Magazine article Phi Kappa Phi Forum

Why We Are Losing the War on Investing for Retirement (and How to Win It)

Magazine article Phi Kappa Phi Forum

Why We Are Losing the War on Investing for Retirement (and How to Win It)

Article excerpt

New advances in technology, communications, and investment theory might make you think we are finally winning the war on investing for retirement. We are not. Here is why and how you can change the outcome.

The year was 1974, not long after I had graduated from college, and it was a big day for my father, who had just retired after thirty years of hard work and many personal sacrifices. I watched as he ceremoniously handed my mother his first pension check--for $478.

"This is it?!" She actually pulled on the check in an attempt to stretch it. "This is what they expect us to live on?!" My dad rubbed his forehead, dropped his shoulders, and walked out of the kitchen--there was nothing he could do about it.

My dad had accepted the notion that his loyalty to his employment would ensure an income during his retirement, but he never looked at whether it would be enough income. During his earning years, participation in a pension plan was passive, and the benefit was defined. Company management made all the decisions based on their own agenda--covering that defined benefit while protecting their personal liability.

To dilute that liability, retirement-investment vehicles evolved to shift the investment decisions into the hands of the participants--the people with the least expertise to be making those decisions. Management's role was carefully delineated by the 1974 Employee Retirement Security Act known as ERISA, and today, more than 90 percent of employment-related retirement investing is in some type of participant-directed plan.

As one of our largest-ever demographics entered its peak earning years and dollars flowed into these plans, both fixed and equity markets reflected this growth in the longest-running bull market in history. That environment was responsible for misleading a large contingent of the investing population into believing that big returns were there for the taking; all you had to do was find the latest "hot pick" based on previous performance. After all, the marketing departments of mutual funds were touting average annual returns of 25 percent on a regular basis. That was all the information individual investors needed to make their decision. Little did they know that a conservative fund with a 10 percent compounded rate of return could yield more than a fund with an average annual return of 25 percent. Huh?

Say we put $10,000 into an aggressive fund and the next year, the fund loses 50 percent; our account has dropped to $5,000. Luckily the following year, the fund doubles and our account is back to an even $10,000. Our return on this investment over two years is zero; but the fund's average annual return is 25 percent (-50% + 100% = 50%/2 years = 25%). That same $10,000 invested in a conservative fund with only a 10 percent annual return makes $1,000 the first year and $1,100 the second year (+10% + 10% = 20%/2 years = 10%); the account is now worth $12,100 of real money, because of the higher compounded rate of return.

The average investor still looks at past performance as if it is a promise of future outcome and does not understand how the fund's return was generated or what that will mean to the dollar value of his or her account in the future. So, how do you think the individual investor fared during the "can't lose" era? Not very well. The table on the preceding page reflects a study by Dalbar, a highly regarded researcher of the financial industry, called the Quantitative Analysis of Investor Behavior (or QAIB), which compares performance for the period 1984 through 2002.

The important stats to notice here are that the S & P 500 has averaged 12.22 percent per year since 1984, but the individual equity investor has averaged only 2.57 percent. The whole point of investing in stocks is to beat low-yielding bonds and inflation over time, but the study reveals that the average bond investor beat the average equity investor almost two to one, returning 4. …

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