Point of View

Defined contribution plan participants can be their own worst enemy because of mistakes that are inherent to human nature. Emotions, confusion and being overwhelmed by an excess of information — including too many investment choices — clouds thinking and affects rational behavior. Individuals can trip themselves up in many ways — not saving enough, ignoring the benefits of tax-deferred savings, and investing too conservatively or aggressively.

After trillions of dollars were lost in the brutal 2008 market downturn, the spotlight is shining brightly on the inadequacy of the typical employee’s retirement savings. That is particularly true for those whose retirement relies entirely on their participation in a defined contribution (DC) plan. In many cases, poor or inappropriate asset allocation decisions by participants led to larger losses than would have been incurred in more broadly diversified, optimized portfolios. A study by Hewitt Associates found the average 401(k) balance fell from $79,600 in 2007 to $57,200 at the end of 2008. Further, for those 401(k) participants nearing retirement, the Employee Benefit Research Institute found that in 2006, about 38% of these investors had 80% or greater invested in stocks. The average account balance for these near-retirees had fallen more than 20% for the 12-month period ending March 2009.

Plan sponsors can help participants by understanding the field of behavioral finance and designing their DC plans in ways that help simplify and minimize the touch points in the participants’ decision-making process.

Common Mistakes

Mercer’s May 2009 “DC Quick Survey” found that 68% of the 180 organizations responding felt that they share responsibility with employees to provide retirement benefits. When considering plan participation quality, there are a number of common mistakes that DC participants tend to make, which lead to negative outcomes. Plan sponsors can help them achieve better results by being more cognizant of these pitfalls.

• Procrastination Leads to Inertia: Despite good intentions, individuals fail to act. Current needs such as discharging debt and job security generally override the desire to plan for a sound financial future. The savings and investment process required to prepare for retirement intimidates most individuals. HSBC’s 2009 “Future of Retirement” study found that only 27% of the 15,000 individuals surveyed from industrialized and emerging economies claim to understand their long-term finances. In addition, only 13% feel very prepared for their retirement. In a DC plan, inertia may lead to not enrolling or doing so at insufficient savings rates in combination with investment choices that do not align with an appropriate investment time horizon.
• Information overload: If some choice is good, it might appear that more choice is better. The prevailing thinking in designing DC plan fund menus several years ago was to give plan participants a wider variety of options from which to select. There was also a school of thought that suggested plan sponsors could help minimize fiduciary risk by giving participants more investment options from which to choose. This approach can often be counterproductive. Often, individuals are overwhelmed with too much information and/or too much choice. A 2003 Columbia Business School research paper found that for every 10 funds added to a DC plan, the participation rate fell by 2%. In addition, a 2008 joint research study conducted by the graduate business schools of Columbia University and the University of Chicago found that “the presence of more funds, even more equity funds, in an individual’s 401(k) plan induces a greater allocation to money market and bond funds at the expense of equity funds.”
• Irrational decision-making: Rather than follow a logical, strategic process with the help of analytical tools, participants make investment decisions based on fear of loss or overconfidence, with too much emphasis on recent market events.
  
  Similarly, many participants use mental shortcuts, or “heuristics,” to make investment decisions. They might choose to contribute a round number — such as 5% or 10% — of their salary. Alternatively, when faced with numerous fund options, they simply allocate their savings evenly across all investment choices rather than analyze which ones are most appropriate. Considerations such as strategy, risk tolerance, projected returns, levels of correlation or fund overlap are misunderstood or ignored.
• Chasing performance: When individuals focus on shorter-term market events, emotions often lead them to do the opposite of what is required. By jumping into the market as excitement and expectations peak, they tend to buy when prices are highest. Then, when the situation looks gloomiest and the market already has declined, emotions often lead them to sell.
• Poorly timed trades: A recent Hewitt study showed nine of the 10 most active trading days for 401(k) plan participants in 2008 occurred the day after a large market downturn (average daily losses of 4%). Because market rebounds can be abrupt and unpredictable, it is doubtful that many of these participants could accurately time the market. It is likely that they would miss the early market rebound, which would compound their shortfall and lead to underperformance against a given benchmark.

