The Equity Risk Premium (ERP) is an essential building block of the market value of risk. In theory, the collective action of all investors results in an equilibrium expectation for the return on the market portfolio excess of the risk-free return, the equity riskpremium. The ability of the valuation actuary to choose a sensible value for the ERP, whether as a required input to CAPM valuation, or any of its descendants, is as important as choosing risk-free rates and risk relatives (betas) to the ERP for the asset at hand. The historical realized ERP for the stock market appears to be at odds with pricing theory parameters for risk aversion. Since 1985, there has been a constant stream of research, each of which reviews theories of estimating market returns, examines historical data periods, or both. Those ERP value estimates vary widely from about minus one percent to about nine percent, based on a geometric or arithmetic averaging, short or long horizons, short or long-run expectations, unconditional or conditional distributions, domestic or international data, data pe/iods, and real or nominal returns. This paper will examine the principal strains of the recent research on the ERP and catalogue the empirical values of the ERP implied by that research. In addition, the paper will supply several time series analyses of the standard Ibbotson Associates 1926-2002 ERP data using short Treasuries for the risk-free rate. Recommendations for ERP values to use in common actuarial valuation problems will be offered.
The Equity Risk Premium (ERP) is an essential building block of the market value of risk. In theory, the collective action of all investors results in an equilibrium expectation for the return on the market portfolio excess of the risk-free return, the equity risk premium. The ability of the valuation actuary to choose a sensible value for the ERP, whether as a required input to CAPM valuation, or any of its descendants1, is asimportant as choosing risk-free rates and risk relatives (betas) to the ERP for the asset at hand. Risky discount rates, asset allocation models, and project costs of capita I are common actuarial uses of ERP as a benchmark rate.
The equity risk premium should be of particular interest to actuaries. For pensions and annuities backed by bonds and stocks, the actuary needs to have an understanding of the ERP and its variability compared to fixed horizon bonds. Variable products, including Guaranteed Minimum Death Benefits, require accurate projections of returns to ensure adequate future assets. With the latest research producing a relatively low equity risk premium, the rationale for including equities in insurers' asset holdings is being tested. In describing individual investment account guarantees, LaChance and Mitchell (2003) point out an underlying assumption of pension asset investing that, based only on the historical record, future equity returns will continue to outperform bonds; they clarify that those higher expected equity returns come with the additional higher risk of equity returns. Ralfe et al. (2003) support the risky equity view and discuss their pension experience with an all bond portfolio. Recent projections in some literature of a zero or negative equity risk premium challenge the assumptions underlying these views. By reviewing some of the most recent and relevant work on the issue of the equity risk premium, actuaries will have a better understanding of how these values were estimated, critical assumptions that allowed for such a low EPR, and the time period for the projection. Actuaries can then make informed decisions for expected investment results going forward.
In 1985, Mehra and Prescott published their work on the so-called Equity Risk Premium Puzzle: The fact that the historical realized ERP for the stock market 1889-1978 appeared to be at odds with and, relative to Treasury bills, far in excess of asset pricing theory values based on investors with reasonable risk aversion parameters. Since then, there has been a constant stream of research, each of which reviews theories of estimating market returns, examines historical data periods, or both.3 Those ERP value estimates vary widely from about minus one percent to about nine percent, based on geometric or arithmetic averaging, short or long horizons, short or long-run means, unconditional or conditional expectations, using domestic or international data, differing data periods, and real or nominal returns. Brealey and Myers, in the sixth edition of their standard corporate finance textbook, believe a range of 6% to 8.5% for the US ERP is reasonable for practical project valuation. Is that a fair estimate?
