I spent the better part of this week addressing several investors’ 401k portfolio allocation needs. Many of my conversations were peppered with stories about either the client’s kids or my own. I really enjoy this aspect of my telephone consultations.
After reflecting on my conversations, something really began to sink in for me: Investors who lack access to better 401k education or advice are at great risk of failing to achieve their financial goals. On the other hand, investors who follow a thoughtfully designed strategy will not only hit their financial targets, but will potentially also experience more happiness in their own lives and the lives of their children.
From these thoughts I embarked to write this fairly detailed instructional article explaining how and why 401k plans may not deliver to expectations. My hope is that you will find it useful in boosting your 401k net worth.
A HISTORY OF PROMISES
For the last three decades, benefits managers have promoted the virtues of the 401k. In theory, this employer sponsored retirement plan enables you to direct pre-tax contributions (often partially matched by your employer) to an account where your money can grow tax free over the course of your career. Also in theory, if you are patient, contribute with consistency, and the market produces average returns over time, your 401k account will provide security in retirement, and a legacy to pass on to your family.
In reality, the 401k plan of our times is malfunctioning. And not just for investors who practiced excessive pre-2008 crisis risk-taking or who are complacent about their portfolio holdings. The 401k system is failing to educate participants like you who genuinely want to take advantage of their 401k for its real potential to fuel a long term plan to create and grow wealth.
THE COST OF NOT KNOWING
The cost of not knowing how to build a successful 401k strategy can be eye-popping. Upon performing portfolio 2nd opinions for average investors, I typically see between 3-8% of returns lost annually because the individual lacks a plan to capture opportunity and to manage risk. A 3-8% annual performance impairment could add up to 9 years of annual salary unearned over a 20 year career.
ARE YOU EXPERIENCING A 401K FINANCIAL CRISIS WITHOUT KNOWING IT?
The failure of 401k plans is easily ignored; it does not cause a psychological shock, as bankruptcies do. Nevertheless, it is a massive financial failure. The 2008 financial crash was a failure of effective risk management. But excessive risk taking is not the only way things can go wrong. The lack of a thoughtfully executed strategy, or access to outside investing expertise prevents retirement savings from being directed to the correct investments. That is where things now stand for millions of investors just like you.
Causes of Failure
Why is the 401k system failing to perform its central function of efficiently growing your money over the long term? There are two reasons.
CAUSE OF 401K FAILURE #1: FINANCIAL FIRMS EMPLOY DECEPTIVE PRACTICES
Long-term savings and investment products are “confidence goods”. As with prescription medicines or auto parts, most purchasers do not understand how they work, or which is best for them. They need guidance from a trustworthy advisor.
Unfortunately, financial companies have not lived up to the standards of their medical or automotive counterparts. It’s true that returns on specific investments are more difficult to anticipate than the effects of allergy medicine or an alternator, but this does not justify the wide gap between the theory of the 401k wealth building opportunity and the reality of most investors’ substandard 401k returns.
Most funds perform in-line with index benchmarks (e.g. the S&P 500). After fees, the average mutual fund equity investor will have seen a return of around 1.5% in the US and 5% in Europe over 10 years (see Exhibit 1). Yet these products may have been sold with return illustrations of up to 10%.
Mutual funds and 401k plan providers expect you to not pay attention
The products financial firms sell are designed to capitalize upon the fact that customers do not want to devote significant time or energy to financial matters, and are unlikely to closely monitor their investment decisions over time. This encourages firms to offer vague features versus tangible benefits and to gouge customers with fees and expenses that most investors won’t recognize.
It is rational for each financial firm to compete in this way because few customers even realize they have a choice. Many consumers elect a 401K allocation pre-selected by their employer and do not follow the changes in the plans over time. Acquiring customers on the marketing themes of consistency, patience, etc., then increasing the price on them over time (as they become complacent) is strategically optimal for a company to increase their profit.
Investors’ views hurt their 401k investment returns
401k Investors are not blameless when it comes to the problem of unclear pricing of financial products. Because such pricing is partly a reaction to customers’ reluctance to pay a sustainable, well understood price (see Exhibit 2). Therefore, the resulting confusion of financial firms’ pricing only continues the problem, since it reinforces the idea that customers should not have to pay for what they receive from financial firms.
Investors want a ‘Do it myself’ approach, but don’t know what to do
Given these strong incentives to give their customers a “bad” deal relative to the advertised benefits, and a long history of actually doing so, it would be a surprise if financial firms were trusted businesses. And, indeed, they are not. Most consumers don’t trust financial firms to manage their investments and in fact only trust themselves. This is particularly acute in the developed nations where customers have the most experience within the financial sector. In a global survey, 63% of respondents said they trusted only themselves or no one to manage their retirement savings (see Exhibit 3). In the U.S. 74% of respondents said they trusted only themselves or no one to management their retirement savings.
