Understanding internal rate of return

PUBLISHED : Monday, 07 January, 2013, 12:00am
UPDATED : Monday, 07 January, 2013, 4:31am

Internal rate of return, or IRR, is one of those concepts bank staff wheel out when they are selling investments, particularly savings and pension plans involving a series of contributions.

The concept has its use. This problem is that outside of professional financial circles very few people understand what IRR means.

That can be challenging for those asked to make an important investing decision based on the measure. So let's try to get a grip on this basic, if somewhat slippery, performance measure.

IRR was devised for use by companies to understand whether a project was worth its upfront investment. Firms who look at such projects typically have other uses for the money. They would take a view about the minimum return they would expect a project should generate to be attractive. This might be pegged to the returns expected from projects with similar risk, or the cost of a bank loan used to pay for the project plus a profit margin.

This minimum threshold for performance is the internal rate of return, or the multipurpose IRR.

If a project's returns beat the IRR, then the chances are it's a worthwhile investment. The higher the IRR of a project, the better. It can support a higher cost of funding.

All well and good, but an individual who wandered into a bank to look at a pension plan might be wondering why he is being asked to understand this complex project-finance measure.

It turns out that IRR is handy for measuring returns of any plan with large upfront contributions followed, eventually, by large payouts. For example, bank sales staff will commonly offer clients annuity plans sold by insurance firms. These plans might involve annual contributions for three years of, say, HK$200,000 per year.

The plan will grow in value with a series of highly uneven payouts, perhaps generating positive returns in year eight.

In the jargon of the industry, IRR is "money weighted". It adjusts for the fact that contributions and payouts are irregular and lumpy, as is often seen for the annuity plans marketed by bank sales staff. By weighting cash flows by their size and dates, investors get a more accurate picture of performance.

IRR is, therefore, an honest measure of a plan's returns. You might use IRR as a CFO would, by comparing various investments' projected returns.

If anyone quotes an IRR, they should be asked to supply the figures behind it, including the cash flow amounts and dates so that investors understand what assumptions are behind the calculation. Ask them to perform the calculation in front of you on an Excel spreadsheet. Be aware this is a subtle, complicated calculation involving guesswork. You need to know what you are getting into, particularly as these annuity plans can involve large cash commitments over long periods. As investors' risk-taking natures slowly return, it's a good time to review the concepts of investment performance to avoid the mistakes that were made in the run-up to the global financial crisis.

A review will also help investors to confidently assess performance claims made by friends, bankers and advisers before rushing in.

Robert Jones is head of FCL Advisory, which advises family offices and wealthy individuals