Putnam Investments recently completed a study in which they examined the wealth drivers in 401k plans for individuals. (I first saw the discussion of their study in this article at AdvisorOne. The full Putnam study is here.) What they did was very clever: they built a base case, and then made various modifications to see what changes had the most impact in driving wealth. Here was their base case:
They assumed that a 28-year-old in 1982 earned $25,000 per year with a 3% cost-of-living increase. The worker contributes 3% of gross salary to a 401(k) plan that receives a 50-cent match on the dollar up to 6% and has a conservative asset allocation across six asset classes. The hypothetical 401(k) also invests in funds in the bottom 25% of their Lipper peer group. By the time the worker turns 57 in 2011, income is $57,198, and the 401(k) balance is $136,400.
Then Putnam examined three sets of wealth drivers to see how they impacted the base case:
- They changed the 4th quartile mutual funds to 1st quartile funds, but kicked out funds after three years if they fell out of the 1st quartile.
- They looked at the effect of adding more equities to the mix, so they boosted stocks from 30% of the account to 60% and to 85%.
- They looked at quarterly rebalancing of the account.
The results were pretty interesting. Picking “better” funds, in concert with the replacement strategy, was actually $10,000 worse than the base case! The portfolios with more equities had their balances boosted by $14,000 and $23,000 respectively—but, of course, they were also more volatile. Rebalancing added $2,000 to the base portfolio balance, but slightly reduced the volatility as well.
All of these strategies—fund selection, asset allocation, and rebalancing—are commonly offered as value propositions to 401k investors, yet none of them really moved the needle much. (Even a “crystal ball” strategy that predicted which funds would become 1st quartile funds only helped balances by about $30,000.)
Then Putnam explored three variations of a mystery strategy. The first version improved the final balance by $45,000; the second version boosted the balance by an additional $136,000; and the third version blew away everything else by adding another $198,000 to the $136,000 base case, for a final balance of $334,000!
What was this amazing mystery strategy? Saving more!
The three variations simply involved moving the 401k deferral rate up from 3% to 4%, 6%, and 8%. That’s it.
The mathematics of compounding over time are very powerful. Because this study looked at the 1982-2011 time period, higher contributions had time to compound. Even moving up the contribution rate by 1% dominated all of the investment gyrations.
The power of compounded savings is often overlooked, almost always by clients and even frequently by advisors. Often one of the best things you can do for your clients is just to get them to boost their deferral rate by a percent or two. They might squawk, but in six months they will usually not even notice it. Then it’s time to get them to boost their deferral rate again! Over time, people are often shocked at how much they can save without really noticing.
Clients often obsess over their fund selection and investment strategy, when they really should be paying attention to their savings rate.