The Best Way 401k Plan Sponsors can Offer Total Return Options
(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)
First let’s separate the concept of using income, specifically dividend income, as a way to measure stock valuations from the idea of using income as in investment objective. As far back as Graham Dodd, whose book Security Analysis many stock pickers feel represents the bible of investing, the existence of consistently paid dividends indicated a financially strong company. Furthermore more, the growth of a company’s dividends has become a favorite yardstick as a way to measure and even predict the future value of the company’s stock. But we’ll get to this later.
We’ve already discussed why the typical 401k fiduciary might unknowingly be leading employees down the false path of income investing. In this article, we’ll answer the typical fiduciary’s most urgent question: What’s the best way to offer a total return option?
But first, how can we better help employees learn what “total return” means? Here’s a simple explanation a 401k plan sponsor can use to describe to employees the concept of investing for total return. If a security pays income at a 5% rate for a year and its price goes up 5% for the year, the net return is the sum of the two (5% + 5% =) 10%. Likewise a security that pays income at a 5% rate and whose price goes down 10% has a net return of -5%. Finally, a security that pays no income but whose price goes up 12% has a net return of 12%. Imagine treating a whole portfolio of securities of securities the same way – the net return becomes the portfolio’s total return. We ignore the portfolio’s income yield because it’s already incorporated in the portfolio’s total return.
Why is this important and how does this concept work in the real world? Let’s conduct an experiment. Your objective is to pay annual expenses of $5,000 per year and you’ve got $100,000 to invest (there’s that 5% withdrawal rate the Ford Foundation was talking about). We use two hypothetical portfolios using Ibbotson SBBI data (from the 2010 Classic Yearbook) to demonstrate our point. In one portfolio – the income portfolio – you invest that $100,000 in 5-year treasuries (i.e., you buy a bond and keep on reinvesting it upon maturity at the then current rate). In the other portfolio – the total return portfolio – you invest in large cap equities, taking your expenses out of the total portfolio every year. To give things a real flavor, we will inflate the expenses by whatever Ibbotson says each year’s inflation rate is.
If you started in 1947 (when interest rates paid only 1.12%), your bond portfolio would have exhausted its principal in 1967. A twenty rear retirement was not bad for the times. For those counting, the $5,000 annual expenses in 1947 dollars have grown to $7,663 annual expenses in 1967. Given the low interest rate environment of the era, in no year did you earn more income than you spent in expenses. This might give you some idea why the folks at the Ford Foundation were so upset. If this news is bad, the next piece of data must have made them absolutely livid.
Had that same portfolio been invested for total return, it would have been worth more than a million dollars in 1967. If that portfolio continued paying the annual expenses through then end of 2010, (when the inflation adjusted annual expense would have become $51,000 per year), the total value of the portfolio would have been worth $35 million.
What a difference! Start with $100K in 1947 to pay your expenses and you have two choices: Invest for income and run out of money in 1967; or, Invest of total return and end up with nearly $40 million today – enough to start your own foundation.
And the data shows this is not merely a timing anomaly. If you started the investing in 1960, the income portfolio runs out of money in 1985 (again, a good 25-year retirement). The total return portfolio would end that year with a gain, finishing with $185K. Starting in 1970, the income portfolio runs out in 1995, the same year the total return portfolio runs out (another 25-year retirement). If you started in 1980, the income portfolio would have begun 2010 with only $85K remaining while the total return portfolio would have had $1.2 million. Commencing this experiment in 1990, you’d have a tad more than $100K in 2009 in your income portfolio, but you’re expenses would be exceeding your income at a rate in excess of $5,000 a year, meaning you’d be eating up your principal soon. The total return portfolio, on the other hand, would be worth almost $250K.
In the face of this data, it’s tough to justify ever investing for income. It’s important to remember, however, exceptions to this rule do exist. We’ve mentioned split-interest trusts, which really fall in the realm outside of retirement plans. Still, it should be stated that good estate planning attorneys recognize the investment implications of split interest trusts and now write them in a way to accommodate total return investing, usually replacing any assignment of income to the beneficiary with the assignment of some set maximum percentage of the portfolio. This gives the investment adviser choice of a broader range of investments, keeps the primary beneficiaries happy and gives the remaindermen the growth they desire.
