Cage Match: Pension vs. 401k

June 26, 2013

Chuck Jaffe recently had a good retirement article on Marketwatch.  He covered a number of topics, especially longevity estimates, but he also had the most succinct explanation of the difference between how a pension and a 401k plan works.  Here it is:

In the days when corporate pensions were the primary supplement to Social Security, Americans were able to generate a lifetime income, effectively, by putting everyone’s lifetime in a pool, then saving and managing the pooled assets to meet the target.

The individuals in a pension plan would live out their lives, but the actuaries and money managers would adjust the pool based on the life experience of the group. Thus, if the group had a life expectancy of living to age 75 – which statistically would mean that half of the pensioners would die before that age, and half would die afterwards – longevity risk was balanced out by the group experience.

Now that we have shifted to making individuals responsible for generating their lifetime income stream, there is no pool that shares the risk of outliving assets.

The bold is mine, but the distinction should be pretty clear.  With a pension plan, you’re covered if you live a long time—because your extra payouts are covered by the early mortality of some of the other participants.  It’s a shared-risk pool.

In a 401k, there’s only one participant.  You.  In other words, you’re on your own.

With a 401k, the only way to cover yourself adequately is to assume you are going to live a long time and save a lot to reserve for it.  If you’ve got enough assets to cover yourself to age 100, the most negative outcome is that your heirs will think very fondly of you.  If you are covered for only a few years of retirement, you’ll need to either keep working, eat Alpo, move in with your kids, or possibly take up motorcycle racing and sky-diving.  None of those sound like great options to me.

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Retirement Success

April 30, 2013

Financial Advisor had a recent article in which they discussed a retirement success study conducted by Putnam.  Quite logically, Putnam defined retirement success by being able to replace your income in retirement. They discovered three keys to retirement success:

  1. Working with a financial advisor
  2. Having access to an employer-sponsored retirement plan
  3. Being dedicated to personal savings

None of these things is particularly shocking, but taken together, they illustrate a pretty clear path to retirement success.

  • Investors who work with a financial advisor are on track to replace 80 percent of their income in retirement, Putnam says. Those who do not are on track to replace 56 percent.
  • Workers who are eligible for a workplace plan are on track to replace 73 percent of their income while those without access replace only 41 percent.
  • The ability to replace income in retirement is not tied to income level but rather to savings level, Putnam says. Those families that save 10 percent or more of their income, no matter what the income level, are on track to replace 106 percent of their income in retirement, which underscores the importance of consistent savings, the study says.

I added the bold.  It’s encouraging that retirement success is tied to savings level, not income level.  Everyone has a chance to succeed in retirement if they are willing to save and invest wisely.  It’s not just an opportunity restricted to top earners.  Although having a retirement plan at work is very convenient, you can still save on your own.

It’s also interesting to me how much working with a financial advisor can increase the ability to replace income in retirement.  Maybe advisors are helping clients invest more wisely, or maybe they are just nagging them to save more.  Whatever the combination of factors, it’s clearly making a big difference.  Given that the average income replacement level found in the study was 61%, working with an advisor moved clients from below average (56%) to well above average (80%) success.

This study, like pretty much every other study of retirement success, also shows that nothing trumps savings.  After all, no amount of clever investment management can help you if you have no capital to work with.  For investors, Savings is Job One.

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Underfunded Pension Plans

February 4, 2013

Many large corporations still carrying defined benefit plans for their workers have underfunded pension plans.  For example, here’s an excerpt from a Wall Street Journal article on the issue today:

“It is one of the top issues that companies are dealing with now,” said Michael Moran, pension strategist at investment adviser Goldman Sachs Asset Management.

The drain on corporate cash is a side effect of the U.S. monetary policy aimed at encouraging borrowing to stimulate the economy. Companies are required to calculate the present value of the future pension liabilities by using a so-called discount rate, based on corporate bond yields. As those rates fall, the liabilities rise.

If you think that underfunded pension plans are only a corporate or government problem, you would be wrong.  Chances are that the underfunded pension plan is a personal problem, even if (or especially if) you have a defined contribution plan like a 401k.  In a corporate plan, the corporation is on the hook for the money.  If you have a 401k plan, you are on the hook for the money.  And, since there is a contribution cap on 401ks, it may well be that you need to set aside additional money outside your retirement plan to make sure you hit your goals.

