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.