Reinventing Retirement Income in America

Studies | Retirement

No. 248
Monday, December 31, 2001
by Brooks Hamilton and Scott Burns


The Performance of 401(k) Plans

Table I - Financial Services Firms' 401(k) Plan Returns Compared to Market Returns

Most 401(k) accounts have grown steadily in the past, thanks to a booming economy. But 2000 brought a different story. From 1999 to 2000, even with employee and employer contributions, the average account shrank from $46,740 to $41,919.14 This focused new attention on the plans and raised questions about the investment choices that plan participants have been making. We expect this will be reinforced by the market decline this year. Does the way workers have been making choices threaten the development of fully funded and portable pensions owned by them? An analysis of how well the plans are faring and of the investing behavior of participants signals the need for some revisions in the plans' operation.

"From 1990 to 1995, defined benefit plans averaged an annual return 1.9 percentage points better than 401(k) plans."

Performance of Company Plans. Each employee benefit plan must file a Form 5500 annually with the Internal Revenue Service, summarizing its results. Using a representative sampling of Form 5500 data tapes for the years 1990 through 1995, the consulting firm Watson Wyatt identified 503 employers that sponsored both a 401(k) plan and a defined benefit plan during all six years. The findings:15

  • The defined benefit plans averaged an annual return 1.9 percentage points better than the 401(k) plans - 10 percent compared to 8.1 percent.
  • For 10 percent of plan sponsors, the average annual return of the defined benefit plan exceeded that of the 401(k) plan by 5.1 percent or more.
  • For 25 percent of plan sponsors, the average annual return of the defined benefit plan exceeded that of the 401(k) plan by 3.5 percent or more.

To illustrate what a 1.9 percentage point difference means to an account, if two individuals each contribute $4,000 a year to a 401(k) account for 30 years, one at an annual return of 10 percent and the other at an annual return of 8.1 percent, each will have contributed $120,000; however, the 10 percent account will grow to about $690,889 while the other grows to about $480,224 - a difference of $210,665 or 44 percent!

"Plans sponsored by financial service firms underperformed an index of 60 percent stocks and 40 percent bonds."

How Financial Services Firms' Plans Fare. Even the 401(k) plans sponsored by firms in the financial services industry have often had below-average returns. While all employees of these firms aren't financially knowledgeable individually, it is reasonable to expect that they would have a higher level of interest, concern and knowledge than employees at non-financial services firms. We looked at the performance of the plans of five well-known financial services firms for the period 1995 through 1998 (the latest year for which data are available). Since two of the five plans included the firms' own stock, our analysis of those two firms excludes that stock and considers only investments chosen by the employees.16 The firms are:

  • Morningstar, the leading provider of mutual fund, stock and variable-insurance investment information and counted on by the 401(k) industry for unbiased data and analysis as well as candid editorial commentary.17
  • Prudential, which offers a broad range of financial products and services for people in the United States and abroad, including mutual funds, annuities, pension and retirement-related services and administration.
  • Hewitt Associates, a global management consulting firm specializing in human resource solutions, including helping companies set up employee benefit plans.
  • Citigroup, which purports to offer a range of quality financial products and services unmatched in the industry.
  • Merrill Lynch, which manages investments for corporate, institutional and governmental clients and claims to be the only firm that ranks among the top three in equity underwriting and secondary trading in all major regions of the world.
Figure II - How Much Financial Service Firms' 401(k) Plans Underperformed an Index of 60% Stocks%2C 40% Bonds

"The plans sponsored by financial services firms underperformed a balanced portfolio by 3 to 10 percentage points."

Table I shows that over the four-year period none of the five came close to matching the performance of the stock market or an index of 60 percent stocks and 40 percent bonds. Only in one year, 1996, did any of the 401(k) plans come close to or exceed the 60/40 portfolio. The mix of stocks and bonds returned 32.3 percent in 1995, 12.0 percent in 1996, 24.3 percent in 1997 and 20.8 percent in 1998. A fixed annual rate of return of 21.0 percent would provide the same overall investment return. The corresponding annual rates of return for the financial services firms were 13.1 percent for Morningstar, 10.5 percent for Prudential, 12.6 percent for Hewitt,18 17.8 percent for Citigroup and 11.0 percent for Merrill Lynch.

As Figure II shows, using the 60/40 index as a benchmark, Morningstar's plan underperformed by 7.9 percent, Prudential's by 10.5 percent, Hewitt's by 8.4 percent,19 Citigroup's by 3.2 percent and Merrill Lynch's by 10.0 percent.

While acknowledging that plan participants may not be knowledgeable about investing, a Hewitt spokeswoman said it is difficult to know whether the four years studied are representative of returns over a longer period of time and whether a 60/40 index is the appropriate benchmark for comparison. She noted that while the Standard & Poor's 500 stock index was high over the 1995-98 period, a typical financial planner would have had clients invested in diversified portfolios that also included investments in such areas as small capitalization stocks and international stocks, which produced low returns during that particular period.

The other 401(k) plans did not respond to numerous telephone calls and e-mails.

This is not a criticism of the firms, which operate under the same constraints on giving financial advice to their employees as do other companies. [See "The Threat of Future Liability" below.] Rather, it is reinforcement for concerns about the investment decisions many participants in 401(k) plans are making (or not making).


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