Figuring out whether your retirement is funded or not depends on some assumptions—and those assumptions are a moving target.  The one thing you know for sure is how much you have saved for retirement right now.  You might also have a handle on your current level on contributions.  What you don’t know exactly is how many years it will be until you retire, although you can generate scenarios for different ages.  What you don’t know at all is what the return on your retirement savings will be in those intervening years—or what the inflation rate will be during that time.

As interest rates fall, pensions are required to assume that their investment returns will fall too.  That means they have to contribute much more to reach their funding goals.

Guess what?  That means you should assume that you, too, will see lower returns and will need to save more money for retirement.  When stock and bond yields are low, it’s realistic to assume that returns will be lower going forward.  Investors right now, unfortunately, are stuck with rates that are near 50-year lows.  It puts a big burden on investors to get cracking and save as much as they can while they are working.  A qualified advisor should be able to give you some sense of your funding level so that you can plan for retirement.


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401k Abuse

January 18, 2013

With the elimination of traditional pensions in many workplaces, Americans are left to their own devices with their 401k plan.  For many of them, it’s not going so well.  Beyond the often-poor investment decisions that are made, many investors are also raiding the retirement kittyBusiness Insider explains:

Dipping into your 401(k) plan is tantamount to journeying into the future, mugging your 65-year-old self, and then booking it back to present day life.

And still, it turns out one in four workers resorts to taking out 401(k)  loans each year, according to a new report by HelloWallet –– to the tune of $70 billion, nationally.

To put that in perspective, consider how much workers contribute to retirement plans on average: $175 billion per year. That means people put money in only to take out nearly half that contribution later.

That’s not good.  Saving for retirement is hard enough without stealing your own retirement money.  Congress made you an investor whether you like it or not—now you need to figure out how to make the best of it.

Here are a couple of simple guidelines:

  • save 15% of your income for your entire working career.
  • if you can max out your 401k, do it.
  • diversify your portfolio intelligently, by volatility, asset class, and strategy.
  • resist all of the temptations to mess with your perfectly reasonable plan.
  • if you can’t discipline yourself, for heaven’s sake get help.

I know—easier said than done.  But still, if you can manage it, you’ll have a big headstart on a good retirement.  Your 401k is too important to abuse.

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Retirement Income Karma Boomerang

October 11, 2012

From time to time, I’ve written about karma boomerang: the harder you try to avoid getting nailed, the more likely it is that you’ll get nailed by exactly what you are trying to avoid.  This concept came up again in the area of retirement income in an article I saw at AdvisorOne.  The article discussed a talk given by Tim Noonan at Russell Investments.  The excerpt in question:

In [Noonan’s] talk, “Disengagement: Creating the Future You Fear,” he observed that lack of engagement in retirement planning is leading people toward the very financial insecurity they dread. What they need to know, and are not finding out, is simply whether they’ll have enough money for their needs.

I added the bold.  This is a challenge for investment professionals.  Individuals are not likely on their own to go looking for their retirement number.  They are also not likely to go looking for you, the financial professional.  They may realize they need help, but are perhaps intimidated to seek it—or fearful of what they might find out if they do investigate.

Retirement income is probably not an area where you want to tempt karma!  Retirement income is less secure than ever for many Americans, due to under-funded pension plans, neglected 401k’s, and a faltering Social Security safety net.  The only way to secure retirement income for investors is to reach out to them and get them engaged in the process.

Mr. Noonan, among other suggestions, mentioned the following:

  • “Personalization” is tremendously appealing. “Tailoring” may be an even more useful term, since “people don’t mind if the tailor reuses the pattern,” Noonan explained. They may even enjoy feeling part of an elite group.
  • “Tactical investing” is viewed positively. “People know they should be more adaptive, but they aren’t sure what of,” said Noonan. Financial plans should adapt to the outcomes they’re producing, not to hypothetical market forecasts.

Perhaps personalization and tactical investing can be used as hooks to get clients moving.  To reach their retirement income goals, they are going to need to save big and invest intelligently, but none of that will happen if they aren’t engaged in the first place.

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Target-Date Fund-mageddon

September 26, 2012

Markets are rarely tractable, which is one reason why significant flexibility is required over an investment lifespan.  Flexibility is something that target-date funds don’t have much of.  In fact, target-date funds have a glidepath toward a fixed allocation at a specified time.  I’ve written about the problems with target-date funds extensively—and why I think balanced funds are a much better QDIA (Qualified Default Investment Alternative).  It appears that my concerns were justified, now that Rob Arnott at Research Affiliates has put some numbers to it.  According to an article in Smart Money on target-date funds:

A target-date fund is a one-decision mutual fund that you can invest in over the course of your entire career.

