It seems more Americans are taking responsibility for managing their own retirement assets instead of relying solely on a pension. Many are also wondering how to fund the period after the traditional retirement age. Given these factors, we believe thinking about a retirement goal has never been more crucial. While there are books that cover the risks involved in contributing or investing for retirement, we are drawn to a simple but effective definition of risk when it comes to retirement. Risk can be defined as the possibility that your retirement assets will not provide for your essential living expenses. While many risks are contained within this overarching statement, this definition can help clarify one s personal retirement goal. This allows us to state a simple retirement goal for most individuals: provide the cash necessary to fund essential purchases during retirement. Certainly, many people will have additional, more complex retirement goals, such as leaving a legacy to future generations or moving beyond just essential purchases. However, this distilled definition of risk should assist with a discussion of the benefits of setting a retirement goal. This discussion should include the following points: goals beget action; clarity of purpose; and pitfalls to avoid. E. William Stone, CFA, CMT Chief Investment Strategist Marsella Martino Senior Investment Strategist Christopher D. Piros, PhD, CFA Director of Investment Strategy Michael Zoller Investment Strategist Goals Beget Action Because retirement is a long-term goal (until it is not), contributing and investing for it unfortunately can end up being displaced by shorter-term concerns. Setting a goal that focuses on retirement and the actions needed to reach that goal can help avoid the all-too-common human trait of procrastination. It is a rare individual, we observe, who chooses to forego current enjoyment through spending money rather than saving money without focusing on the long-term value of the sacrifice. A focus on the retirement goal should help properly place retirement among one s financial priorities. You might ask, why is a focus on retirement so important? Time is the investor s friend when it comes to investing for retirement. Starting early is key, we believe. For example, using an assumed return of 5%, $1,000 turns into $2,650 over 20 years but becomes $7,000 over 40 years. So despite the 20-year period money being invested for half the time, it is worth only about a third of what it would be pnc.com
Chart 1 Value of a Dollar over 40 Years at Various Assumed Growth Rates Chart 2 Growth of 401(k) at $6,000-per-Year Contribution with a 50% Employer Match over 40 Years at Various Assumed Rates of Return Source: PNC. The projections regarding investment returns are hypothetical in nature, do not represent any specific product or strategy, do not reflect actual investment results, and are not guarantees of future results. Source: PNC. The projections regarding investment returns are hypothetical in nature, do not represent any specific product or strategy, do not reflect actual investment results, and are not guarantees of future results. worth if it were invested for 40 years (Chart 1). This is what we see as the magic of compounding that is invaluable to someone investing for retirement. In addition, the employer plans that match retirement contributions, up to a certain percent, as many 401(k) plans do, make the case for time even more compelling. If we assume that someone contributes $6,000 per year for 40 years and the company matches 50% of that contribution, then this $9,000 in assets growing at an assumed rate of 5% per year becomes more than $1 million. Much like our previous example, the same activity for only 20 years at that 5% growth rate becomes less than $300,000 (Chart 2). Clarity of Purpose In our opinion, clarity of purpose is probably the most important benefit of concentrating on retirement as a goal. The byproduct of this goal orientation typically allows an investor to focus on the importance of reaching the goal rather than beating some arbitrary index or timing the market. For too many investors, the siren song of consistently outperforming an index often distracts them from their true goal of providing for their retirement needs. This type of performance investing generally has not served investors well. Our own PNC studies have shown that hiring or firing a manager based solely on short-term performance (even three years is considered short term for this purpose) is a recipe for underperformance. In fact, PNC has an entire department, Investment Advisor Research, dedicated to analyzing investment managers beyond just short-term performance statistics. 2 September 2014
Actual investor behavior has been shown to be detrimental in many cases to the returns reaped even by investors in funds with very good managers. Morningstar, Inc. calculates an Investor Return for mutual funds, which is an attempt to measure the return received by the average investor using cash inflows to and outflows from the fund. Using a manager (Fund X) we picked at random but known to have a strong long-term performance history, this concept becomes more tangible. Fund X had annualized returns of 19.5% over the last three years while the S&P 500 returned 16.8%. According to Morningstar, the average investor in Fund X due to the timing of his purchase and sale decisions experienced returns of 16.9%. While this return is still slightly above the index, it is significantly eroded from the level of those holding the fund for the entire period. Market timing is also not likely to be fruitful because these declines in the market are not predictable; trying to time them is an unreliable tactic, in our opinion. An investor rarely experiences the average long-term performance of stocks in any given year. Rather, the investor can experience significantly higher- or lower-than-average returns. In addition, the declines during a calendar year can be steep, averaging close to 15%, even if the final result for that year is satisfactory (Chart 3). The difficulty of market timing is clear: For the 20-year period ended in 2013, the market enjoyed an average annualized total return of 9.2%. A $10,000 initial investment assuming one stayed fully invested in the turbulent periods as described above would have grown to $39,524, not including the reinvestment of dividends, in which case the total investment would be closer to $50,000. Using price appreciation only, if an investor for some reason pulled money out during that 20-year period, the problem would usually be that it is hard to catch the upturn in the market. For example: missing the 10 best days, a portfolio balance would be worth: $19,739 ($19,785 less); and missing the 20 best days, a portfolio balance would be worth: $12,306 ($27,218 less). 