You can't blame the average investor for confusing an investment's annual return with its annual yield. For centuries, trustees and their beneficiaries have focused on the income an estate yields, not the growth in its value. Indeed, as explained in "7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 1st Deadly Sin – 'Income Matters'," the barons of medieval England forced King John to sign the Magna Carta in 1215AD partly because the king's trustees had been looting the estates of widows and orphans in part to help the king fund various unpopular policies. Back then, an estate's yield didn't come with decimal points and percentage signs. It came in bushels and on bones. It didn't fill abstract things like bank accounts. Instead, it filled the very real need of hungry stomachs.
A solid six centuries later in 1830, one of the seminal cases of American trust law (Harvard College v. Amory) re-emphasized the predominant importance of income and asset safety. Over the next hundred years or so, trustees and remaindermen (those beneficiaries who inherit the assets of the estate once the income beneficiaries die), discovered the rules of trustees as promulgated under the agricultural economy did not transfer too easily in the industrial age. Whereas the assets in an agricultural estate (i.e., land) tended to naturally appreciate, the assets in an industrial estate (i.e., securities) often did not.
Frustrated by the lack of growth in their portfolio, in 1969 Ford Foundation trustees issued two reports overturning Harvard College v. Amory first from a theoretical standpoint and then from a practical standpoint. It turns out the rules are different, but not just because the assets have changed. The earlier forms of trusts – the kinds addressed by the Magna Carta and Harvard College v. Amory – are of the form called a "split-interest" trust. This means the same trust has multiple beneficiaries with competing objectives – one desiring income and one desiring growth.
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The Ford Foundation argued in the case of endowments – and this would apply to individual retirement accounts like IRAs and 401(k)s, too – the income beneficiary and the growth beneficiary were one in the same. As a result – whether the Ford Foundation, other endowments, or individuals investing for their retirement –studies bear out these investors can earn significantly better results by investing for total return as opposed to investing for income. For more than two generations, the primacy of total return has ruled the world of trustees (and their fellow brethren, fiduciaries).
Yet, the two most popular forms of 401(k) investment options seem designed specifically to lead employees astray and into the 1st Deadly Sin – Investing for Income. Again, we should not fault these investors. Many received their investor education from their brokerage firm, whose traditional investment goals – investing for Income, Safety and Growth (mimicking Harvard College v. Amory) – have since been replaced by the modern investment goals. But 401(k) plan sponsors can't rely on the financial industry. They have a fiduciary duty to help frame their plans so employees are more likely to avoid errors like this.
The best way 401(k) plan sponsors can offer total return options is usually through the Investment Policy Statement and all associated participant reporting mechanisms. Popular "safe" income-oriented options like money market funds and stable income funds should be labeled as "short-term" or "Wealth Distribution" options. Without getting into the details of the actual types of investments, the remaining options should be labeled as "long-term" and managed in a manner consistent with the "Wealth Accumulation" and "Wealth Preservation" investment objectives.
Finally, 401(k) plan sponsors should adopt an employee education program that explains the virtues of time diversification in an understandable way, including meeting the controversy of this idea head on. A simple analysis of rolling long-term holding periods shows this. In addition, examples of regular post-retirement withdrawals (at the Ford Foundation's recommended rate of 5% per year) could prove helpful. Lastly, a good story of the illusion of statistics can help reinforce some common sense cynicism, should anyone in the audience have a passing familiarity with the academic literature on time diversification.
Want an example? Let's say you're a baseball manager in the National League. It's the bottom of the ninth with two outs and men on first and second. You're down by three and you need to pick a pinch hitter to go to bat. On deck is the pitcher and, since you've emptied your bullpen, he's got to bat (they didn't give him the nickname "Sure Out" just because he has a rifle arm). You have two choices to pinch hit. Walking Wally, who's on base average is 95% mainly because he stands only 2 ½ feet tall, walks a lot but can't hit it out of the infield. Hammering Hank strikes out 90% of the time but hits home runs the other ten percent. The "safety" call has you picking Wally. The "risky" call has you picking Hank. Trouble is the only way you even have a hope to make it to extra innings is by picking Hank. The only thing Wally guarantees is a loss. With Hank, at least you've got a chance. Maybe risky has less risk and safety isn't so safe after all?
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Christopher Carosa
Chris Carosa has been writing a weekly article and monthly column for BenefitsPRO online and BenefitsPRO Magazine since 2011 and is a nationally recognized award-winning writer, researcher and speaker. He’s written seven books, including From Cradle to Retire: The Child IRA; Hey! What’s My Number? – How to Increase the Odds You Will Retire in Comfort; A Pizza The Action: Everything I Ever Learned About Business I Learned By Working in a Pizza Stand at the Erie County Fair; and the widely acclaimed 401(k) Fiduciary Solutions. Carosa is also Chief Contributing Editor of the authoritative trade journal FiduciaryNews.com and publisher of the Mendon-Honeoye Falls-Lima Sentinel, a weekly community newspaper he founded in 1989. Currently serving as President of the National Society of Newspaper Columnists and with more than 1,000 articles published in various publications, he appears regularly in the national media. A “parallel” entrepreneur, he actively runs a handful of businesses, including a small boutique investment adviser, providing hands-on experience for his writing. A trained astrophysicist, he also holds an MBA and has been designated a Certified Trust and Financial Advisor. Share your thoughts and story ideas with him through Facebook (https://www.facebook.com/christophercarosa/)and Twitter (https://twitter.com/ChrisCarosa).