Each fund is designed for those aiming to retire at a certain date. The fund starts with a lot of “risky” stocks, and over time it moves to “safer” bonds. The fundamental idea is that at any given moment between age 21 and age 65 you should be invested in a particular balance of assets — more stocks when you are younger, and more bonds when you are older.

The track to retirement, according to the industry jargon, is a “glidepath.”

Billions of dollars are invested in these target-date funds. They are today the default investment option in many 401(k) plans. Now comes Rob Arnott, the chairman of Research Affiliates and one of the handful of serious money managers in the country. In a new research paper he published yesterday, “The Glidepath Illusion,” he has blown this idea full of holes. “Shockingly,” he says, “the basic premise upon which these billions [of dollars] are invested is flawed.”

When Mr. Arnott investigated the results of such target-date funds, he found them to be incredibly variable—and possibly upside-down.  (I put the fun part in bold.)

Arnott has mined data from the stock and bond markets going back to 1871 and then run simulations to see how these target-date portfolios would have worked in practice. He considered a fund that started out with 80% stocks and 20% bonds, and then adjusted gradually over an investing life of 41 years so that it ended up 80% bonds and 20% stocks. He considered an investor who invested $1,000 a year, adjusted for inflation, from the day she started work at age 22 to when she retired at 63.

Bottom line? This investor could have done very well — or very badly. Far from enjoying a smooth “glidepath” to a secure retirement, she could have retired with as little as $50,000 in savings or as much as $211,000. She could have ended up with a retirement annuity of $2,400 a year — or $13,100 a year. There was no way of knowing in advance.

That wasn’t all. Arnott found that in most eras, investors would have actually been better off if they had stood this target-date strategy on its head — in other words, if they had started out with 80% bonds, and then took on more risk as they got older, so that they ended up with 80% stocks.

No kidding. Really.

The median person following the target date strategy ended up with $120,000 in savings. The median person who did the opposite, Arnott’s team found, ended up with $148,000. The minimum outcome from doing the opposite was better. The maximum outcome of doing the opposite was also better.

Amazing.  Even the minimum outcome from going opposite the glidepath was better!  Using even a static 50/50 balanced fund was also better.  Perhaps this will dissuade a client or two from piling into bonds only because they are older.  No doubt path dependence had something to do with the way returns laid out, but it’s clear that age-based asset allocation is a cropper.

Asset allocation, diversification, and strategy selection are important.  Decision of this magnitude need to be made consciously, not put on autopilot.

[You can read Mr. Arnott’s full article here.  Given that most 401k investors are unfortunately using target-date funds instead of balanced funds, this is a must read.  I would modestly suggest the Arrow DWA Balanced Fund as a possible alternative!]

Click here to visit for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.

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Are 401k Investors Making a Mistake with Hybrid Funds?

September 26, 2012

I think this is an open question after reading some commentary by Bob Carey, the investment strategist for First Trust.  He wrote, in his 9/11/2012 observations:

  • Hybrid funds, which tend to be comprised primarily of domestic and foreign stocks and bonds, but can extend into such areas as commodities and REITs, saw their share of the pie rise from 15% in Q1’07 to 22% in Q1’12.
  • One of the more popular hybrid funds for investors in recent years has been target-date funds. These funds adjust their asset mix to achieve a specific objective by a set date, such as the start of one’s retirement.
  • In 2010, target-date fund assets accounted for 12.5% of all holdings in employer-sponsored defined-contribution retirement accounts. They are expected to account for 48% by 2020, according to Kiplinger.
  • Plans are shifting away from the more traditional balanced funds to target-date funds for their qualified default investment alternative (QDIA).

There’s a nice graphic to go along with it to illustrate his point about the growing market share of hybrid funds.

Are 401k Investors Making a Mistake?

Source: First Trust, Investment Company Institute  (click to enlarge)

He points out that 401k assets in hybrid funds are rising, but the growth area within the hybrid fund category has been target-date funds.  It troubles me that many 401k plans are moving their QDIA option from balanced funds to target-date funds.  QDIAs are designed to be capable of being an investor’s entire investment program, so the differences between them are significant.

There is a huge advantage that I think balanced funds have–much greater adaptability to a broader range of economic environments.  Balanced funds, particularly those with some exposure to alternative assets, are pretty adaptable.  The manager can move more toward fixed income in a deflationary environment and more toward equities (or alternative assets) in a strong economy or during a period of inflation.

