Cruise control can drive your 401(k) - just don't hit the gas
(The writer is a Reuters columnist. The opinions expressed are his own.)
By Mark Miller
CHICAGO May 13 (Reuters) - 401(k) plans are all about automation these days, especially target date funds, which keep workers' accounts in balance for an age-appropriate level of risk. It's the investing world's version of cruise control, but a study released today finds that many investors are turning on cruise control while putting their feet on the gas pedal - a move that's hurting their returns.
The study looks at several forms of investing help that 401(k) plan sponsors provide to employees, and the news is encouraging. Workers who use target date funds (TDFs), professional account management or online advice get 3.32 percent better returns - even after the cost of those services - than those who go it alone. That may not sound like a lot, but it adds up: The researchers calculate that it could translate to a 79 percent account balance gain for someone age 45 today at age 65.
The study was conducted by Aon Hewitt, the employee benefit consulting firm, and Financial Engines, a key provider of 401(k) advice services. It examines the performance of 723,000 participants in 14 large 401(k) plans that used all three forms of help from 2006 to 2012. Even though both firms have an ax to grind arguing for professional plan services, the findings are striking, especially since a growing number of 401(k) plans are adding automation and advice options. Aon Hewitt reports that 86 percent of 401(k) plans offer TDFs, up from 33 percent in 2005.
"The upshot for the typical investor is to recognize that investing is hard to do well," says Wei-Yin Hu, vice president for financial research at Financial Engines. "If your employer offers a form of help, use it, and choose whatever type of help best fits your needs. Chances are good that you'll do better than you would investing on your own."
But the findings on TDFs should set off alarm bells for plan participants and sponsors alike. These funds are designed as one-stop investment solutions that automatically keep your account balanced between stocks and fixed-income investments to an age-appropriate level; as retirement gets closer, the amount of riskier equities is reduced. The idea is to put all, or nearly all, of your account balance into the TDF and let it ride.
Only 37.8 percent of participants investing in TDFs were using them as a "one-stop" investment, however, according to the study. Among those who split their investments with other mutual funds, only 35 percent was invested in the TDF, on average. Even more worrisome, 42 percent of investors who had 50 to 95 percent of their portfolios in TDFs had 90 percent of the remaining portion of their portfolios invested in the stock of their own companies - a potential over-concentration that can make the portfolio significantly more risky than necessary.
This partial target date usage had a negative impact on returns. Median annual returns for 2010 to 2012 were 2.44 percent lower than for participants who used help of all kinds, after fees.
Hu thinks one indirect culprit is another automation trend - auto-enrollment of new workers in 401(k) plans. Most auto-enroll features use TDFs as the default investment choice for 100 percent of contributed funds. But as account balances grow, workers tend to start diversifying their investments, Hu says.
"If people have gotten any investment education, the first thing they probably learned is not to put all their eggs in one basket," he says. "But they don't always understand that TDFs are one of the few exceptions to that rule."
Still, the trend is promising. The study found that 34 percent of workers in the 14 plans use some form of help, compared with 30 percent in 2011, the last time this study was conducted. The trend toward advice is especially positive when employers find a way to integrate it without driving up overall plan costs. Financial Engines charges a managed account quarterly fee of 60 basis points or less to help participants select mutual funds from the plan's menu, which are added to the expenses of the underlying funds. Most often, it recommends low-cost index mutual funds, which creates breathing space to add financial advice without driving overall costs to excessive levels.
The next step for plan providers and third-party advisory firms should be integration of more holistic financial planning help. Financial Engines plans to take a step in that direction this year, when it rolls out a service for 401(k) participants aimed at helping them make optimal Social Security filing decisions.