You can't retire on a benchmark

Over a decade ago, a colleague of mine made a statement that I will never forget. He said, “I don’t know why investors are so focused on beating the S&P 500. You can’t retire on the S&P!”  I’ve thought about this statement a lot over the last ten years. I’ve thought about how our industry and the media focuses so much on benchmark relative performance that it has become a primary driver of our investment decision-making process.

Unfortunately, as an industry we don’t provide a lot of education around index construction. We don’t discuss the basic facts that indexes don’t have fees or pay taxes.Is it realistic to compare a client’s investment experience when you consider these basic facts? Indexes were originally developed as tools to effectively evaluate active money managers in defined benefit plans.Today, there is a tremendous amount of emphasis placed on index performance by individual investors.

Choosing a proper benchmark to measure success

Recently, I’ve noticed that some client statements may have the S&P 500 listed along with the Bloomberg US Aggregate Bond Index. Yet the investor’s investment portfolio is comprised of globally diversified investment solutions along with real assets.It’s like comparing an apple to an orange.What should be the proper benchmark?Isn’t it the client’s desired outcome or goal that matters most?

Let’s say in January of 1998 an investor had a 10-year goal to save aggressively for retirement. She chose to invest with a reputable US Large Cap manager and outperformed every year for the next 10 years.By the end of 2008, her annualized return was 1% better than the benchmark. Would you call that a success? The benchmark relative performance would have been terrific; however, the client would have had a 10-year annualized return of 0%.Did that meet the investor’s desired outcome?

Focus on the right outcome

What should be the correct measurement of success?Many investors have a plan that is designed around an expected rate of return. The goal of the investment portfolio should be to achieve the expected return with a tolerable amount of risk. In the case of the investor aggressively saving for retirement, had she used a multi-asset approach from 1998–2008 the outcome over the 10-year period would have been more desirable than the prior example as defined by the balanced allocation. An outcome-oriented benchmark of 4%, 5% or 6% may make more sense to a long-term investor than a single index-based benchmark. 

Market returns cannot be predicted.Advisors and investors alike can plan, but they can’t predict future returns. In fact, it’s shocking to some when they see that emerging markets had the best performance as demonstrated in the chart below from January 2000-2018. During that time, many investors would not have been able to stomach being invested in emerging markets.

*Annualized return. Non-U.S. Equity – MSCI EAFE Index; Global Equity – MSCI World Index; Emerging Markets – MSCI Emerging Markets Index; Global Real Estate – FTSE NAREIT All Equity Index (1/1/1995-2/18/2005) & FTSE EPRA/NAREIT Developed Index (2/18/2005-12/31/2018); Cash – Bloomberg US Treasury Bill 1-3 Month Index; Global High Yield – Bloomberg Global High Yield Index (1/1/1990-12/31/1997) & BofAML Global High Yield TR Hdg Index (12/31/1997-12/31/2018);Infrastructure – S&P Global Infrastructure Index; U.S. Bonds – Bloomberg U.S. Aggregate Bond Index; U.S. Equity Large Cap – Russell 1000® Index. Balanced: 30% Russell 3000® Index; 35% Bloomberg U.S. Aggregate Bond Index; 20% MSCI EAFE Index; 5% MSCI Emerging Markets Index; 5% FTSE EPRA/NAREIT Developed Index; 5% Bloomberg Commodity Index. Please note that this chart is based on past index performance and is not indicative of future results. Indexes are unmanaged and cannot be invested in directly. Index performance does not include fees and expenses an investor would normally incur when investing in a mutual fund. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets.

An investor searching for a more consistent return pattern with a 60/40 Index portfolio would have fared well relative to other asset classes. In fact, a 60/40 Index portfolio as measured by the S&P 500 would have performed slightly better than U.S. stocks over the 18-year time frame¹. As a fellow Regional Director has pointed out, a tangible way to consider changing the discussion with clients is to review their portfolio allocation. Is the strategic allocation today suitable for helping them achieve their desired outcome?

Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.
Sources: US Stocks: S&P 500 Index, Non-US Stocks: MSCI EAFE Index, EM Stocks: MSCI Emerging Markets Index, Bonds: Bloomberg US Aggregate Bond Index, Cash: Citigroup 3 Month Treasury Bill Index, 60/40: 40% S&P/15% EAFE/5% EM/40% Bonds

Know how much your clients are losing to taxes

Finally, taxes should also be taken into consideration when evaluating success over time. An outcome-oriented benchmark should be considered after fees and taxes.  Advisors (and investors) have historically evaluated success based on the rate of return seen on their statements compared to an index. Again, these numbers for both the individual and index don’t take taxes into account. Each year investors can lose quite a bit of their return to taxes. Advisors may want to consider incorporating tax efficiency into their clients’ investment planning because it can have a significant impact on helping them achieve their long-term outcomes.

As of 12/31/2018.

Calculation methodology: Assumed starting hypothetical portfolio value of $100,000. U.S. equity market return applied to starting value to arrive at ending pre-tax value. Percent lost to taxes is the estimated taxes due divided by $100k. This amount is then subtracted from the ending pre-tax value shown to arrive at final after-tax value.

Sources: U.S. equity market return: Russell 3000® Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.

Average U.S. Equity Fund Distribution: Capital Gains/Share (% of NAV) based on Morningstar U.S. OE Mutual Funds and ETFs. % = Calendar Year Cap Gain Distributions / Year-End NAV. Distribution is assumed to be made at last day of year and reinvested. Tax rate is 23.8% (Max LT Cap Gain 20% + Net Investment Income 3.8%).

In 2018, 86% of U.S. equity mutual funds paid a capital gain distribution². And for those that paid the capital gain distribution, the average payout was 11% of net asset value of the fund.Indexes don’t take taxes into consideration. We believe focusing on growing after-tax wealth and working to minimize the performance headwind caused by taxes—may help achieve better outcomes for clients.

U.S. stocks represent the cumulative return for S&P 500 for Jan. 2009 through Dec 2018

Morningstar U.S. OE Mutual Funds and ETFs. % = Calendar Year Cap Gain Distributions / Year-End NAV. For years 2001 through 2013, used oldest share class. 2014 forward includes all share classes. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Popular indexes are and will continue to be effective tools for investments professionals to measure the skill of active managers. We recommend advisors work with investors to develop more outcome-oriented benchmarks while they consider incorporating after-tax wealth into their plan.  

We are now more than 10 years into a bull market for US stocks, as measured by the S&P 500 Index. As we prepare for possible lower annualized returns, now may be a good time to consider adopting a new measurement for success. One that’s focused on changing the client conversation to an outcome-oriented discussion.

The bottom line

After looking at the evidence, it’s fair to say that you cannot retire on a benchmark. My colleague made a very insightful point 10 years ago. However, our industry has still not created a goals-based or outcome-oriented benchmark that is listed on statements. We’re of the belief that as an advisor, your job is to help investors shift their mindset away from a benchmark while staying focused on their outcome.

In the end, it’s helping clients achieve their desired outcome that matters most.