Most target-date funds have a glide path that involves a heavier and heavier allocation to bonds as the investor ages.  While this might be worthwhile in terms of reducing volatility, it could be ruinous in terms of inflation protection.  Inflation is one of the worst possible environments for someone on a fixed income (i.e. someone living off the income from their retirement account).  Owning bonds just because you are older and not because it is the right thing to do given the market environment seems like quite a leap of faith to me.

Asset allocation decisions, whether strategic or tactical, should be investment decisions.

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Wealth Drivers in 401k Accounts

September 10, 2012

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:

  1. 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.
  2. 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%.
  3. 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.

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More on the Value of a Financial Advisor

September 5, 2012

I noticed an article the other day in Financial Advisor magazine that discussed a study that was completed by Schwab Retirement Plan Services.  The main thrust of the study was how more employers were encouraging 401k plan participation.  More employers are providing matching funds, for example, and many employers have instituted automatic enrollment and automatic savings increases.  These are all important, as we’ve discussed chronic under-saving here for a long time.  All of these things together can go a long way toward a client’s successful retirement.

What really jumped out at me, though, was the following nugget buried in the text:

Schwab data also indicates that employees who use independent professional advice services inside their 401(k) plan have tended to save twice as much, were better diversified and stuck to their long-term plan, even in the most volatile market environments.

Wow!  That really speaks to the value of a good professional advisor!  It hits all of the bases for retirement success.

  • boost your savings rate,
  • construct a portfolio that is appropriately diversified by asset class and strategy, and
  • stay the course.

If investors were easily able to do this on their own, there wouldn’t be any difference between self-directed accounts and accounts associated with a professional advisor.  But there is a big difference—and it points out what a positive impact a good advisor can have on clients’ financial outcomes.

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How Your 401k Really Grows: Savings

August 16, 2012

CNBC ran an interesting article on the 401k market today.  Fidelity Investments handles about 12 million 401k accounts which they report on, in aggregate, periodically.  Here’s what I found most interesting from their recent release:

Over the past 10 years, about two-thirds of annual increases in account balances have been due to workers’ added contributions and company matches, with one-third the result of investment returns.

Surprised?  You shouldn’t be.  While investment performance is important, so is savings.  In a very slow decade for the market, the bulk of 401k growth came from new contributions.  Even in a stronger market for financial assets, it would not be surprising to see most of the increase in balances coming from savings since the average 401k balance is only $72,800, according to the article.

The savings rate is another area with plenty of room for improvement.  The article notes:

The average employee contribution in Fidelity-administered 401(k) plans has remained steady at around 8 percent of annual pay for the past three years.

8% is a good start, but most experts recommend something closer to 15%.  Given the current low-yield environment, seeking out investment returns wherever they can be found and saving as much as possible are going to be critical keys to 401k success.

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Stupid Investing Tricks

July 26, 2012

That’s the title of a Jason Zweig article for the Wall Street Journal.  In the article, he points out how investors over-react to short-term information.

According to new research, this area of the “rational” brain [frontopolar cortex] forms expectations of future rewards based largely on how the most recent couple of bets paid off. We don’t ignore the long term completely, but it turns out that we weight the short term more heavily than we should – especially in environments (like the financial markets) where the immediate feedback is likely to be random.

In short, the same abilities that make us smart at many things may make us stupid when it comes to investing.

For the ultimate in over-reaction, he writes:

For quick confirmation, look no further than this recent study, which analyzed the accounts of nearly 1.5 million 401(k) investors and found that many of them switch back and forth from stocks to bonds and other “safe” accounts based on data covering very short periods.

You might argue that the long run is nothing but a string of short runs put together,  or that you can get peace of mind by limiting your risk to fluctuating markets when prices fall, or that major new information should immediately be factored into even your longest-term decision-making. But many of these 401(k) investors were overhauling their portfolios based entirely on how markets performed on the very same day.

Yep—by “very short period,” he means the same day.  That’s what the authors in the academic article, Julie Agnew and Pierluigi Balduzzi, found.  They write:

We find that transfers into “safe” assets (money market funds and GICs) correlate strongly and negatively with equity returns. These results hold even after controlling for lead-lag relationships between returns and transfers, day-of-the-week effects, and macro-economic announcements. Furthermore, we find evidence of contemporaneous positive-feedback trading. That is, we find a positive effect of an asset class’ performance on the transfers into that asset class on the same day. Overall, these results are surprising, in light of the limited amount of rebalancing activity documented in 401(k) plans. It appears that while 401(k) investors rarely change allocations, when they do so their decisions are strongly correlated with market returns.

