Shortfall: The forgotten risk

June 2, 2021

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Shortfall Hero Graphic

For investors, the road toward financial goals is rarely a smoothly paved one. Along the way, there are potholes, ditches, and the occasional chasm that's all but impossible to cross.

We're aware of the pitfalls and risks that are immediately visible: volatility, maximum drawdown, illiquidity, among others. But with the generous returns that financial markets have provided over the past dozen years, one risk has easily been forgotten: shortfall risk, or the danger of not meeting your financial objectives.

And, unlike volatility and other short-term risks that can be addressed through prudent risk management or behavioral intervention to prevent panic selling, shortfalls are permanent and irreversible.

For some investors, a shortfall may only mean a modest adjustment to one's retirement lifestyle. For others—foundations, endowments, to name a few—it may mean the impossibility of meeting their mission of, for example, funding charitable grants or college scholarships.

While such asset owners may have counted on a nominal investment return of 6% or more to meet their objectives, that's becoming an unlikely scenario given current market valuations. Faced with this reality, investors may need to either increase portfolio risk for higher expected returns or pursue measures outside the investment portfolio to help guard against shortfall risk.

Shortfall risk is almost a given in today's market

Since emerging from the global financial crisis, investors have been well-compensated by simply staying invested in the markets. However, outsized returns over the past decade or so have created a gap between future return objectives and expected returns based on current historically low bond yields and high equity valuations.

Vanguard's own market models project returns in the low- to mid-single digits for the traditional core asset classes. We're not alone in this assessment. In an annual survey of capital market assumptions, 39 investment firms in 2020 gave average expected 10- and 20-year returns that were substantially lower than in 2019 for nearly all asset classes.1 (A notable exception was private equity, but more on that later.)

If return assumptions become reality, it could have dire consequences for some investors and institutions that relied on a certain return threshold to meet obligations without depleting capital or reducing future spending.

Non-investment solutions for shortfall risk

Before making any changes to an investment program, asset owners should revisit their objectives and return expectations.

In addition to creating more clarity and focus, going through this process can help identify other opportunities to fill potential shortfalls outside the investment portfolio, such as spending less and saving more.

For a nonprofit, this could mean expanding fundraising efforts, implementing cost-cutting initiatives, or reducing portfolio spending rates. These actions are likely to have a greater—and more certain—impact than any single investment decision.

Of course, some investors may not have much flexibility because of fiduciary obligations or demands on the financial portfolio; in those cases, both investment and non-investment changes may be needed.

Private equity could help overcome shortfall risk

High-quality bonds and global stocks will always have a place in any investor's portfolio. But given the greater risk of shortfalls, some investors may want to consider expanding the asset classes for inclusion in a portfolio.

Each asset class in Figure 1 can play a crucial role in a portfolio but have very different risk characteristics. For example, cash offers high liquidity and capital preservation, serving a vital role in helping to meet short-term obligations or objectives. As the investment horizon is extended, it quickly becomes the most risky investment when measured against shortfall risk.

With a 1.2% 10-year annualized expected return, cash would result in a 66% cumulative shortfall of a 6% return objective. Even a 100% U.S. public equity portfolio—with its significant volatility and drawdown risk—is expected to fall well short of a 6% return objective.

Figure 1. Risk characteristics and expected returns of asset classes

Shortfall Figure 1

Notes: The chart is a "heat map" denoting the level of risk relative to other asset classes for that given risk category. Cooler colors denote less risk; warmer colors, more risk. Maximum drawdown is the maximum loss from a peak to the trough, a measure of downside risk. Because private equity (PE) data is based on appraisals and less frequently reported than public equity, it creates artificially smooth returns, dampening perceived risk. The following indexes were used as asset class proxies: U.S. 3-Month Treasury; Bloomberg Barclays U.S. Aggregate Bond Index, Bloomberg Barclays U.S. High Yield Corporate Bond Index, Bloomberg Barclays USD Emerging Markets Government Bond Index, MSCI US Broad Market Index, MSCI World ex-USA Index, MSCI Emerging Markets Index. For private equity, we used an excess return of 350 basis points over global equities as represented by MSCI All Country World Index, a reasonable proxy for PE returns, based on Vanguard and non-Vanguard research.2

Source: Vanguard Capital Markets Model® (VCMM) as of December 31, 2020.

IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of December 31, 2020. Results from the model may vary with each use and over time. For more information, please see the Notes section.

Private equity (PE), on a standalone basis, is both high risk and extremely illiquid. However, it has the lowest shortfall risk, given its median expected return of 9.1% over 10 years in our models. In the previously cited survey, other investment advisors gave an average expected return of 9.2% over 10 years and 10.2% over 20 years—the highest among all the asset classes.

What would happen if you added PE into the portfolio mix, increased risk allocations, or both? Would it give our hypothetical portfolio the ability to bridge the chasm of shortfall risk?

