Choice of Benchmark When Forecasting Long-term Stock Returns

Recent advances in pension product development seem to favour alternatives to the risk free asset so often used in financial theory. In this paper, we investigate other benchmarks of the financial model than the classical risk free asset; for example, a benchmark following an inflation index is just one important case. Modelling extra returns above the inflation of risky assets is important, for example, for actuarial applications aiming at providing real income forecasts for pensioners. We study market timing when three alternative benchmarks are considered: the risk free rate, inflation and the long bond yield. We conclude that forecasting future stock returns is of similar complexity for all three considered benchmarks. From a pension fund modelling perspective, it therefore seems that one should use the most convenient benchmark for the problem at hand.