This is a very polite way for academics to say “when the stock market went down, investors panicked and piled into ‘safe’ assets.”  Jason Zweig’s article points out that people react to how their last two trials worked out.  That’s pretty much in line with anecdotal stories that buyers of profitable trading systems will stop using them after two or three losses in a row.  The long-term is ignored in favor of the very short term.

With typical understatement, Agnew and Balduzzi write:

This is potentially worrisome, as it suggests that some investors may deviate from their long-run investment objectives in response to one-day market returns. We provide evidence that these deviations can lead to substantial utility costs.

“Substantial utility costs” in plain English means investors are screwing themselves.

Now, none of this is a surprise for advisors.  We all have the same discussion with clients during every decline.  The party line is that more investor education is needed, but these neurological studies suggest that people, in general, are just wired to be bad investors.  They might overemphasize the last two trials no matter how we educate them.

So what is the takeaway from all of this?  I certainly don’t have a simple solution.  Perhaps it will be helpful to reframe what a “trial” is for clients as something much bigger than the last couple of quarters or the last two trades.  It might help, at the margin, to continue to emphasize process.    Maybe our best bet is just to distract them.  Like I said, I don’t have a simple solution—but I think that a lot of any advisor’s value proposition is how successful they are at getting the client to invert their normal thought process and get them to focus on the long term rather than the short term.

Source of Stupid Trick:

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Advisors to the Rescue: Savings Edition

July 16, 2012

There’s already lots of evidence that individuals on their own don’t do very well investing.  Compounding your net worth is extra difficult when you also don’t know how much to save.  (As we’ve shown before, savings is actually much more important than investment performance in the early years of asset growth.)

An article at AdvisorOne discussed a recent survey that had some surprising findings on consumer savings, but ones that will be welcome for advisors.  To wit:

The survey found that, regardless of income level, more than 60% of consumers who work with an advisor are contributing to a retirement plan or IRA, compared with just 38% of those without an advisor.

Furthermore, 61% of consumers who work with an advisor contribute at least 7% of their salary to their plan. Just 36% of consumers without an advisor save at this rate.

The guidance and education that advisors provide their clients to bring on these good saving habits translate to higher confidence, too. Of non-retired consumers with an advisor, half said their advisor provided guidance on how much to save. More than 70% of Americans with an advisor say they’re confident they’re saving enough. Just 43% of consumers without an advisor felt the same.

The differences in savings are really shocking to me.  Less than half of the consumers without an advisor are even contributing to a retirement plan!  And when they do have a retirement plan, only about a third of them are contributing 7% or more!

Vanguard estimates that appropriate savings rates are 12-15% or more.

I find it interesting that many consumers point out that their advisors gave them guidance on how much to save.  It is pretty clear that even simple guidance like that can add a lot of value.

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The Big Trend: Professional Asset Management Within the 401k

July 10, 2012

According to a Vanguard report, one of the big trends in the 401k market is the move toward professional asset management.  An article at AdvisorOne on this topic says:

One-third of all Vanguard 401(k) plan participants invested their entire account balance in a professionally managed asset allocation and investment option in 2011, according to Vanguard’s How America Saves 2012, an annual report on how U.S. workers are saving and investing for retirement.

The report notes that “the increasing prominence of so-called professionally managed allocations—in a single target-date or balanced fund or through a managed account advisory service—is one of the most important trends in 401(k) and other defined contribution (DC) plans today.”

Two things concerned me about the report.  I’m not at all surprised by more and more 401k participants moving toward professionally managed allocations.  QDIAs (qualified default investment alternatives) make sense for a lot of participants because they are legally allowed to be your entire investment program.  I was surprised about the make-up of the account allocations, given the problems encountered by target-date funds during the last bear market.

In 2011, 33% of all Vanguard participants were invested a professionally managed allocation program: 24% in a single target-date fund (TDF); 6% in a single traditional balanced fund, and 3% in a managed account advisory program. The total number is up from 9% at the end of 2005.

I am amazed that target-date funds are preferred to balanced funds.  No doubt target-date funds are an improvement over investors hammering themselves by trading in and out, but target-date funds have some well-publicized problems, not the least of which is that they tend to push the portfolio more toward bonds as the target date nears.  That could end up exposing retirees to significant inflation risk right at the time they can least cope with it.  It seems to me that a balanced fund with some ability to tactically adjust the portfolio allocation over time is a much better solution.

