied by market pricing has been materially lower than what was calibrated in our model. Whilst an argument could be made that bond yields have been artificially suppressed by policy actions (which would mean that the market’s ‘true’ expectations for interest rates are in fact higher than implied by the forward rates), we believe that the implied path of cash rates over the next 5 to 10 years for most developed markets is in fact quite reasonable.

�� As economic and market conditions have evolved, our Global Investment Committee has reduced its conviction in the Standard calibration of the model and increased its conviction in the Alternative calibration.

�� An increasing divergence between our medium-term views and forecasts (developed by our Asset Research Team and which underpin our dynamic asset allocation process) and our asset model assumptions which support our strategic advice. The latter typically do not explicitly incorporate our medium-term views, unless we have a view that misalignments in markets are extreme.


Inflation and interest rate outcomes under the two model calibrations

As discussed above, the basis of the Yield Reversion model calibration is a scenario where inflation and cash rates revert from current levels to our normative assumptions over a 10-15 year period, whereas under the Lower for Longer calibration, inflation and rates remain at low levels for an extended period of time. The result of this is that the levels at which these variables are assumed to settle at in the long term (i.e. in 20 years’ time) are materially different, as summarised in Table 1 for Australia and the US.

In order to incorporate these longer-term parameters into our asset model, we extrapolate from initial (i.e. current) yields and prevailing levels of inflation to the long-term values set out in Figure 1. Figures 1 and 2 show the outworking of this process and compare the projected outcomes for inflation and cash rates under our Yield Reversion and Lower for Longer calibrations, to the path of forward inflation and interest rates that are implied by market pricing as at 30 June 2016.

Table 1. Year 21 projected inflation and interest rates

Year 21 projected values Yield Reversion Lower for Longer

DifferenceUS p.a.

Australia p.a.

US p.a.

Australia p.a.

Inflation 2.50% 2.50% 2.00% 2.00% -0.50%

Real cash rate 1.25% 2.00% 0.75% 1.50% -0.50%

Nominal cash rate 3.75% 4.50% 2.75% 3.50% -1.00%

Bond risk premium 1.00% 1.00% 0.50% 0.50% -0.50%

10 year bond yield 4.75% 5.50% 3.25% 4.00% -1.50%

Source: Willis Towers Watson

Figure 1. Projected inflation compared to implied forward rates

Source: Bloomberg LP, Willis Towers Watson. Note: Zero term premium assumed at all tenors

0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Projection Year

US Inflation

Market Implied Yield Reversion Lower for Longer

2 6 8 124 10 14 16 18 20

0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Projection Year

Australia Inflation


2 6 8 124 10 14 16 18 20


1 Assuming that the path of forward rates is a reasonable representation of the market’s expectations for future interest rates. As noted previously, an argument could be made that bond yields have been artificially suppressed by policy action which could mean that the market’s ‘true’ expectations for interest rates are in fact higher than implied forward rates (the reverse is usually true due to expectations that bonds will deliver a risk premium over cash).

As can be seen from Figures 1 and 2, the Yield Reversion calibration results in a path of inflation and interest rates that is significantly higher than the forward rates implied by market yields as at 30 June 2016, whereas the outcomes under the Lower for Longer calibration are much closer to forward rates. One possible interpretation of this is that:

�� The Lower for Longer calibration is one that assumes a prolonged period of low inflation and economic growth and that that the market is broadly ‘correct’ in its view on the path of cash rates1, and

�� The Yield Reversion calibration has a more optimistic view of economic outcomes and so effectively encapsulates a view that the market is overly pessimistic in its view on the path of cash rates.

It is important to note that adopting the Lower for Longer calibration does not necessarily imply a different set of normative assumptions – if normative assumptions are defined as outcomes in an ‘average’ regime then it is difficult to reconcile the existence of two different sets of normative assumptions.

