I recently read a study published by the Putnam Institute (affiliated with Putnam Investments) that I found remarkable and worth sharing with you for two reasons. First, it is not self -serving like much of the material put out by the mutual fund industry and second, it illustrates several vital points that we are constantly trying to reinforce to participants in the 401(k) plans we serve as investment advisor.
The study began with a reasonable base case: sort of a 401(k) “every person”. An individual who was age 28 in 1982 (just after the inception of the 401(k) plan in the United States) earning an income then of $25,000 and receiving a 3% annual cost of living increase. His 401(k) plan offered a match of $0.50 on the dollar up to 6% of salary. The study assumed that the individual invested in a conservative, but not guaranteed, mix of investments that ranked in the bottom 25% (worst) of their category for performance. The base case also assumed that the individual saved 3% of gross salary in the plan, and made no changes in the plan over the next 29 years. After 29 Years the individual was 57 years old, earned an income of $57,198 per year and had a 401(k) balance of $136,400.The study then looked at the impact of four factors that could have influenced the ending 401(K) Balance for this individual, investment fund selection, investment mix, account rebalancing and finally how much the participant contributed.
In brief, the study tested several common methods used to choose one investment fund over another as well as the use of inexpensive index funds. None of the options tested led to any significant difference in the end value of the account. This leads us to recommend that you use all index fund investment options (or the ETF equivalents) when investing in your 401(k) plan. Actively managed funds charge, on average, 1.25% of your retirement savings to use them, while index funds on average charge 0.45%.If selecting for outperforming active managers produces no significant advantage to the return you will receive, why pay extra. If your plan does not offer low cost index fund options, speak to your HR administrator and ask if they can be added. Be persistent, plan sponsors cannot afford to ignore requests regarding less expensive investment choices in their plans.
The second factor, asset allocation, did make a larger difference in the end value of the account. Had the participant used one of the more aggressive portfolios tested, the end value of the account would have been significantly higher. More risk – more return, no surprise there. However, this has to be taken with a grain of salt as this would have also have produced a significantly more volatile ride (the growth portfolio dropped -38% from 2001-2003, and -42% from 2007-2009) therefore it may have been difficult for that participant to have stayed the course with the more aggressive portfolios. Ask to see your plan’s investment advisor to develop an investment plan that has a risk level that you’re comfortable with. No investment plan will work if you lose faith in it and do not stick with it. Better yet, work with a fee-only, independent investment advisor to develop a plan. If your plan does not offer investment advice, ask your HR department if they would consider changing to a plan that does.
The study also examined the effect of rebalancing on the ending value of the portfolio. Rebalancing is the process of periodically resetting the investments back to the original mix that you selected. Hopefully your investment mix has been carefully selected to provide a decent return at a level of risk that you are comfortable with. As one investment or the other does well it may stray far from the original mix and now be too risky or too conservative. Rebalancing will return the investment portfolio to the original mix and the intended risk level. This study confirmed what we have seen in previous studies and what we tell our clients, rebalancing is an important risk control tool but does not add significantly to performance. In this study, quarterly rebalancing added on very slightly to returns but produced significantly less volatility (less risk). This lower volatility should enable you to feel more comfortable with your investments and stick with your investment plan through tough markets.
The only factor that dramatically and reliably increased the end value of the base case portfolio was increasing the amount saved. All other things being equal, if you save twice as much you end up with twice as much in the end. Why is it that the simplest things always have the biggest impact?
The take home message from this study should be; when managing your 401(k) you should consider the following factors in this order of priority:
1. How much am I saving, is it enough to fund my retirement? This is the single biggest factor in determining how much money you will have to retire.
2. Am I using the right investment mix? Will it give me the return I need and not be so volatile that I can’t stay with it when the markets turn sour?
3. Do I rebalance effectively, it will reduce the risk in the account and give you a smoother ride.
4. Are the funds I am using cost effective? There is very little that can be gained by trying to choose active managers within a 401(k) plan. Use the low cost index fund options in your plan.