There are other exceptions which may be relevant to retirement plans, though, including what options plan sponsors might want to offer in their 401k plans. The first, and most obvious, are short term objectives. Investors looking to cash out at least a portion of their retirement to pay for some immediate expense will need a way to protect principal. Money markets or stable income options offer adequate investment alternatives. Bear in mind, though, although the fiduciary does seek to maximize income in these vehicles, their primary purpose is to protect the dollar.
The third exception does (usually) belong in the long-term category. This objective occurs when the investor has enough money to self-endow. This remains controversial in light to the Ford Foundation report (and the Ibbotson data above), but some very wealthy individual may wish to self-endow, meaning they will assign certain income producing assets to cover expenses. Rarely would (or should) an investor do this with their entire portfolio (remember, we’re discussing extremely well-to-do people here). It might make sense, through a balanced portfolio approach, to invest for income with part of the total portfolio (the “assigned asset” approach) and invest for total return with the remainder of the portfolio. If a retirement investor does do this, however, they would have to have the ability to invest directly in bonds, (as opposed to bond funds) or else they would not be able to construct the portfolio properly.
One last word about dividends. As mentioned at the opening of this article, securities analysts have been using dividend history as a measure of stock value for years. While the objective of seeking to maximize dividend income is generally inappropriate, the use of a company’s dividend history in determining the fundamental value of that company’s stock is appropriate. In general, a stock has more fundamental value if:
- It has consistently paid dividends.
- It has a history of raising dividends (or has a history of not lowering dividends).
- It has a consistent and low dividend payout ratio (i.e., dividends remain a small fraction of earnings).
In the late 1990s, however, some analysts felt the story of the significance of dividend yield may have changed. They theorized capital gains and reinvested earnings provided greater long term value to the investor than do dividends. However, with the Bush Tax Cuts removing or at least reducing the double taxation associated with dividends and an expanding number of “growth” companies becoming “mature” companies (e.g., Microsoft, Oracle, Cisco), dividend payments returned in the 2000s.
But individual dividend analysis is more the stuff of how the sausage is made and is of less concern to 401k plan sponsors than identifying appropriate investment options (which, after all, is what the title promised). It’s clear investors ought to be given options to handle the two exceptions above. Many, if not most, 401k plans do have either a money market option or a stable income option (or both). Nevertheless, the Department of Labor was quite adamant when it stated these are not appropriate long-term options. The worst thing employees can do is stash all their long-term investments in these kinds of options. To discourage this type of behavior, plan sponsors should classify them as “short-term” or “Wealth Preservation”/”Wealth Distribution” objectives. Here, identifying investment by their current yield would make sense.
For “long-term” objectives, which would include both “Wealth Accumulation” and “Wealth Distribution,” its clear 401k plan sponsors need to describe investments associated with long-term objectives in terms of their total return, not current yield. It’s also important for plan sponsors to make sure those responsible for investing the portfolios of each option (whether they be mutual funds or privately managed securities portfolios) take a total return approach to investment. This means a general bias towards equities with good prospects for price appreciation (as opposed to emphasizing dividend yield). It may be scandalous, but this is another reason to question why a 401k plan would offer a bond fund as an option.
Finally, and incidentally, the only decade the total return portfolio appears to fail is when you start in 2000. At the end of 2009, the total return portfolio is about $30K while the income portfolio is $95K. Perhaps at this time it makes sense to mention the caveat of the Ibbotson data – it only represents index returns. As we reported last year, the “Lost Decade” of the 2000s really only applied to index investors, as most actively managed mutual funds made money during the decade (see “Does the ‘Lost Decade’ Signal the End of Passive Investing?” Fiduciary News, January 5, 2010). Even with those positive returns, the income portfolio would have remained ahead of most actively traded total return portfolios as of 2009. But, with equity markets continuing to recover and the interest rate environment remaining low, time is on the side of the total return portfolio.
This, of course, gives us a hint as to why total investing works so well, but we’ll save the full discussion – and the controversy it has generated – for the next installment.
Part I: What do Robin Hood, Investment Income and Fiduciary Duty have in Common?
Part II: Plan Sponsor Warning: What’s Wrong with Emphasizing Income?
Part III: Is Income Really the Only Way for a 401k Fiduciary to Meet an Objective?
Part IV: If Income Doesn’t Matter, What Should Plan Sponsors Look For?
Part V: How the ERISA Fiduciary Can Avoid the 1st Deadly Sin – Whither “Time Diversification?”