Dr. Frank Sortino and Dr. Hal Forsey
In the July-August issue of Harvard Business Review, Dr. Robert Merton says; “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 mind-set and metrics from asset value to income. Merton goes on to say, “Investment value and asset volatility are simply the wrong measures if your goal is to obtain a particular income.” We highly recommend you read this article. While we do not agree with his solution, We do believe he makes many cogent observations. What we would like to focus on now 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 last 3 months, 1 year, 3 years, 5 years…but always with the warning that 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 on a benchmark, like the S&P 500 or 50 other irrelevant indexes. What do any of these returns over some arbitrary time period have to do with showing the participant where they are relative to their goal? NOTHING!
Forget the moments: Recalling the first moment (the mean), or second moment (the standard deviation) from historic returns to capture a past experience or tell you anything meaningful about future experiences is like trying to remember the experience of seeing the Grand Canyon for the first time by recalling only the date and time of day you saw it. Conjuring up an image is what the mind does. Better yet, take a picture that will capture what you saw and what to expect the next time you go there.
Here is the big picture taken with our special 21st century camera. Think of it as a financial X-ray camera. Do you have a clue as to what Graphic 1 is portraying? In addition to the graphic being too small it is not intuitively obvious (Click on the picture).
Merton rightly says: “to 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. You’d no more require employees to make those kinds of decisions than an automaker would dump a pile of car parts and a technical manual in the buyer’s driveway with a note that says, “Here’s what you need to put the car together.”
Well, we are not talking to a car buyer. We are talking to people who have the fiduciary responsibility for seeing to it that the 401(k) buyer is getting her money’s worth. For that reason, YOU, the fiduciary, need to learn more about how to help your client, your employee, your participant…your beneficiary. You don’t need to learn how to read X-rays in order to benefit from them, but you do need to know they exist and that you can go to a doctor with the training to read them.
So, let’s get started: the blue image shows the entire range of possible returns for the passive indexes that exactly fill up all those asset allocation boxes at the top of graph 1. The black image shows what happens when you add those few active managers, out of thousands of possible managers, who could actually add value. The arrow points to the upside potential ratio that shows the optimal portfolio with active managers has 30% more upside potential than downside risk, where risk is that you will not have enough money at retirement to achieve the payout that Merton says is the true goal. The totally passive portfolio has 10% more downside risk than upside potential. There can be no justification for choosing the totally passive portfolio. PRI has provided empirical evidence that the statistics provided in Graph 1 are better predictors of future performance than the mean and standard deviation of returns (historical, current, or projected). So, what information should the plan sponsor pass on to their employees?
Relevance: Merton has this to say on that subject: “The only feedback she needs from her plan provider is her probability of achieving her income goals. She should not receive quarterly updates about the returns on her investment (historical, current, or projected) or about the current allocation of her assets. These are important factors in achieving success, but they are not meaningful input for the choices about income that the customer has to make.” So, we say, the plan sponsor should not require the participant to make those choices, but instead, use the managed account QDIA option to provide the plan participant the following information:
The MapVest® report shown above says, in the top left hand corner, “Currently, you are on track to replace 70% of your pre-retirement salary from your retirement account.” There is more, but suffice it to say, what Merton calls for, we can deliver.
Where we differ:
While there is much that we agree with in Dr. Merton’s important article in Harvard Business Review, there are these important differences:
- Merton’s solutions ignore the return each investor needs to earn on their investment over time to achieve that desired payout at retirement. Instead 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.” I did my doctoral dissertation on immunization strategies. In our opinion, the costs associated with trying to create Merton’s Category 1 or 2 inflation protected income vehicles are not worth the hidden risks.
- We do not see 401(k) plans as a liability management problem, as Merton claims. 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 Desired Target Return® 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. Therefore, the DTR® is the single most important calculation one can make with respect to any investment whose goal is some future payout.
Conclusion: If participants are ever to achieve the goal of replacing a percentage of their salary at retirement we are going to have to drastically change the way we measure their performance toward their goal. It is up to the plan sponsor to demand a solution for participants designed around the Desired Target Return that leads to each participant’s payout goal. We end with a thank you to Dr. Merton for his important insights and a major point of agreement:
Merton: “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.”
 Bernardo Kuan’s study, page 30, the Sortino Framework for Constructing Portfolios, El Sevier, Amazon.com