Consequences of Poor Behavior

The impact of all these mistakes adds up. Typical outcomes are poor diversification, asset allocation that is overly aggressive or conservative, and insufficient retirement savings.

According to a 2008 comprehensive study of nearly 1 million 401(k) participant portfolios by Financial Engines, 69% of all participants have portfolios that are inefficient or have inappropriate risk levels. Making matters worse, those earning the lowest salaries are most likely to have inappropriate asset allocations.

Similarly, participants earning the lowest salaries and those closest to retirement are more likely to have too high a concentration in employer stock. More than half of all participants earning less than $25,000 held more than 20% of their portfolio in company stock. Moreover, one in four participants over age 60 had 50% or more of their portfolio in employer stock.

In addition, even an appropriate asset allocation that is properly weighted can get off track.

Solutions That Help Modify Behavior

There are ways to help DC plan participants avoid mistakes, improve savings rates and potentially achieve better investment results. Four of the most effective methods are automatic enrollment, automatic increases in savings rates, rebalancing portfolio allocation to original investment elections and automatic default into professionally managed vehicles, such as target date retirement funds.

The evidence in favor of automatic enrollment is overwhelmingly positive. A study by the Vanguard Center for Retirement Research found the participation rate among new hires rose to 86% from 45% after introducing automatic enrollment. But simply enrolling participants without automatically increasing their savings rates will likely back-fire because of inertia. Ideally, the incremental increase of participants’ contribution rates every year is the single best chance they have of reaching retirement savings goals.

From accumulation in the savings years to capital preservation in the spend-down years, target asset allocation vehicles can address the dual concerns of initial asset allocation and automatic rebalancing throughout the participant investment lifecycle.

Target asset allocation vehicles, whether they are based on tolerance for risk or year of retirement, can be a good solution for meeting the needs of a majority of DC plan participants. Moreover, target date retirement funds effectively integrate a defined benefit plan investment philosophy into a DC investment choice. A well-diversified portfolio combines a robust asset allocation with a systematically rebalanced glidepath to meet the funding liability at retirement.

Target date retirement funds are likely best constructed with four primary asset categories: equities, fixed income, an inflation-hedge component and short-term cash investments. Each category should contain multiple asset classes, such as domestic and international stocks (with exposure to developed and emerging markets), TIPS, commodities, global real estate and high-yield bonds. The minimization of risk is enhanced due to the typically lower levels of correlation between these asset classes.

More Education Necessary

As a qualified default investment alternative, a target date fund is an effective and cost efficient way to integrate initial asset allocation and rebalancing back to targets defined by a retirement date-based strategy. They can incorporate a broader, more sophisticated investment mix, including alternatives that tend to have low correlation with the major asset classes.

There are some troubling misconceptions about target date funds that have recently surfaced. A survey conducted by Envestnet Asset Management and Behavioral Research Associates earlier this year indicated that close to 62% of respondents believed they would be able to retire at a fund’s target date; almost 38% believed target date funds offered a guaranteed return; more than one-third believed their savings would grow faster; and most alarming, almost 30% thought they would not need to save as much.

In addition, contrary to what some plan sponsors might have thought, not all target date asset allocation philosophies are similar. One issue made clear in the recent bear market is the variance in manager glidepaths. Although it is universal that the most aggressive asset allocation will be held in the longer-dated funds, the percentages to which managers allocate to higher risk asset classes, like equities, can vary widely. More importantly, as glidepaths roll down toward their target dates, key differences among managers tend to emerge, particularly among the 2020-2025, 2010-2015 and income glidepath points. Often, while appropriate from an investment thesis standpoint, participants were exposed to higher levels of risk than either they or their plan sponsors realized.

The most distinguishing factor in target date fund management is the glidepath. How much risk does a manager believe is appropriate? Does the glidepath provide management to retirement (typically age 65) or through retirement (sometimes referred to as “target death”)? Plan sponsors need to research the slope of a manager’s glidepath, understand the implications based on the level of risk assumed by participants, confirm how the manager defines a successful financial outcome at retirement and what quantifiable methods have been used to validate the probability of success.

Sponsors that follow a prudent due diligence process in plan design, combined with effective education communicated in a strategic manner, may influence participant behavior, thus enabling them to save and invest for a more financially secure retirement.

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