1 In previous retirement papers (see, for example, Managing Retirement and Pre-Retirement Assets in Volatile Markets, April 2014), we have shown the value of systematic rebalancing that is, rebalancing back to your target Making Retirement a Goal Chart 3 S&P 500 Returns and Largest Calendar Year Drops (Through December 31, 2013) Source: J.P. Morgan Asset Management, Standard and Poor s, PNC Chart 4 Benefits of Systematic Rebalancing Source: Bloomberg L.P., PNC 1 Indexes are unmanaged, are not available for direct investment, and are not subject to management fees, transaction costs, or other types of expenses that an account may incur. Indexes performance results do not represent, and are not necessarily indicative of, the results that may be achieved in accounts investing in the corresponding investment strategy; actual account returns may vary significantly. 3
Table 1 Historical Average Annualized Returns January 1926-July 2013 Real Nominal S&P 500 6.82% 10.00% Long-Term Gov t Bond 2.49 5.54 30-Day T-Bill 0.52 3.51 Inflation NA 2.97 Source: Ibbotson Associates; Morningstar, Inc.; PNC Table 2 Correlation of Five-Year Returns with Realized Inflation January 1930-November 2012 Stocks Bonds T-Bills Nominal Return 0.31 0.19 0.49 Capital Gain 0.31-0.35 0.00 Income 0.03 0.43 0.00 Real Return -0.05-0.61-0.56 Source: Morningstar, Inc., PNC asset allocation by selling the asset that has done well and buying more of the asset that has done relatively poorly (Chart 4, page 3). This is in distinct opposition to the market timing practiced by many, which essentially amounts to buying more of what is doing well think stocks in the late- 1990s, for example. Chart 4 shows that a naïve market timing strategy would have worked until the market cracked in early 2000. Clarity of purpose can also be helpful when considering the reason for owning the various assets within a retirement investing portfolio. Each should serve to help investors reach their retirement goals. While this example will deal primarily with stocks, it will touch briefly on some other asset classes as well. What we do know is that over the long term stocks have tended to produce significant positive real returns that is, returns after inflation (Table 1). As the price for these outsized returns, the S&P 500 historically has experienced a large decline defined as a 20% drop in stock values about every two and a half years and more price volatility than other asset classes. As we noted earlier, a primary goal of retirement assets is to provide for the essential outlays during retirement. Stocks are likely an integral part to any investment retirement assets plan because: historical returns have been attractive; and stocks have grown purchasing power over time. As someone is investing for retirement, higher returns are preferable to lower returns with all other things being equal. While there can be no guarantees that stocks will continue their outperformance of other asset classes, we believe more than 200 years of data and despite two world wars and many other crises certainly suggest it. Another part of the retirement goal is to help provide for essential outlays, and that means one needs to be mindful of inflation. In our view, a retirement investor today needs to make those retirement purchases at a future time, so the purchasing power of those eventual assets becomes a crucial issue for funding the essential retirement outlays. In observing the correlation of five-year returns on U.S. stocks, bonds, and Treasury bills with realized inflation from 1930 to 2012 (Table 2), we note the nominal return on each asset class is positively correlated with subsequently realized inflation. As might be expected, nominal T-bill returns have the highest correlation with inflation. This is consistent with the fact that money market rates reset frequently and tend to track significant changes in inflation, at least on average. We are primarily concerned about the real, inflation-adjusted returns on these asset classes. As shown in Table 2, the real return on stocks is essentially uncorrelated with realized inflation. That is good news, since it implies that stocks tend to do a good job of protecting purchasing power. Real returns on bonds and T-bills, however, are strongly negatively correlated with inflation. We conclude that both of these asset classes do a relatively poor job of protecting purchasing power. This is not to say that bonds and T-bills (cash) do not belong in a retirement investing plan. Each has a job, with bonds providing a 4 September 2014
more secure income stream along with less volatility and some downside protection against poor economic outcomes. Cash provides liquidity and nominal safety, which is an important part of any portfolio. Alternative investments, as we utilize them, could provide a diversification of risks away from just the traditional asset classes of stock, bonds, and cash. We believe this clarity of purpose can help investors set the correct asset allocation and stick to it in both good and bad markets. We believe asset allocation, a topic we have often discussed, is at the heart of investing for retirement because it includes an understanding of and takes into account a risk tolerance level for many things, including volatility. In addition, selecting an appropriate long-term strategic asset allocation to match a retirement goal, investment holding period, and risk tolerance from a behavioral finance perspective may help mitigate the danger of becoming distracted from the long-term focus. In the simplest terms, behavioral finance looks at individuals most primitive impulses to explain why they experience these feelings that may lead to suboptimal financial decision making. Without planning and keeping their real goals in mind, retirees could make less-than-optimal decisions should the market environment prove difficult. Many retirees were faced with such circumstances after the technology bubble burst in the early 2000s; following the events of September 11, 2001; and during the financial crisis and subsequent market declines in 2008 09. Please see our January 2014 