A feature from Ann Zuraw, Zuraw Financial Advisors, LLC. Advisor Views offers timely investment news and market updates designed to keep you informed, while enhancing your overall investment experience.
Your 401(k) Plan: Is it Time to Re-Think Your DIY Strategy?
If asked, most people would probably agree that saving for a secure and comfortable retirement is one of their primary investment objectives. While seemingly commonplace today, saving for retirement may not have been such a concern for our parents or grandparents as company sponsored pension plans provided many retirees with a steady and dependable income in their golden years. Today, however, the tide has turned, and ensuring financial security in retirement is primarily the responsibility of the individual. Fortunately, many employees have access to various vehicles to help them save for retirement, including the 401(k) plan.
An employer sponsored, qualified retirement plan, 401(k) plans allow employees to save for retirement by electing to have a set percentage of their pay deducted and contributed to the plan each pay period. Typically, the plans offer a menu of investment options from which participants can choose, and the employees’ contributions are invested accordingly. Since deductions are made on a pre-tax basis, participation not only helps employees save for the future, but it also helps to lower their current taxable income. Additionally, contributions and earnings grow on a tax-deferred basis and are not subject to taxation until they are withdrawn from the plan.
As an incentive to encourage employee participation, many plans offer employer matching contributions. Deposits made by the employer to the accounts of participating employees, matching contributions may be dollar for dollar, or they may be a percentage of the participant’s contribution up to a certain limit. Over time, the compounding of investment earnings and the deferral of taxes on the employee contributions and, if applicable, employer matches can substantially add to participants’ wealth.
It’s not always smooth sailing
While the 401(k) offers employees the opportunity and incentive to build wealth for their futures, research indicates that a significant number of plan participants fall short of their savings goals.1 While some portion of the shortfall may be attributable to participants simply not saving enough each month, a lack of investment knowledge can hamper one’s portfolio growth, while investor behaviors can also negatively affect portfolio returns.
As previously discussed, 401(k) plans typically allow participants to choose investments for their portfolios from a list of eligible options that have been selected by the plan sponsor. Traditionally, these choices would include a diverse mix of investments designed to satisfy the planning needs of different types of investors. Unfortunately, some participants may lack the experience necessary to build a broadly diversified portfolio. Furthermore, once their investment selections have been made, many fail to monitor or rebalance their portfolios in a systematic way. In the absence of re-balancing, the asset allocation may stray from its intended target weightings resulting in a portfolio exposed to either more or less risk than may have been originally intended.2
While limited knowledge of basic investment strategies can have an impact on returns, compounding this problem is the fact that as human beings, we tend to make emotional decisions with respect to our money, and these decisions can affect investment returns in a substantial way.
Consider, for example, a study by DALBAR, Inc., a Boston-based financial services research firm, that compared the return of the average equity fund investor to the return of the S&P 500. According to DALBAR, over the period 1994-2013, the S&P had an annualized return of 9.22%, while the average equity fund investor averaged only 5.02%.3 While a portion of the return difference may be attributed to the fees and costs associated with investing in mutual funds, a majority of the difference may well be the result of investor behavior. When emotion overtakes logic, investors may make poor investment decisions such as selling during periods of volatility, or buying enthusiastically once the market has recovered. Unintentionally, this often results in the classic mistake of “selling low,” and “buying high,” a formula that’s all but guaranteed to result in sub-par investment returns.
When considering the role of emotion and behavior as it relates specifically to the returns of retirement plan participants, a study by the Center for Retirement Research at Boston College supported the notion that, by-and-large, participants are not as good at managing their retirement assets as are the investment managers of defined benefit pension plans. According to the study, over the period 1988-2004, defined benefit plan returns outpaced those of 401(k) plans by about one percentage point per year.4 While not conclusive, one could theorize that investor emotion combined with questionable investment decisions may have contributed to the underperformance of the participant directed 401(k) plans compared to the unemotional, professionally informed decisions of those responsible for oversight of the defined benefit plans.
In addition to highlighting the return difference between the participant directed 401(k) plans and the defined benefit plans, the Boston College study also showed that a significant percentage of the 401(k) participants lacked adequate diversification in their portfolios. While about half of the participants practiced some measure of diversification, the other half didn’t; the group that lacked diversification tended to hold almost all stock in their portfolios, or they held no equities at all.5
And what about participants’ comfort levels when it comes to making investment decisions for their plans? According to a 2013 study conducted by Fidelity, 77% of the 3,100 plan participants surveyed admitted to not having the time or knowledge to be confident in their investment decisions, yet many attempted to make their own decisions anyway.6 Furthermore, and perhaps ironically, a 2008 survey by the Profit Sharing/401(k) Council of America reported that even when professional investment advice was offered to them, nearly 72% of the participants failed to take advantage of it.7
So what does this mean for the participants of America’s 401(k) plans?
The data seems to indicate that many plan participants could probably benefit from additional assistance when it comes to planning for retirement. One way that sponsors have begun helping participants, while encouraging them to save, is through the growing use of automatic enrollment. Automatic enrollment is a feature that allows the employer to enroll an eligible employee in his or her retirement plan unless the employee communicates that they wish to “opt out,” and not participate.8 While not universally available, automatic enrollment seems to have a positive impact on employee participation. According to ShareBuilder401k, while the average employee participation rate is approximately 66%, participation increases to about 92% when employees are auto-enrolled.9
While auto-enrollment can help increase participation among those employees who may not be inclined to enroll on their own, others may be committed to participating, but they may need help in navigating their investment decisions. If you feel you need some advice on the options in your plan that may be best for you, we would encourage you to speak with us. As financial advisors, we are well positioned to offer advice on how to allocate your retirement plan assets based on your time horizon and risk tolerance, as well as in light of any other investments you may hold outside of your plan.
Additionally, rather than selecting individual funds to build your portfolio, consider choosing a model portfolio if they are available as an investment option within your plan. Rather than trying to choose individual funds to create a suitable asset allocation, model portfolios can help eliminate the guesswork as they are designed to offer broad diversification and exposure to numerous asset classes in a single, professionally constructed portfolio. Furthermore, these portfolios typically offer multiple models ranging from conservative to aggressive in an effort to satisfy the risk appetites and time horizons of different types of investors. Additionally, many model portfolios enjoy automatic rebalancing: a feature designed to keep the portfolio allocations in line with their stated risk/return objectives.
Symmetry investors are very familiar with benefits of a model portfolio. Indeed, Symmetry’s academic-based, turn-key investment strategy makes it easy for investors to work in partnership with their advisors to choose a globally diversified portfolio with an appropriate mix of stocks and bonds, based on each individual’s unique goals, time horizon and risk tolerance.
As always, we appreciate the opportunity to serve your financial planning needs. Please contact us with questions or for additional information.
|1,2,4,5,6 http://www.am-a.com/pdf/white-papers/wp_Participantdirectedplansfinal.pdf3 Source: “Quantitative Analysis of Investor Behavior, 2014” DALBAR, Inc. www.dalbar.com7 http://www.independentactuaries.com/wp-content/uploads/2013/02/Participant-Directed-Accts-vs-Trustee-Directed-Accts.pdf8 www.irs.gov9 www.sharebuilder401k.com/auto-enrollment.aspx|