CAUSE OF 401K FAILURE #2: INVESTORS LACK UNDERSTANDING OF THEIR INVESTMENT OPTIONS
Funds managed by investment experts are relatively conservative, with an average stock to bonds ratio of 40/60. However, when investments are managed by consumers, the resulting asset allocation is typically riskier, with an average stock to bonds ratio of 70/30 (see Exhibit 4).
Investors who manage their own 401k without advice face confusion
Allocations to riskier investments, such as equities, make sense when consumers seek this risk. In many cases, though, they do not. When asked, “What investment product would you like?”, across all geographies, customers chose safety over risk (see Exhibit 5).
Today’s volatile markets make 401k investment decisions burdensome
A low cost portfolio delivering stable returns is the correct goal for many investors. The challenge is for investors to find new ways to deliver this given the dramatic volatility that is now a reality affecting most 401k investment choices.
Most investors are neither financially savvy nor very interested in financial services. In the U.S., the majority focuses only on big decisions, such as mortgage or pension purchases, but not on-going decisions about transferring money out of under-performing investments, managing risk or being active about identifying new opportunities (see Exhibit 6).
A SOLUTION TO THE 401K FINANCIAL CRISIS
How can 401k savings be invested more effectively, encouraging long-term growth and capital protection? In this section, we answer the question both for investors who want to better self-manage their 401k, and those who are ready for professional advice.
PICK AND PRAY? NO WAY. IT’S TIME TO GET SMARTER
Knowledge is power so prepare to become much stronger. Learning several simple tactics to thoughtfully manage your 401k enables you to know exactly what’s working and what’s not. Accurate, relevant information enables you to make insightful decisions as you are building up your wealth.
This four step approach will give you the power to more productively focus your efforts and resources on a strategy designed to help you succeed.
1. Invest. With a plan. Far too often investors don’t follow a concrete plan. Your 401k plan should include at least:
- Exact target retirement date
- Exact target growth rate (annual rate of return)
- A quarterly portfolio review
2. Construct a smarter portfolio. All funds are not created equal. When selecting the funds for your 401k, you should always do the following:
- Identify the available funds within your plan that offer the highest dividend.
- Identify the available funds within your plan that charge the lowest fee.
- From the two above, select the funds with a 10 year return track record that most closely matches your target growth rate.
- Your bond/equity ratio should begin with a 50/50 split and be adjusted based upon the catalysts listed below.
3. Monitor Catalysts. An intelligent 401k investing strategy is prepared for major changes in the financial markets. Preparation begins with awareness, therefore you will need to monitor the catalyst events which most significantly impact stock markets. Situational awareness enables you to seize the best opportunities, and to proactively manage risk.
Important examples of catalysts include:
- FOMC Meetings – 8 times annually
- Gross Domestic Product (GDP) report – Quarterly
- Institute for Supply Management (ISM) Non Manufacturing report – Monthly
4. Manage risk with sell discipline
It is critically important to control risk in your 401k if you expect to realize its economic potential. Effective risk management begins with sell discipline. Sell discipline is the exiting of a fund holding when a specific price point (e.g. a loss) has been reached. This can also be applied when the fund has achieved its target price (e.g. a gain), a catalyst to its growth has been violated, a risk to the investment opportunity has been identified, or even if other candidates are more attractive.
Failure to manage risk effectively can make the pursuit of long-term gains a futile effort (see Exhibit 7), but a focused effort that improves your performance annually by a just a few percentage points can make an enormously profitable difference (see Exhibit 8).
WHAT YOU CAN DO TO FIX YOUR 401K FINANCIAL CRISIS
Schedule 90 minutes to devote to getting your 401k on the right track. Use that time to gather the following:
- A copy of your most recent 401k statements (needs to include total balances and all holdings).
- The complete list of your 401k options (the full list of funds you can buy).
- The 401k plan document explaining how often you can buy and sell, and how to do so.
With this basic information you’re on your way. Next, follow the steps outlined above to thoughtfully build your 401k strategy. If you want the help of a professional, Index Strategy Advisors, Inc. will provide you with the help you need to get started:
Although the 401k plan of our times is malfunctioning, you don’t have to experience your own 401k financial crisis. Take action now. Get the education and/or advice necessary for your 401k to realize its real potential to fuel a long term strategy to create and grow your wealth and ensure that you meet your retirement goals on your own schedule. You will be a happier person, and if you’re a parent, like me, your kids will one day thank you for it.