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Deviating From the Standard

You Might Want to See Your Annualized Returns Figured Another Way

September 09, 1997|SCOTT BURNS

Good news: The return on your 401(k) or 403(b) plan is probably even better than your defined-contribution plan provider tells you it is.

How can this be?

It's a matter of reporting and measuring.

The standard practice in newspaper reports and the mutual fund industry is to show the performance of mutual funds as lump-sum investments--as though you made one investment once and watched it grow. In fact, defined-contribution plans are based on systematic investments--regular contributions over a long period of time.

The difference--higher or lower--in rate of return can be substantial.

Actually, regulators and observers have suggested that mutual fund companies and brokerages provide personalized returns, based on each investor's actual investment history as well as distributions and all expenses, but only a handful do so.

A standard systematic return figure may be easier for funds to publish and may also be useful as an alternative way to help individuals compare funds.

Such a figure would, in effect, weight the return based on how much money was actually invested each year, so that the return in later years, when there would be more money in the account, would influence the average more than do returns in earlier years.

"When you dollar-cost average, the benefits depend on the volatility of the fund and the timing of the investment," explained Jim Raker, a senior research analyst at Morningstar.

This doesn't necessarily mean you would be better off investing systematically instead of in a lump sum--assuming you have the choice. In a rising market, an investor who puts a lump sum in a fund will accumulate returns on the full amount every year and end up richer at the end of five years than one who invests the same amount in systematic increments each month over five years. But in a falling market, the systematic investor would be richer, having lost less money.

Be that as it may, investors who make regular contributions might like to see systematic return figures when comparing funds rather than only ones based on a lump sum.

The Vanguard Index 500 Fund, for instance, shows a 20.51% annualized rate of return for a single sum invested for the five years ended July 31, according to the database of fund tracker Morningstar Inc. of Chicago. But according to calculations made with Morningstar's Principia Portfolio Developer software, the average annual return for systematic investments over the same period was 25.77%.

Most funds' figures will follow that pattern because the bull market was stronger in the last two years.

Now let's look at a notable exception: Fidelity Magellan, a leading choice for defined-contribution retirement plans. The fund provided an average annual return of 19.60% for a lump-sum investment over the same five-year period, but the average annual return for systematic investment was only 17.93%. Why? Much of the systematic-investment money was contributed more recently, during periods of relatively poor performance for that fund.

All of which opens up a rather major question: Do we really know how our defined-contribution fund investments are doing?

To help answer that question, I spoke with Kurt Cerulli, a Boston consultant to the financial services industry. Cerulli gave me a list of the leading equity mutual funds used in defined-contribution plans. (See accompanying chart.)

If you make a fund choice for your 401(k) or 403(b) plan based on the traditional reporting of past results, you could be judging on the basis of misleading figures.

Of 25 of the leading equity funds used in defined-contribution plans, all but six show higher annualized return figures for systematic investments over lump-sum investments over the same five-year period.

What to do, then? If you are a systematic investor--as most people are--start asking for systematic investment results in addition to lump-sum results.


This Way and That Way

The table compares two performance measures of the 25 leading equity funds in defined-contribution retirement plans such as 401(k)s and 403(b)s for the five years ended July 31. The first column lists systematic average annual return figures assuming a regular monthly investment. The second column lists the five-year average annual return calculated the traditional way--a lump sum left invested for the entire period.


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