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Goal-Oriented Target: How Leading Advisers and 401k Plan Sponsors are Using this New System to Replace Outdated Modern Portfolio Theory Risk Tools

Goal-Oriented Target: How Leading Advisers and 401k Plan Sponsors are Using this New System to Replace Outdated Modern Portfolio Theory Risk Tools
August 01
00:02 2017

Last week’s article summarized the current state of affairs for many 401k plan sponsors with regarding to employee education, specifically as it concerns helping them understand investments. Left unanswered in that article was it’s opening question: “So, what’s the alternative?” These next several paragraphs will begin to answer that question as well as provide links to other resources that provide greater detail.

This journey began with a concern about the misuse of Modern Portfolio Theory tools designed to define risk and recommend investment strategies. It’s been clear for some time now that “risk tolerance”-centered investment decision making systems often lead retirement savers to make choices that fail to reflect their best interests. This is fundamentally a fiduciary issue, and plan sponsors need to be cognizant of the repercussions of continuing to allow the use of these tools. (To be fair, neither regulators nor academic researchers have been too quick to abandon Modern Portfolio Theory, so the true nature of this risk may have to wait for a new set of class action attorneys more familiar with behavioral finance research rather than MPT.)

There are two problems with the legacy risk-based tools. First, and quite simply, they don’t work in the real world. They mistakenly define vastly exceeding one’s goal as “bad” and barely missing one’s goal as “good.” Second, not only do they fail to identify “missing the goal” as the singular worst outcome, they fail to capture the degree with which failing to attain the goal places the retirement saver in “peril.”

That’s right, the word “peril” better represents what most people (i.e., those not immersed in MPT statistics) have understood “risk” to mean. The assessment of one’s “peril,” however, cannot take place until one has properly defined one’s goal. That the phase of the system we will focus on here.

Leading edge advisers, and the 401k plan sponsors that use them, have already implement an alternative system. This system starts with what is called a “Goal-Oriented Target” (“GOT”). The GOT is a number, but it’s a number based not on investment returns, investment risk, or any other of the myriad of MPT-based statistics. It doesn’t rely on complex “Monte Carlo”-type analyses best confined to think tank computers, not the smart phones used by everyday folk. All the numbers required for input represent real numbers specific to each retirement saver. They’re easily accessible and just as easy to understand.

Most important, the GOT represents a definitive goal. Sophisticated practitioners are using this tool right now to help better set, align, and measure progress towards the goals of a comfortable retirement. They have seen how retirement savers respond most favorably to the GOT system. They know that by replacing outdated MPT-based tools with tools reflecting the conclusions of more recent research in behavioral finance, the GOT system removes from plan sponsors the fiduciary liability exposure created through the use of those MPT-based tools (for specific and detailed examples of how financial professionals are using the GOT system, see “Has the 401k Fiduciary Unknowingly Put Employees in Peril?”)

Because of the way it’s calculated, the GOT remains agnostic to any particular investment style. In other words, unlike almost any other “retirement calculator” it doesn’t rely on investment return assumptions. In addition, unlike most asset allocation analyzers it doesn’t require you to make a decision on your preferred investment style in order to use it. That decision can come later, if you even opt to make such a decision (modern automatic investing “default” options in 401k plans can offer retirement savers a chance to escape making any investment decisions).

What the GOT system does do, however, is provide a personalized benchmark retirement savers (and their advisers) can then use to measure progress towards their goals of a comfortable retirement. More important, the GOT is an eminently practical number. It’s a true benchmark. Many spreadsheet bases retirement tools focus on the actual dollars accumulated. This “number” was made famous in a TV commercial with peoples’ retirement numbers floating above their heads. The commercial implied if you don’t know your dollar number you’re worse off than if you do. Behavioral research suggests otherwise.

While this dollar based number is not a wholly impractical system of measurement, it fails in two important areas. First, it actually discourages retirement savers as, though it’s a real and fairly accurate number, it’s much too large for many people to comprehend. As a result, they simply ignore it and everything associated with it. Second, it remains “theoretical” in the sense you can’t use it as a quick-and-easy benchmark. Sure, with enough mathematical machinations, you can convert it to terms that are usable, but this just isn’t an intuitive process.

In contrast, the GOT is a (hopefully) much smaller number representing the percentage annual return required to attain one’s retirement goal. People seem to be more accustomed to smaller numbers and are especially familiar with them within the framework of investment returns. This makes the GOT especially valuable, since it’s almost second nature for someone to look at the investment return on their annual 401k statement and compare it to their GOT. If they’re actual return meets or exceeds their GOT, they’re doing fine. If it misses in any particular year, then they need to assess the impact and determine if any of the GOT input components that they control need to be adjusted in any way. (For a detailed description of how the GOT system works, including a simple example, see “How Does Goal-Oriented Targeting Work?”)

The nuts and bolts of the GOT system are within an intuitive calculator that fits on your smart phone. It’s based on the three primary components retirement savers control that most influences their ability to meet or exceed their retirement goal as identified by a 2012 Wharton study (see “New Study Reveals Three 401k Strategies More Important than Asset Allocation”). They are: 1) When you start saving; 2) How much you save; and, 3) When you retire. This data along with one’s salary and current total retirement savings, all easily available for all retirement savers, is then entered into the free “Retirement Readiness Calculator” (the retirement saver has the option to add supplemental information like projected retirement need, Social Security payments, and other income). They then simply press the appropriately labeled “Press to Calculate” button and – voilà! –  the GOT appears in the box. (For a fuller explanation on its use, complete with an example, see “Retirement Readiness Calculator.”)

Although the calculator appears quite intuitive and seems easy to use (disclosure, it is), interpreting the results and going beyond the numbers may require a bit more experience than the average retirement saver has. That’s where the adviser comes in. The typical financial professional has much experience in both interpreting the GOT and determining the different scenarios the retirement saver can pursue. In fact, one of the best things about the Retirement Readiness Calculator is that you can right-then-and-there input the different scenarios to see how changing, for example, one’s annual contribution or one’s retirement date, will impact how much average investment return you’ll need on an annual basis (i.e., your GOT). What’s more, veteran advisers are quite familiar with resources that will allow retirement savers to see the likelihood of attaining their personal GOT based on the number of years until retirement. (One such table is available in the article “How a Fiduciary Can Assess a Retirement Investor’s GOT.”)

Finally, professional fiduciaries are in a position to advise and recommend to retirement savers exactly what these savers should do to reduce their GOT (yes, lower GOTs are more attainable than higher ones). You can see samples of this in “5 Things to Do to Improve a Retirement Investor’s Goal-Oriented Target.” It is therefore critical that plan sponsors vet those service providers responsible for employee education to make sure these vendors are well versed in the use of the GOT system.

The GOT system offers a viable and practical alternative to relying on outdated MPT tools. Although still widely in use, MPT-based calculators and analyzers can sometimes lead retirement savers to make decisions that aren’t in their best interest. That statement alone should trigger concerns from the mindful fiduciary.

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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