The other significant problem I see is that savings rates are still far too low.  Consider these statements from the AdvisorOne article:

The average participant deferral rate rose to 7.1% and the median (the median reflects the typical participant) was unchanged at 6%.

and then…

Vanguard’s view is that investors should save 12% to 15% or more.

I added the emphasis, but it’s easy to see the disconnect.  Investors are saving 6%, but they probably need to be saving more than 15%!

Advisors, for the most part, have very little control over their client’s 401k plans.  Clients sometimes ask for advice informally, but advisors are often not compensated for the advice and firms are sometimes reluctant to let them provide it for liability reasons anyway.  (A few advisors handle client 401k’s through the independent brokerage window, but not every plan has that option and not every firm lets advisors do it.  It would be great if the financial powers-that-be could figure out a way to reverse this problem, but the recent Department of Labor regulations appear to be going in the other direction.)

If you’re an advisor, it’s probably worthwhile to have a serious discussion with your clients about their 401k plans.  They may not be handling things in the optimal way and they could probably use your help.

Your client may need your help


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Never Underestimate Inertia!

July 8, 2011

The law of unintended consequences strikes again.  A few years ago, in 2006 to be exact, legislation enabling automatic employee enrollment in 401ks was passed in order to boost retirement savings.  An article in the Wall Street Journal suggests that automatic enrollment might be having the opposite effect.

Under the law, companies are allowed to automatically enroll workers in their 401(k) plans, rather than require employees to sign up on their own. The measure was intended to encourage more people to bulk up their retirement nest eggs—a key goal in a country where millions of people aren’t saving enough.

But an analysis done for The Wall Street Journal shows about 40% of new hires at companies with automatic enrollments are socking away less money than they would if left to enroll voluntarily, the Employee Benefit Research Institute found.

More people were getting enrolled in the plan, but the initial contribution rates were set at lower levels than new enrollees typically selected on their own!

More than two-thirds of companies set contribution rates at 3% of salary or less, unless an employee chooses otherwise. That’s far below the 5% to 10% rates participants typically elect when left to their own devices, the researchers said.

Some of the plans have automatic escalation, but even these plans did not seem to go far enough.

An October study by EBRI and the Defined Contribution Institutional Investment Association found that, depending on their incomes, 54% to 73% of employees would fall short of amassing enough money to retire if they enrolled in their companies’ 401(k) plans at the default-contribution rate and were auto-escalated by 1% a year to a maximum of 6%.

The net result has been a mixed bag.  Enrollment rates have climbed from 67% to 85%, but contribution rates have dropped!

Among plans Aon Hewitt administers, the average contribution rate declined to 7.3% in 2010, from 7.9% in 2006. The Vanguard Group Inc. says average contribution rates at its plans fell to 6.8% in 2010, from 7.3% in 2006. Over the same period, the average for Fidelity Investments’ defined contribution plans decreased to 8.2%, from 8.9%.

Vanguard estimates about half the decline “was attributable to increased adoption of auto-enrollment.”

Obviously, it’s not the auto-enrollment itself that’s the problem.  It’s simply that most of the plans have the automatic enrollment savings rate or the top escalation rate set way, way too low—and Big Brother underestimated inertia.

The study found that if people were auto-enrolled at 3%, they were just too lazy to proactively change it to 10%, or whatever.  If you are in charge of auto-enrollment at your firm, the obvious fix is to start it at 6% or so, and escalate it 1% annually, up to 15% or so.  A few more people might opt out due to the higher initial rate, but—again, due to inertia—most people would leave it alone and thus have a chance at a decent retirement.

Don't let inertia get the best of you


Financial advisors, on the other hand, know all about inertia.  Advisors have to fight client inertia all the time.  Inertia is closely related to the behavioral finance construct of fear of regret.  Clients don’t want to make a mistake that they will regret, so they take no action at all.  Philosophically, of course, taking no action is also taking an action, but clients tend not to see it that way, despite the fact that in the long run, opportunity cost usually dwarfs capital loss.

Markets offer infinite opportunities for error and regret (much of which is unfortunately actualized by the typical retail investor) but you can’t let a little thing like that dissuade you.   That’s why one of the most important functions of a financial advisor is to get clients to do the right thing at the right time.  Disciplined use of relative strength can often be a big help in that regard.

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