Odds are you don’t run a hedge fund; you just manage a relatively more modest retirement account like a 401(k) or IRA—essentially a pension plan for one. But even if your account is much smaller, managing those investments isn’t much easier. Even professionals with years of training, lots of assets, and an army of consultants mess it up. The average guy needs help looking at his yearend statements that should be arriving soon. But most of the tools at his disposal steer him onto the wrong track because they are more appropriate for running a hedge fund than a pension plan.
Hedge funds try to grow wealth and (often but not always) beat the market. Pension funds solve a different problem: pay out income to retirees. Each of those objectives has different measures of success. Professional investors often judge a hedge fund by comparing its performance to a benchmark, usually an index of similar assets. Their objective is (roughly) earning more than that benchmark. Pension funds also use these benchmarks to judge how their assets performed, but beating the benchmarks is not the primary goal. First, they calculate how much money they need to pay current and future retirees. Next, they adjust (or at least they are supposed to) their investments to make sure they can make those payments with as little risk as possible. This is a far cry from how the vast majority of people consider their investments.
Too much focus on fund performance
Your portfolio is likely made up of several index or mutual funds. Each of them has a benchmark you can look at to see how well it fared relative to the competition over the last few years. But this isn’t necessarily very helpful when it comes to retirement because your needs are more long-term. How your funds did relative to your coworkers’ last year does not tell you if you are on the right track.
However, it’s becoming more likely you’re invested in a target date fund, which invests in a mix of stocks and bonds, and moves more into bonds as you age. According to David Blanchett, head of retirement research for Morningstar Investment Management, most investors shouldn’t bother comparing their assets to benchmarks. “Eighty percent of people should be in a target date fund and defer to that,” he says. That way all you have to do is pick how much you save each pay-cycle, which Blanchett says is the most important decision you can make.
Blanchett says if you do want to check on how well your target date fund is doing, you can look at a Morningstar analyst report. These reports compare your target date fund to benchmarks (along with other “forward looking” factors), come out with a simple rating—gold, silver, and bronze are all good, and neutral or negative are less good. If your fund has a high rating, you can relax. Otherwise, you may want to ask your benefits person why this fund was chosen for you.
A target for the target
But Brett Hammond of MSCI, which develops stock indices many money managers commonly use as benchmarks, thinks these sorts of ratings are inadequate. The ratings appear to put a heavy weighting on how a particular target date fund performed relative to other target date funds, often the largest. That puts pressure on other funds to not stray too far from the industry average, rather than sticking with a proper investment strategy.
Furthermore, retirement investors are investing for decades and need assurance their assets can finance a comfortable retirement. Hammond thinks individuals should invest more like defined benefit plans do (at least in theory) by focusing on meeting their liabilities rather than the recent performance of their assets.
In other words, he says, “We need a target for the target.” That means assessing your personal goals and making sure you are on track to meet them. That may sound more complicated than just checking a single rating that applies to everyone—but it needn’t be. Hammond developed a ratio based on your asset balance and current salary. If that ratio is near one, or above, you are in good shape. If it’s very small, you may need to consider saving more or taking on more risk. If it’s far above one—Hammond’s cut-off is 1.2—you are in great shape and may want to consider cutting back on stocks to lock-in all those good returns before the market falls again.
Distilling complex pension accounting into a single, accessible metric requires some heroic assumptions about the future of interest rates and what your future salary will be (most people assume you should shoot to replace 70% of what you earned just before retirement). Even professionals struggle to figure this stuff out and often get it wrong.
But difficulty is no excuse to leave the average investor with subpar tools. Traditional benchmarks can steer savers astray by over-focusing on short-term performance and not providing a picture of their long-term needs. Some crude version of the asset salary ratio could be calculated and included on 401(k) and IRA statements. It’s not a perfect solution, but at least it gets savers thinking about their goals and if they have any prayer of meeting them.