One way to think about the two model calibrations therefore is to consider the Lower for Longer calibration as one where the key variables reach normative levels further out than the 10-15 year timeframe assumed in the Yield Reversion calibration

Figure 2. Projected cash rates compared to implied forward rates

Source: Bloomberg LP, Willis Towers Watson. Note: Zero term premium assumed at all tenors

Projection Year

US Cash Rates


2 6 8 124 10 14 16 18 200%

1%

2%

3%

4%

5%

Projection Year

Australian Cash Rates


2 6 8 124 10 14 16 18 200%

1%

2%

3%

4%

5%


Equity return outcomes under the two model calibrations

It is important that the expectations/’story’ underlying a calibration of the model are applied consistently across all asset classes. In particular, changes in the risk free yield curve should impact the pricing of all other assets. Rational investors should therefore value a return-seeking asset by:

�� Projecting the real cashflows arising from the asset

�� Making an allowance for the impact of anticipated inflation on these cashflows, and

�� Discounting the resulting nominal cashflows at the risk free rate plus a risk premium in order to form a view on a reasonable valuation for that asset (or equivalently forward-looking returns from that asset).

Applying this to equities, if it was believed that bond yields were going to rise faster than forward rates (as implied by the Yield Reversion calibration), then this would imply:

�� A headwind for equities as they de-rate in line with rising bond yields, and

�� If equity excess returns are to be maintained then the de-rating must be offset by higher than average levels of growth.

Conversely, if interest rates are expected to remain persistently low (as in the Lower for Longer calibration) then this would imply lower levels of growth and therefore lower equity excess returns. Under the Lower for Longer model calibration, we therefore also assume a lower Equity Risk Premium (ERP) compared to that assumed in the Yield Reversion Calibration, as shown in Table 2.

Using a dividend discount model, it is possible to infer from market prices the level of future sales growth that is expected by current market pricing, and historically sales growth has had a strong correlation with nominal GDP growth. Similarly, it is possible to, using the cash rate and ERP assumptions in Table 2, determine the level of future sales growth that is implied by the assumptions underlying the Yield Reversion and Lower for Longer calibrations. This is shown for the US market in Figure 3.

Figure 3 shows that the level of future sales growth implied by the Yield

Table 2. Expected equity returns under the two calibrations of our asset model

Year 21 projected values

Yield Reversion Lower for Longer

DifferenceUS p.a.

Australia p.a.

US p.a.

Australia p.a.

Nominal cash rate 3.75% 4.50% 2.75% 3.50% -1.00%

ERP 5.00% 4.50% 4.00% 3.50% -1.00%

Expected equity return

8.75% 9.00% 6.75% 7.00% -2.00%


Figure 3. Future sales growth implied by asset model calibrations compared to market pricing

Source: Bloomberg LP, Factset, Willis Towers Watson

Reversion calibration is towards the upper end (around the upper quartile) of the historical (last 16 years) range of market expectations for future sales growth. In contrast the Lower for Longer calibration implies a level of future sales growth that is towards the lower end (around the lower quartile) of the historical range. Consistent with the inflation and interest rate outcomes, this could be interpreted as saying that the Lower for Longer calibration assumes a prolonged period of low economic growth, whereas the Yield Reversion calibration assumes that future economic growth is relatively high.

US equity implied sales growth

Market Implied Yield Reversion Implied Lower for Longer Implied

0%

1%

2%

3%

4%

5%

6%

7%

8%

0 03 06 09 12 15

Year


Impact of model calibration on asset class assumptions

Expected nominal returns

To illustrate the impact of adopting different model calibrations, the expected returns over the next 10 years generated by the two model calibrations, as at 30 June 2016, for the major asset classes are set out in Table 3 below. We also compare these to the corresponding expected (Standard/Yield Reversion calibration) returns as at 31 March 2016 and 30 June 2015.

We can see from Table 3 that under the Yield Reversion calibration our expected return assumptions have generally reduced across all asset classes, by around 1% to 1.5% pa compared to June 2015 and 0.5% to 1.0% pa compared to March 2016. This has almost entirely been driven by the ongoing reduction in cash rates and bond yields which has reduced

the starting point and path for risk free interest rates over the next ten years. Under the Lower for Longer calibration, expected returns reduce even further by around another 0.5% to 1% pa compared to the Yield Reversion calibration. This is driven by the lower terminal values assumed for cash rates, inflation and the equity risk premium.

Expected real returns

Table 3 also shows that expected inflation under the Lower for Longer calibration is around 0.5% pa lower over the next 10 years than under the Yield Reversion scenario. This will offset to some extent the impact of adopting the Lower for Longer calibration when considering expected returns in real terms, as shown in Table 4.

