The researchers argued that their proposed approach to benchmarking “could potentially help investors obtain a clearer picture of the long-term returns a fund provider expects to deliver, a fund’s track record relative to those expectations, and the relationship between fund returns and a “typical’ investor’s ability to finance retirement,’ the researchers said in the paper.
“Target date funds pursue a unique, goals-based objective, using a combination of securities and ‘packaged’ advice to help investors accumulate sufficient resources for retirement,” the Vanguard researchers wrote. “Existing benchmarks provide no sense of the funds’ success in meeting this objective. It is almost as if a tour guide agreed to take a traveler from A to B, but never clarified how the pair would get to B, or even precisely where B was. The traveler would be lost.”
Common current approaches to benchmarking include: a comparison with Morningstar or Lipper peer groups; a custom peer-group or index benchmark in which fund performance is compared with the return of a hypothetical portfolio with an identical asset allocation; or target date fund indexes, such as those by Dow Jones, where an index provider creates an index for each target maturity date and shifts the asset allocation toward a more conservative mix as the maturity date approaches.
Part of the problem with the use of existing benchmarks, the paper commented, is that they tend to emphasize short-term volatility rather than long-term return because existing benchmarks are typically used to assess six- or 12-month performance.
Vanguard researchers propose two new complementary benchmarks: one that identifies the return required by the typical investor to reach retirement sufficiency and the second to examine fund performance relative to the investment manager’s return expectations.
When examining whether a fund would be successful in helping the typical target date fund investors (based on the average income earner and average contributor) attain sufficient retirement assets, the researchers’ analysis had three steps:
- It determined the savings target for a typical investor at retirement (age 65). It established the savings target as the amount of money that will allow investors, in 85% of the scenarios, to maintain their pre-retirement standard of living during retirement, without running out of money by age 95.
- Next the paper identified the rate of return required to achieve the savings target over a 40-year savings period. This analysis does not incorporate financial market uncertainty or the lifecycle pattern of asset allocation. Vanguard’s calculation based the amount and timing of the investor’s contributions on the lifecycle pattern of income and the average contribution behavior of the 401(k) participant population for the given income level. Based on these retirement plan savings rates, an investor would need to earn a real return (above inflation) of 1.6% to 3.8% to reach the savings-sufficiency target by age 65.
- The final step established the required rate of return with a margin of safety. Vanguard recognized that a number of individual or 401(k) plan specific factors could change the wealth accumulation pattern. For example, these found in step two increased for those without employer medical benefit or a decline in Social Security replacement (for which the necessary returns increase to 3% or 5% above inflation).
The second proposal Vanguard puts forth is to benchmark relative to return expectations. This approach specifies what return an investment manager expects to earn and then reports actual returns relative to those expectations. In this method, the researchers said that the provider is held accountable for the appropriateness of the return assumptions used in constructing the funds. “The proposed benchmark ensures that the manager is evaluated against the investment objectives it sets forth—in effect, the “advice’ that it is proposing as a solution to the challenge of building and managing an appropriate retirement portfolio,’ the paper states.
Current benchmarking is flawed, the paper concludes: “What constitutes retirement security—and the expectations that inform the investment manager’s plan for helping investors achieve it—is never made clear.’ However, the two new approaches proposed, “have a variety of merits as benchmarking tools that could potentially fill the information gap that has prevented investors from conducting a meaningful evaluation of these powerful retirement-savings vehicles.”