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1 April 2017 CFA Institute Journal Review

On Measuring Performance toward Retirement (Digest Summary)

  1. Sandra Krueger, CFA

The true goal of future retirees is to receive a desired payout at retirement. Given this goal, investment performance should be evaluated using a desired target rate of return. This approach gives future retirees a better picture of their portfolio than does comparing results with such indexes as the S&P 500.

What’s Inside?

The performance measures of Harry Markowitz’s modern portfolio theory (MPT) framework are ill suited to the needs of investors trying to achieve a prescribed payout. The authors apply the theories of what has been collectively called the post-modern portfolio theory (PMPT) framework to construct and measure portfolio performance for future retirees. They believe that performance in this context should focus on the desired target rate of return (DTR) needed to achieve the desired payout at retirement and that the standard investment objective of future retirees should be to maximize the potential to exceed their DTR, subject to the risk of falling below it. In PMPT, the focus is not on wealth maximization but rather on the strategy that helps investors navigate through market cycles to achieve their DTR.

How Is This Research Useful to Practitioners?

This approach is useful to investment advisers who help define investment objectives for their clients. Reports can plot DTRs against time to demonstrate how investors are progressing toward their goal of achieving the desired payout at retirement. By using pictures, investors can see at a glance whether they are on course for meeting their retirement goals. The authors draw attention to the inadequacies of brokerage accounting reports, which often show returns that do not tell investors whether they are on course for their future retirement goals.
In some circumstances, using a DTR approach may help make it obvious that the extra risk an investor is taking in pursuit of higher returns is done voluntarily—that is, because the investor wants higher returns, not necessarily because the investor needs them.
In addition, compliance and risk professionals should consider this research as it relates to client suitability rules. Risk tolerance questionnaires can ask the wrong questions and end up misleading investors, who sometimes adopt an approach that is too conservative. Unsatisfied clients can result in bad press and reputational damage.
Finally, the DTR approach is a derivative of the larger ongoing industry debate on the efficacy of the money-weighted (or internal) rate of return versus the more ubiquitous time-weighted rate of return. The former is more appropriate for calculating client-specific performance, whereas the latter is more suitable for portfolio manager performance.

How Did the Authors Conduct This Research?

The authors describe two case studies from the Pension Research Institute (PRI) that use a DTR approach for portfolio asset allocation. The first case study assumes that a 401(k) participant was 55 years old, had a $700,000 balance in a defined contribution plan, and began investing at the top of the market in 2007. The results show that a DTR strategy would have kept her invested throughout the market collapse and on track to meet her retirement payout goal in March 2011.
The second PRI case study, currently in progress, uses an investment of $100,000 with a DTR of 8% to demonstrate how using a DTR approach could help small investors.

Abstractor’s Viewpoint

Some in the industry call the DTR by other names—for example, the required rate of return or simply the target return. It would be interesting to know the type of advisers who currently use the DTR approach with their clients and whether their clients’ expectations are being met. The authors discuss the theoretical performance of one US investor using US exchange-traded funds. This research could be extended to include international investors and other assets.

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