Investment & Portfolio Strategy paper, Five Keys to a Successful Retirement, for a more expansive discussion of the iterative process of setting an asset allocation and adapting to market conditions. Pitfalls to Avoid While these pitfalls have already been either discussed in passing or alluded to earlier in this paper, we believe they are worthy of an explicit discussion given the possible impact on a retirement portfolio. Chart 4 (page 3) highlights the first risk, which is that actions taken to follow this goal-oriented method can (and will) underperform other methods during some periods. As noted previously, our rebalancing method would have underperformed in the mid to late 1990s despite having attractive long-term performance. This pitfall is not to be underestimated, in our view, but not for the reason one might think. The real danger to us is not the short-term underperformance of goal-based portfolio management but rather that an investor cannot stomach this relative performance and chooses to follow another method. This can have even greater negative consequences for this investor consider the investor following a rebalancing strategy in the 1990s and finally in 1999, deciding that it was a new era and stocks were the only place to be, only to see stocks plunge in the coming bear market. Robert Arnott 2 discusses this relative performance problem as it applies to pension fund management, but it holds directly applicable lessons for individuals investing for retirement since more individuals are now 2 Robert D. Arnott, Managing Assets in a World of Higher Volatility and Lower Returns, CFA Institute Conference Proceedings (2004). 5
responsible for essentially managing their own pension plans (since most do not have a defined benefit plan). Arnott shows that a portfolio designed to defease a pension liability and provide a 3% higher return think of this as providing for your essential retirement outlays in nominal terms along with 3% to deal with other possible risks such as additional inflation would have underperformed a portfolio of 60% equities and 40% bonds for five consecutive three-year spans between 1996 and 2000. While this goaloriented portfolio should be attractive to anyone focused on the real goal of providing for the outlays needed in retirement and it did in fact snap back to outperformance after 2000, what person or board managing a pension other than true believers could withstand such a long period of underperformance relative to traditional performance investing? There is little doubt in the annals of behavioral finance that greed and envy, when it comes to financial decision making, can lead to poor outcomes. Therefore, our view is that goal-based investing can be a powerful tool for any investors, but especially those investing for retirement. Despite that fact, one must be mindful that there can be long periods when performance-based investing can look significantly more attractive. Conclusion For the individual contributing and investing for retirement, well-defined goals and risk parameters, along with a specified investment holding period, help provide a road map for a well-constructed asset allocation. Despite the fact that individual assets are often volatile, we believe assets can be combined to effectively manage risk, enhancing the predictability of asset returns. In addition to providing a plan to achieve the portfolio objectives, establishing a strategic match between the asset allocation and the client s goal provides a basis for: consistent evaluation of progress toward achievement of those objectives; and measurement of the success of the investment strategy. PNC believes that one of the most important approaches to investing is to diversify across all major asset classes to more effectively manage risk and return. We use our proprietary tools, analytical techniques, and knowledge to allocate assets among the major asset classes to achieve uniquely focused client objectives rather than simply concentrate on beating a stock market index, otherwise known as performance investing. The strategic matching concept: brings the investor together with an appropriate mix of assets to achieve objectives; establishes a road map to long-term goals; allows for a consistent basis for evaluating progress in achieving objectives; and moves beyond thinking only of S&P 500 or other index performance as an appropriate benchmark. Navigating the often complex path to a successful retirement can be daunting. Your PNC investment professionals can help you map out your goals for a successful retirement. 6 September 2014
The PNC Financial Services Group, Inc. ( PNC ) provides investment and wealth management, fiduciary services, FDIC-insured banking products and services, and lending of funds through its subsidiary, PNC Bank, National Association ( PNC Bank ), which is a Member FDIC, and provides specific fiduciary and agency services through PNC Delaware Trust Company. This report is furnished for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation, or particular needs of any specific person. Use of this report is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client s individual account circumstances. Persons reading this report should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in this report was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness, or completeness by PNC. The information contained in this report and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in this report nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities recommended and followed by PNC affiliates. PNC does not provide legal, tax, or accounting advice unless, with respect to tax advice, PNC Bank has entered into a written tax services agreement. PNC does not provide services in any jurisdiction in which it is not authorized to conduct business. PNC Bank is not registered as a municipal advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Act ). Investment management and related products and services provided to a municipal entity or obligated person regarding proceeds of municipal securities (as such terms are defined in the Act) will be provided by PNC Capital Advisors, LLC, a wholly-owned subsidiary of PNC Bank and SEC registered investment adviser. Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC or the Federal Reserve Board. Securities involve investment risks, including possible loss of principal. 2014 The PNC Financial Services Group, Inc. All rights reserved.