Adding risk to reduce risk

Figure 2 looks at globally diversified portfolios, some with 60% in equities and 40% in fixed income and others with 70% equities and 30% fixed income. Within the equity portion of the portfolio, some have 10%, 20%, or 30% devoted to PE. (For a 60/40 portfolio, that translates to 6%, 12%, and 18% of the overall portfolio in PE, respectively.) The bars indicate the probability of meeting or exceeding annualized returns of 6% over 10 years.

Figure 2. Probability of exceeding 6% annualized 10-year nominal returns

Shortfall Figure 2

Notes: Half the hypothetical portfolios have 70% in equities and 30% in bonds; the other half have 60% in equities and 40% in bonds. The percentage in PE refers to the percentage of the equity allocation in PE, so 10% PE means 10% of the equity allocation (or 7% of an overall 70/30 portfolio or 6% of an overall 60/40 portfolio). Within public equities, we assumed a mix of 60% domestic stocks and 40% international stocks; within bonds, 70% domestic and 30% international. The following benchmarks were used as asset class proxies: MSCI US Broad Market Index, MSCI All Country World ex-USA Index, Bloomberg Barclays U.S. Aggregate Bond Index, Bloomberg Barclays Global Aggregate ex USD Index (USD hedged). For PE, we assumed a 350 bps excess return over global equities as represented by MSCI All Country World Index.2

Source: Vanguard Asset Allocation Model, as of December 31, 2020.

In almost all cases, increasing PE allocations as a percentage of total equity improved the overall probability of meeting or exceeding a 6% return. Interestingly, the 60/40 portfolio with 30% private equity (or 18% illiquid and 82% liquid assets) has the same 27% probability of achieving a 6% return as the 70/30 portfolio with no PE.

This illustrates the potential trade-off decisions asset owners may need to face. Here is a clear example where they can either increase risk allocations to maintain 100% portfolio liquidity or keep risk assets steady but take on some portfolio illiquidity to improve the chances of success.

Ultimately, these decisions may not be mutually exclusive. Depending on the asset owner's comfort level with different risks and what they deem a minimum acceptable probability for achieving return objectives, they may pursue some combination of the above.

One avenue, of course, is to reassess how low of a return can sustain the investor's objectives. In our examples, the probability of meeting a 6% return remains daunting, even with the addition of PE. However, if you lower the expected return to 4%, the probability significantly increases, ranging from 53% to 75% for the hypothetical portfolios in Figure 3.

Figure 3. Probability of exceeding 4% annualized 10-year nominal returns

Shortfall Figure 3

Source: Vanguard Asset Allocation Model, as of December 31, 2020. This chart uses the same assumptions as the previous chart.

Interestingly, adding PE to the 60/40 portfolio increased the expected return to the point that it matches or exceeds the return of the supposedly riskier 70/30 portfolio without PE.

What's around the bend?

The future will always remain uncertain. In the end, all investing involves trade-offs, and no single portfolio can meet all needs. These sample strategies can jump-start the conversation to expand the definition of risk and refine what's important to each individual or institution.

It is only human to worry about the more immediate and visible risks such as volatility and illiquidity. But most investors do not need 100% liquidity. If that were true, none of us would buy our own homes or invest in real capital. An institution having 18% of the portfolio locked in private equity still means 82% of assets are liquid and available for spending needs, but the overall portfolio may achieve higher returns over the long run.

This is not to say that PE is the solution for all. Most individual investors and even some institutions would not meet PE eligibility requirements, eliminating it as an option. PE investments are complex and require patience. They are a long-term commitment of investment capital and can experience negative returns in the early years until underlying investments mature. Restrictions limit an investor's ability to transfer or sell PE investments.

In addition, there are other avenues to address shortfall risk, some unrelated to the investment portfolio. Cutting discretionary spending or launching a fundraising campaign may provide a better return than adding a riskier asset class to the portfolio.

But clearly, investors should not be so focused on temporary risks that they lose sight of the greater long-term risk of shortfalls. On the road toward financial goals, you can easily ride out most potholes—just make sure you have a spare tire. But you don't want to come upon the chasm with no way across. With the proper planning and navigation, that should not be an issue.


Francis M. Kinniry, Jr., CFA
Global Head of Private Investments

Edward M. Dinucci, CFA
Senior Private Investment Specialist

1 Horizon Actuarial Services, LLC. Survey of Capital Market Assumptions: 2020 Edition. July 2020. The survey included return assumptions from 39 investment advisors, though some were obtained through published white papers. (Vanguard was among the latter.) Expected 10-year returns across asset classes on average were 27 basis points (bps) lower than in 2019 and 35 bps lower for 20-year returns.

2 For more details on the methodology and assumptions used for PE performance, please refer to The Role of Private Equity in Strategic Portfolios and The Case for Private Equity at Vanguard.


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