What is an Actual Return?
An actual return refers to the actual gain or loss an investor experiences on an investment or portfolio. It is also referred to as the internal rate of return (IRR).
The Basics of Actual Return
As opposed to expected or assumed returns, actual return is what investors really receive from their investments. For example, a fund disclosure such as this one from Manulife might state, “The securities of the Fund you invest in earn 5% each year, although the actual return will likely be different.” Analyzing the reasons for the discrepancy between expected and actual return figures helps in understanding the role systematic (the market’s) and idiosyncratic (the manager’s/fund’s) risk factors played in portfolio returns. Drivers of actual returns include trading costs, manager fees, investment timeframe, whether additional investments or withdrawals were added during the time period, as well as the impacts of taxes and inflation.
Both the Securities and Exchange Commission (SEC) and the Government Accountability Office (GAO) have studied and made proposals to require mutual fund companies to improve the disclosures they provide to investors and potential investors. The SEC issued its ruling in February 2004. The main focus had been on fees, specifically how to help investors better understand the fees and expenses of their funds and how to enable them to compare fees across fund companies, but the final rule also specifically mentioned the need for funds to distinguish between actual and expected returns. For example, a mutual fund illustrating performance over a five year period, in describing the cost of a hypothetical investment would have to reference actual return numbers as well as actual cost figures.
Actual Return Figures and Pension Plan Assets
Actual return is also used to describe the performance of a company’s pension plan assets. In this case, it is referred to as “actual return on plan assets.” The actual return is compared to expected return. The formula for computing actual return for pension plan assets is: Ending Balance (fair value) – Beginning balance (fair value) + Benefits – Contributions. Since pension plan accounting rules allow employers (companies, governments, universities) to calculate assumed rates of return for their pension obligations, they do not reflect employers’ actual obligations to current and future retirees. Because expected returns are often based on rosy assumptions, they tend to understate obligations and overstate a company’s financial position. While companies must provide reconciliation of the two sets of numbers (actual return versus expected return) in the footnotes to their financial statements, proposals have been made to change reporting requirements to make it easier for readers to discern companies’ actual returns and obligations.