So I’m sitting with a corporate exec the other day going over her 401(k). She’s a middle-aged woman who definitely knows her stuff when it comes to finance and investments. She gives me all the usual data – you know, currently salary, current retirement savings value, annual contribution, expected Social Security, retirement date. I put it in the spreadsheet blender and – presto! – out comes the rate of return she needs from now until her last day of work in order to retire in comfort. I call this her “Goal-Oriented Target” and it is quite achievable at somewhere between 4 to 5 percent.
I’m about to move on to the next step when, out of the blue, the CEO of the company ambles by. He’s what some might call a “ragged veteran” of sorts. He’s seen a million-and-one investment advisors, hopping from one to another whenever the underperformance bug hit. No doubt familiar with all the tools of the advisor trade, he confidently asks the woman, “This is all fine and good, but how does this relate to your risk tolerance?” She politely smiles a respectful smile and says nothing.
I stop dead in my tracks.
Sensing the woman knows more than she’s letting on, I immediately congratulate the old man for asking the perfect question to follow up our half-hour of rigorous mathematical calculations. I turn to the woman and ask her if she’s familiar with the risk tolerance test administered by brokers, mutual fund companies and virtually any website remotely connected to investing. She says, “Yes.” Then I ask her, rather bluntly (which was OK because she sensed where I was going), “Would the results of any of those tests change your Goal-Oriented Target?”
“No,” she said, understanding perfectly my point.
“That,” my head now swung to the firm’s leader, “is why we don’t ever want to let an employee – or any investor for that matter – get mislead by the results of a risk tolerance questionnaire.”
Here’s the awful reality of the above story. Not only is it a dramatization of real life events, but, in real life, the company CEO is the plan sponsor who has the fiduciary responsibility to avoid promoting investment “tools” that can mislead employees. That’s why academic researchers have questioned the use of risk tolerance questionnaires since at least 1999 and why so many professionals today decry their unidimensional shortcomings (see “Should 401(k) Plan Sponsors Ban Risk Tolerance Questionnaires?” FiduciaryNews.com, Aug. 13, 2013).
No matter one’s risk tolerance, it is mathematics that rules the day when it comes to retirement savings. For those aficionados, it is specifically the internal rate of return calculation based on net present value, annual contribution rate and the net future value of funding to fill the retirement spending gap not addressed by Social Security, pensions and other outside income.
Facts, not feelings, rule the day when it comes to living a successful retirement. Gone are the days of the 1980s when modern portfolio theory ruled the roost, self-esteem (or feelings) carried weight, and everyone’s ideal of the perfect male was Alan Alda. The sooner we lead 401(k) plan sponsors and investors out of that utopian wasteland, the better. And there’s no better way to start than to state with blunt certitude the irrelevance of (if not outright danger in using) risk tolerance questionnaires.
For more from Chris Carosa, see: