Recognizing That All “Rates of Return” Are Not the Same

By Jeff Chang

As a “baby-boomer” and one of the millions of my generation getting ready for retirement, I’ve naturally begun to focus more on the ups and downs of the stock market and all of the “advice” regarding how and when the current bull market will correct itself. Admittedly, I am not an investment advisor and this blog is not about handing out specific investment advice. However, I do feel qualified to share a few basic observations about investing practices and behavior that may be of interest and use to participants managing their own retirement investments or plan fiduciaries responsible for ultimate pension or OPEB obligations.

Observation No. 1 – Not all “rates of return” are the same, particularly when you are in withdrawal or distribution mode. Many, if not most, funds and advisors make claims about the rates of return of certain funds over various time periods. Generally, these rates of return represent averages of each annual return over the specified period. However, due to a phenomenon referred to as the “sequence of returns,” individuals (or plans) that are in “pay-out mode” can experience dramatically different results in their remaining portfolios – even though they are all obtaining the same “average rate of return.” This effect is well-illustrated by two graphs, published by BlackRock.

Observation No. 2 – You want to avoid downside risk just as you are beginning (or getting ready) to retire. One of the corollaries of the sequence of returns is that during a “distribution period” it is better to take loss in return later, when it will have a lesser impact on you overall savings. In other words, a 25 percent loss will have a much larger impact on your retirement account if you suffer it at a time, (say, when you’re 65) when you have $1 million in savings versus at a later time when you have only $250,000 in savings. If this makes sense to you, it should suggest that, depending on your overall retirement savings plan (and the relative importance of your defined contributions/401(k)/457(b) account(s)), you may not want to expose large portions of your “hard-earned savings” to a significant loss.

Observation No. 3 – Portfolio re-allocation may not be the same as portfolio insulation. As described in my earlier blog on liability-driven investing, if your investment horizon is getting shorter – that is, you are getting ready to draw on (and rely on) your retirement savings – it may make sense to change and match your investment approach to better ensure that you can meet your obligations rather than aspire to obtain certain “long-term” rates of return. For example, a “moderate” 60/40 portfolio that starts with $1 million, but loses 20 percent of its value, becomes $800,000. On the other hand, a $1 million portfolio that is invested $600,000 in 1 percent money-markets and $400,000 in diversified equities, would end up in a far different place, even if the stock portion lost 25 percent of its value ($606,000 + $300,000 = $906,000).

Observation No. 4 – Be aware of, and honest about, your investment horizon. I see too many individuals and cities still trying to chase returns and squeeze every last bit out of the current bull market. The big question is: Can you tell when the bull market is over and when to get out? Given the fact that most “boomers” and cities don’t have time to recover from significant losses to their retirement savings (or pension investments), your shortening investment horizons should be a major factor in your decision-making. For example, if a 65-year-old with $1 million in savings suffers a 30 percent loss all at once, she would need 4 consecutive years of 10 percent returns to get back to where she was. If you don’t have the time to recover from such a loss, consider your risk tolerance in conjunction with your retirement time horizon. These are fundamental investment concepts – ones that apply equally to individual retirement accounts and to much larger pension/OPEB funds.

Jeff Chang is a partner at Best Best & Krieger LLP. He has four decades of experience skillfully evaluating benefit and retirement plan compliance to achieve maximum outcomes for public agency clients throughout California. He can be reached at jeff.chang@bbklaw.com or (916) 329-3685.

Print Friendly, PDF & Email
This entry was posted in Investments, Retirement Plans and tagged , , , . Bookmark the permalink.

Comments are closed.