Table 4 shows that, if the Lower for Longer calibration were adopted, compared to one quarter and one year ago this would result in a reduction in expected real returns over the next 10 years of around:

�� 0.5% pa for investment grade bonds and cash

�� 1.0% pa for return-seeking diversifying assets, and

�� 1.5% pa for listed equities.

At the total portfolio level this is likely to result in around a 1% pa reduction in expected real returns for a typical ‘growth’ portfolio, which would translate to approximately a 10% to 15% reduction in the probability of achieving return objectives expressed relative to CPI.

Table 3. Expected annual nominal return over the next 10 years (offshore assets hedged to AUD)

June 2015

March 2016

June 2016 Yield Reversion vs Lower for Longer vs

US p.a.

Australia p.a.

June 2015

March 2016

June 2015

March 2016

CPI 2.5% 2.3% 2.3% 1.9% -0.1% 0.0% -0.6% -0.4%

Cash 2.9% 2.7% 2.2% 1.9% -0.7% -0.5% -1.0% -0.8%

Australian Govt Bonds 2.9% 2.4% 1.7% 1.8% -1.3% -0.8% -1.1% -0.6%

Global Govt Bonds 2.6% 1.9% 1.1% 1.4% -1.5% -0.8% -1.3% -0.5%

Global IG Credit 3.5% 3.1% 2.1% 2.4% -1.4% -1.0% -1.1% -0.7%

Australian Equities 7.4% 7.2% 6.7% 5.4% -0.7% -0.5% -2.0% -1.8%

Global Equities 8.1% 7.8% 7.3% 6.0% -0.8% -0.6% -2.1% -1.8%

Hedge Funds 5.6% 5.3% 4.7% 4.2% -0.9% -0.5% -1.4% -1.1%

Unlisted Property 7.8% 7.2% 6.0% 5.6% -1.8% -1.2% -2.2% -1.6%

Infrastructure 8.1% 7.8% 7.2% 6.5% -0.9% -0.5% -1.6% -1.3%



Table 4: Expected annual real return over the next 10 years (offshore assets hedged to AUD)

June 2015

March 2016

June 2016 Yield Reversion vs Lower for Longer vs

US p.a.

Australia p.a.

June 2015

March 2016

June 2015

March 2016

Cash 0.5% 0.4% -0.1% 0.0% -0.6% -0.6% -0.4% -0.4%

Australian Govt Bonds 0.5% 0.2% -0.6% 0.0% -1.1% -0.8% -0.5% -0.2%

Global Govt Bonds 0.2% -0.4% -1.2% -0.5% -1.3% -0.8% -0.7% -0.1%

Global IG Credit 1.0% 0.8% -0.2% 0.5% -1.2% -1.0% -0.5% -0.3%

Australian Equities 4.9% 4.9% 4.3% 3.5% -0.6% -0.6% -1.4% -1.4%

Global Equities 5.5% 5.4% 4.9% 4.0% -0.6% -0.6% -1.5% -1.4%

Hedge Funds 3.0% 2.9% 2.4% 2.2% -0.7% -0.6% -0.8% -0.7%

Unlisted Property 5.1% 4.7% 3.5% 3.5% -1.6% -1.2% -1.6% -1.2%

Infrastructure 5.6% 5.4% 4.9% 4.6% -0.7% -0.6% -1.0% -0.9%



Linking asset class assumptions to our capital market views

While our asset class assumptions are long-term in nature, medium-term views on asset classes do inherently incorporate some view of long-term outcomes. For example, a medium term view on 10-year government bonds requires a forecast of the path of cash rates over the next 10 years.

Rather than explicitly incorporating medium-term views on the path of outcomes into the asset model, we instead reflect these when specifying which calibration of the model is our preferred calibration at a point in time1.

A summary of our key asset class views as at December 2011 and at June 2016 that influence our preferred calibration is set out in Table 5.

Our preferred calibration for the asset model

From Table 5 we can see that in December 2011 our view was that the long-term discounted path of interest rates was lower than our expectations, whilst equity excess returns were expected to be higher than ‘normal’. This meant at that time our medium-term views were more consistent with a model calibration that had a higher ERP and level of terminal interest rates (i.e. the Standard/Yield Reversion calibration).

