What does Personal/Internal Rate of Return mean for a 401k?

Question

My 401k statements show a "Personal Rate of Return" (also called Internal Rate of Return), and I am curious what this actually means.

Does this indicate how my funds are performing in the market? Or is it just an expression of how much I contributed?

I am interested in the former, so I can evaluate the funds I have chosen. I'm not as interested in the latter, as I plan to simply contribute the max amount my employer will match.

My 401k provider says that their Internal Rate of Return calculation "considers the account balance at the beginning of the period, any contributions, any withdrawals, any growth or decline in the value of the account’s assets, and the period’s ending balance."

Does this mean that IRR is just a fancy way of calculating end balance divided by beginning balance?

Answer 1

No, the IRR isn't how your funds are performing in the market unless you are putting in the max on Jan. 1 and then not adding or removing anything for the year so that it matches the total return of the fund.

It's a computation of what is your personal rate of return in terms of how much money have you put in, which is beginning balance plus contributions, compared to the ending balance factoring in any withdrawals. Thus it is how much each dollar you invested did over the course of the period that the return is given.

Something to point out here is that if you are dollar-cost averaging then the IRR is a better measure of how your performance is as it isn't quite the same as the total return of the fund.

Consider the case of a fund that goes up 10% each month and you invest $100/month into the fund for an entire year, just to keep the Math simple here.

The fund's total return is (1.1)^12 = 3.138428376721 which is 214%. So, if you invested $1200 at the start of the year, you'd have $3766.11 at the end of the year for a gain of $2566.11.

However, if we space out the computations, the end total becomes a mere $2352.27, for a gain of $1152.27, as the compounding is reduced. Thus, in this case your IRR is 96% since you invested $1200 and made $1152.27 on it.

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For those wanting the raw figures, here is the $100/month returns at the end of each month:

• 110
• 231
• 364.1
• 510.51
• 671.561
• 848.7171
• 1043.58881
• 1257.947691
• 1493.74246
• 1753.116706
• 2038.428377
• 2352.271214

In contrast, here is how the $1200 invested as a lump sum, does:

• 1320
• 1452
• 1597.2
• 1756.92
• 1932.612
• 2125.8732
• 2338.46052
• 2572.306572
• 2829.537229
• 3112.490952
• 3423.740047
• 3766.114052

As the final totals are rather different, the rate of returns should also be quite different. The total returns are different because in one case, the person spaced out the purchases compared to the other case. These shouldn't both have the same return unless you're going to factor in the time value of money somehow to make up the difference.

Answer 2

A properly calculated IRR will show you your return over the year. To avoid the Beardstown Ladies phenomenon, deposits and withdrawals should be accounted for.

I handle a retiree's account, an IRA that showed a 6% gain for the year. It started the year at $100K, ended at $106K. She asked me why we were so much lower than the 13.41% the S&P did. I pointed out we took a near $10,000 distribution. She said that was great, I really beat the index by 2.59%! Uh, no. The broker showed S&P index but ignored dividends, so the "S&P total return" was 16% which I lagged by .1%, due to the expense ratio and the timing of the withdrawal.

The brokers statement did not offer a true IRR, but an ending balance/beginning balance change that to me is of no value at all.