The wealth and investment management industry is full of performance benchmarks and value-added metrics, from stock and bond indices to Sharpe Ratios, alphas and betas, and more. We now expect financial advisors to report aggregate returns and risks relative to suitable, neutral and unbiased benchmarks, at the end of each month, quarter and year.
This trend is a good thing. Unfortunately, when it comes to assessing performance of retirement income portfolios, the existing benchmarks and indices -- whether we consider the S&P 500 or the broader Russell 3000 or even the MSCI family -- all fall short.
Ponder this situation. Clients of yours retired two years ago in January 2008, with a million dollars of investable assets. At the time, their portfolio was made up of about 60 percent equities and 40 percent bonds.
Then, over the next 24 months they withdrew $5,000 per month -- or $60,000 per year -- for living expenses, with periodic adjustments for inflation and cost of living adjustments. So, over two years they received checks in their mailbox totaling approximately $120,000.
As you can imagine, in late December 2009 your clients' nest egg is worth far less than the original million dollars. In fact, according to my back-of-the-envelope calculations, their portfolio is worth about 26 percent less than two years ago -- even though the blended 60/40 index is only down about 13 percent over the same two-year period.
Obviously, your clients are alarmed and looking for culprits. Comparing their portfolio to such an asset allocation benchmark will provide a distorted picture.
But how do you explain that their portfolio is down 26 percent as a result of the dreaded "curse of the sequence of returns?" Unfortunately, your clients got unlucky before they got lucky, even though "on average" they received decent returns.
Still, how do you, as the person entrusted with managing these clients' wealth, account for their apparently lagging returns? Sure, you can try to blame them for withdrawing too much, or spending more than allowed, or poor timing -- but this quickly becomes a subjective and hard-to-quantify battle. How can you change the conversation from a soft "it is because you spent too much" to a hard "you withdrew more than the benchmark allowed"?
This very tangible and contemporary dilemma is why I think it is time to create and promote an index that is geared towards systematic income plans as opposed to buy-and-hold accumulation plans. The index accounts for both market performance and the maximum lifetime spending rate that can be obtained without incurring any longevity risk.
I call it the Sustainable Portfolio "SP" Withdrawal Index. The QWeMA Group (www.qwema.ca) will launch and report this innovative benchmark starting January 1, 2010.
Here's how the "SP" Withdrawal Index works. Imagine that your clients retired on January 1, 2008 and allocated 60 percent of their $100,000 nest egg to a diversified portfolio of equities and 40 percent to bonds. On the same day, you obtain a quote from an insurance company for a "real" (inflation-adjusted) single premium income annuity (SPIA) which indicates this same $100,000 would generate a sustainable, monthly, inflation-adjusted $523.03 per month.
This 6.3 percent rate ($6,276 per year divided by the $100,000) is the maximum sustainable withdrawal rate that can be achieved with no longevity risk. The Sustainable Portfolio "SP" Withdrawal Index assumes the 60/40 equity/bond portfolio is depleted by same monthly withdrawals, as determined by the real SPIA monthly payout, forever.
Thus, even though you and your clients may have absolutely no interest in annuitizing, the
Sustainable Portfolio "SP" Withdrawal Index is the benchmark their portfolio must beat.
The "SP" Withdrawal Index identifies the inflation-adjusted income stream the portfolio would produce if completely annuitized. Put simply, the "SP" Withdrawal Index allows you to compare your clients' portfolio to a portfolio which is being withdrawn according to a plan that is 100 percent sustainable. Beat that and you really added value.
Accordingly, if the clients' portfolio is down more than the "SP" Withdrawal Index, it has underperformed the benchmark. And if their portfolio is above the "SP" Withdrawal Index value, they have outperformed the suitable benchmark.
The nearby table illustrates how the Sustainable Portfolio "SP" Withdrawal Index would have performed over the last two years. You can see that the January 2009 index was up to a value of $106.87 by January 2010. So, if your clients retired in January 2009 -- made withdrawals -- and their portfolio grew by more than 6.87 percent, they beat the relevant benchmark.
The same goes for the clients who retired in January 2008. If their portfolio is down by less than 26.48 percent (i.e., $100 initial investment minus $73.52 index value at January 2010), they have obviously lost a substantial sum of money -- and justifiably are upset -- but the fact is they are doing better relative to the benchmark.
To reiterate: The SP Index is not intended to promote irreversible annuitization. Instead, it is designed to advocate for and make available a suitable index for measuring investment performance for retirement income portfolios.
The main point I am making here is that this benchmark takes into account both withdrawals and the sequence of returns, as well as the largest spending rate that can generate 100 percent sustainability. In the absence of these three pieces of information, comparing your clients' investment performance to a straight point-to-point equity index ignores the risks which are unique to retirement income.
These are very different from the risks in accumulation. You'd be comparing apples to toasters.
Going forward, The QWeMA Group (www.qwema.ca) will be reporting and updating the (vintage 2008, 2009 and 2010) SP Withdrawal Index on a semi-annual basis.
In addition, The QWeMA Group will launch a new index on January 1 of each year -- to reflect new retirees, new annuity quotes and new inflation expectations. (In theory, of course, one could create monthly retirement start dates, monthly tracking, and alternative asset mixes, but as with any new and different idea, simplicity is golden.)
If you think about such an index for a moment -- say the vintage January 2010 which starts at $100 -- it might grow over some short period of time, but it is expected to fall. Yes, the "SP" Withdrawal Index (SPWI for short) is expected to drift downward over time since it is unlikely that a 60/40 equity/bond allocation can beat the annuity rate on a consistent basis. So, if your clients run out of money before the relevant SPWI index hits zero, you have failed them.
One way to avoid this type of failure is to increase their allocation to annuity-type products.
In the future I expect insurance companies and annuity manufacturers to offer products whose payout is triggered by such an SPWI -- as this is the benchmark that truly matters to retirees.
More on this later -- for now, I will simply note that this benchmark enables us to clearly distinguish the value added by different retirement income products, a topic I will turn my attention to in much greater detail in coming columns.
Moshe A. Milevsky, Ph.D. is an associate professor of finance at York University in Toronto, and Executive Director of the non-profit IFID Centre at the Fields Institute for Research in Mathematical Sciences. His next book, entitled Your Money Milestones: a Guide to Making the 9 Most Important Financial Decisions in Your Life, will be published by FT/Pearson and available in early 2010.