As present, our view is that listed equities are moderately unattractive, that is that equity excess returns are likely to be lower than normal over the medium term. In addition, while we assign a moderately underweight rating to global sovereign bonds, we noted in our Global Markets Monthly July 2016 that this view relates primarily to shorter-term price risks to bonds and that our view is that the

1 This would require more frequent and possibly more substantial revisions to our asset assumptions, which runs counter to the primary purpose of the asset model, which is that it is used primarily to assist with longer term, strategic asset allocation decisions.

Table 5. Willis Towers Watson’s medium-term asset class views at December 2011 and June 2016

Asset class Dec 2011 June 2016

Global listed equities Moderately overweight Moderately underweight

Global sovereign bonds Moderately underweight Moderately underweight

medium and longer-term discounted path of cash rates is reasonable. Consistent with the above, we also have a view that economic growth is likely to remain low (sub-potential) for an extended period of time, which aligns with the lower level of future sales growth implied by the Lower for Longer model calibration. The implication of this is that, at present, our medium-term views are more consistent with a model calibration that has a terminal level of interest rates that is around market implied levels and a lower ERP.

As a result, in the absence of other considerations that we discuss in the next section of this paper, at the current time our preferred calibration is the Lower for Longer model calibration.


Table 6 summarises the key differences between the two calibrations of our asset model and the beliefs and/or purpose that would lead to one being more suitable than the other.

Determining which calibration to use

To provide further context to the discussion in the previous section of this paper, Figure 4 shows the level of conviction held by our Global Investment Committee in the two calibrations of our asset model at the current time (June 2016) and also as at December 2011.

As can be seen from the chart, whilst we had a strong preference for the Standard (now Yield Reversion) calibration at December 2011, our current preference for the Lower for Longer calibration is now slightly stronger. We would therefore describe both model calibrations as being broadly plausible. The appropriate calibration to use should therefore be

Table 6. Considerations in determining which model calibration is most appropriate

Yield Reversion Lower for Longer

Key focus/approach �� Extrapolation approach

�� Emphasis on long-term history

�� Extrapolation approach

�� Emphasis on current market pricing

Features of year 20+ projections

�� Inflation in line with policy targets

�� Real interest rates and bond yields near historical norms

�� ERP in line with historical norms

�� Inflation undershoots policy targets

�� Real yields remaining suppressed compared to historic norms

�� ERP at the lower end of the historical range

Supporting beliefs/views

�� History contains many regimes – it is hard to forecast which regime will apply many years into the future

�� Current conditions are very extreme so place less emphasis on these

�� Economic growth is likely to rise and remain above potential for at least the next five to ten years

�� Central banks resume normalised policy over the next five to ten years

�� Demographics and debt levels have been tailwinds to historical returns

�� These will become headwinds in the future so place less emphasis on historic data

�� Economic growth is likely to remain sub-par over the medium to long term

�� Central banks will continue to run easy monetary policy (relative to history) over the medium to long term

Fit for purpose �� Investors with very long (20+ years or more) time horizons

�� Where expected return outcomes need to be very stable through time

�� Where it is desirable to remove the impact of current market pricing

�� Applications that focus primarily on risk rather than return

�� Investors with medium to long term time horizons

�� Where there is a desire not to stray too far from returns implied by current market pricing

�� Where having a more objective process is desirable

Figure 4. Willis Towers Watson’s Global Investment Committee conviction in model calibrations

determined as much by the context and usage of the model and by beliefs regarding which calibration is a ‘better’ guide to the range of future economic outcomes.

December 2011 June 2016

Standard/Yield Reversion Alternative/Lower for Longer

100%

80%

60%

40%

20%

0%


Risk and correlation assumptions

The preceding discussion in this paper has focused entirely on the expected returns in the Yield Reversion and Lower for Longer calibrations of our asset model. This has been the primary focus when considering alternative calibrations of the asset model because expected returns are the first order driver of the modelled likelihood of a portfolio achieving an investor’s stated return objectives.

