Robert C. Merton, 1997 Nobel laureate, wrote in the July-August issue of Harvard Business Review: “The seeds of an investment crisis have been sown. The only way to avoid a catastrophe is for plan participants, professionals and regulators to shift the mindset and metrics from asset value to income.”
Mr. Merton in his article, “The Crisis in Retirement Planning,” echoes our view that everyone is focusing on the wrong goal. As he wrote: “If the goal is income for life after age 65, the relevant risk is retirement income uncertainty, not portfolio value.”
Mr. Merton goes on to make many cogent observations. What we focus on is the implication for performance measurement.
Whose performance are you measuring? For too long the performance of money managers has been presented as synonymous with the participant's performance toward their goal. Participants are deluged with returns on each manager for the past three months, one year, three years, five years, but always with a warning, “Past returns may not predict future returns.” How about “seldom ever predict future returns”? Then to fill up a few more pages of the performance report, each manager is measured against the returns of a benchmark like the Standard & Poor's 500 stock index or some other index irrelevant to a participant's real needs. What do any of these returns over some arbitrary time period have to do with showing the participants where they are with their retirement savings program relative to their goal? Nothing.
Calculating the mean or the standard deviation of historic returns to capture a past experience or tell you anything meaningful about future experiences is like trying to remember the date and time of day you first saw the Grand Canyon. Conjuring up an image is what the mind does. That image captures more than just the date and time of day you saw it.
We need to stop relying on the mean and standard deviation from past returns and use statistical advancements like a bootstrap procedure developed by Bradley Efron, professor of statistics and biostatics at Stanford University, to conjure up a more complete picture of past financial experiences in a way that provides a better predictor of future performance.
Instead of relying solely on what did happen in the past few years to generate a few misleading returns and standard deviations, it presents a picture of what could have happened from which we can calculate the potential to exceed the return needed to achieve a specified payout relative to the risk of not achieving that payout. It is applicable to defined benefit as well as defined contribution plans.
As Mr. Merton rightly wrote, “(T)o my mind it's a real stretch to ask people to acquire sufficient financial expertise to manage all the investment steps needed to get to their pension goals. That's a challenge even for professionals.” We agree. The plan sponsor should not attempt to transform the participant into a professional portfolio manager, but instead use the managed account qualified default investment alternative options to provide the plan participant with a professional who has those skills.
Where we differ
While there is much that we agree with in Mr. Merton's important article, we have key important differences.
Mr. Merton ignores the return each investor needs to earn on their investment over time to achieve that desired payout at retirement. Instead Mr. Merton posits a “safe, risk-free asset,” which, if you had enough money and it existed, would be an inflation-protected annuity. We do not believe such a thing can be created through a liability-driven investment strategy called immunization. We are familiar with immunization strategies and know something of their shortcomings. Why would anyone want to lock in, say, a 4% return when what is needed is more than 8% to fund a plan? That is locking in a 4% loss. As interest rates rise when Federal Reserve policy inevitably abates, the pain of losses in bond portfolios will not be perfectly offset by a decrease in liabilities because immunization never works perfectly. As a result, liabilities will still be underfunded.
We do not see 401(k) plans as a liability problem. We see 401(k) plans as an asset-liability management problem. As we have pointed out for many years, the link between assets and liabilities is the return that discounts all those future payouts after retirement to the present value of the current assets and future contributions. This discount rate is directly related to what the participant is trying to achieve, whereas the mean and standard deviation of historic returns are not and interest rate risk is not.
We originally called this discount rate the minimal acceptable return, but attorneys have convinced us the word “minimal” could be misunderstood to be a promise. For that reason we changed it to “desired target return.” We believe this measure is the single most important calculation one can make with respect to any investment whose goal is some future payout. The upside potential ratio is based on the entire distribution of investment outcomes and focused on the return that must be earned on the assets to meet the desired payouts for retirees. It is the potential to exceed the DTR relative to the risk of falling below the DTR. That risk/reward trade-off is relevant to what the investor is trying to accomplish.
We close with a major point of agreement with Mr. Merton, when he wrote: “Clearly, the risk and return variables that now drive investment decisions are not being measured in units that correspond to savers' retirement goals and their likelihood of meeting them. Thus, it cannot be said that savers' funds are being well managed.”
But following our suggestions, outcomes could be better.
Frank Sortino is professor emeritus in finance and Hal Forsey is professor emeritus in mathematics at San Francisco State University. Both are principals at Sortino Investment Advisors LLC, Menlo Park, Calif.
This article originally appeared in the November 24, 2014 print issue as, "Everyone is focusing on the wrong goal in retirement planning".