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.