Turning to the risk and correlation assumptions in the model, we have chosen to maintain the same volatility and correlation assumptions in both model calibrations for a number of reasons:

�� Although the return outcomes are lower, the future state of the world envisaged by the Lower for Longer calibration is not necessarily one that is inherently ‘riskier’ or more volatile than the Yield Reversion calibration. Indeed it is possible to argue that an environment of lower inflation and potential growth, controlled rises in interest rates and stable equity valuations may in fact be less volatile than a higher growth world.

�� Similarly, there is no reason to expect that ‘normal’ asset class relationships will not apply in the state of the world assumed by the Lower for Longer calibration. For example, the justification for a lower ERP in this calibration is predicated on the relationship between bond yields, equity discount rates and equity valuations holding in the long term.


�� has a very long, multi-decade timeframe, and/or

�� has a materially more optimistic view of economic outcomes than what is currently discounted in market prices.

Conversely, an investor who uses the Lower for Longer calibration would be one who:

�� believes that future state of the world will be materially different to the past (e.g. due to headwinds from demographics and debt levels)

�� places more emphasis on current market conditions than historical data, and/or

�� believes that economic outcomes are likely to remain muted over the medium to long-term.

Adopting the Lower for Longer calibration would reduce the expected real return on a typical ‘growth’ portfolio over the next ten years by around 1% pa compared to using our assumptions from June 2015 and March 2016. Therefore, provided that the required supporting beliefs are held, it would be appropriate to adopt the Lower for Longer model

In this paper we have set out two calibrations of our asset model (Yield Reversion and Lower for Longer) which, going forward, we will maintain and use to communicate two sets of long-term asset class assumptions. We believe that both calibrations are plausible representations of long-term future outcomes. Currently, we have a preference for the Lower for Longer calibration as it more closely aligns to the long-term economic expectations implied by our medium-term asset class views.

This said, the asset model calibration/key long-term parameters that should be used to generate the asset class assumptions need to reflect both the views and beliefs of an investor, and the purpose for which the assumptions will be used.

An investor who uses the Yield Reversion calibration would be one who:

�� believes that it is difficult to predict which regime will apply over the long-term (and that historically driven assumptions are a reasonable estimate of the ‘average’ regime)

Conclusion

calibration as the basis for setting assumptions that are to be used for projecting financial outcomes over the next five to ten years.

An important example of such an application is the assessment of the likelihood of a portfolio achieving an investor’s return objectives. This could (and arguably should) in turn have implications for an investors’ investment strategy and/or objectives and we will be engaging with clients to assess the potential impact of adopting the Lower for Longer calibration of the model and, if this calibration is adopted, the appropriate actions to take in response.

Further information

For further information, please contact your Willis Towers Watson consultant, or:

Jeffrey Chee +61 3 9655 5126 [email protected]

Copyright © 2016 Willis Towers Watson. All rights reserved.WTW-AP-2016-WEB-4656

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About Willis Towers WatsonWillis Towers Watson (NASDAQ: WLTW) is a leading global advisory, broking and solutions company that helps clients around the world turn risk into a path for growth. With roots dating to 1828, Willis Towers Watson has 39,000 employees in more than 120 countries. We design and deliver solutions that manage risk, optimise benefits, cultivate talent, and expand the power of capital to protect and strengthen institutions and individuals. Our unique perspective allows us to see the critical intersections between talent, assets and ideas — the dynamic formula that drives business performance. Together, we unlock potential. Learn more at willistowerswatson.com.

The information included in this presentation is intended for general educational purposes only and should not be relied upon without further review with your Willis Towers Watson consultant. Willis Towers Watson is not a law, accounting or tax firm and this presentation should not be construed as the provision of legal, accounting or tax services or advice. Some of the information included in this presentation might involve the application of law; accordingly, we strongly recommend that audience members consult with their legal counsel and other professional advisors as appropriate to ensure that they are properly advised concerning such matters. Additionally, material developments may occur subsequent to this presentation rendering it incomplete and inaccurate. Willis Towers Watson assumes no obligation to advise you of any such developments or to update the presentation to reflect such developments. In preparing this material we have relied upon data supplied to us by third parties. While reasonable care has been taken to gauge the reliability of this data, we provide no guarantee as to the accuracy or completeness of this data and Willis Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any errors or misrepresentations in the data made by any third party. This document may not be reproduced or distributed to any other party, whether in whole or in part, without Willis Towers Watson’s prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Willis Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document including any opinions expressed herein.

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