Reinventing Retirement Income in America
Table of Contents
- Executive Summary
- The Importance of Retirement Income
- Determinants of Retirement Income
- The Change in Retirement Pension Plans
- The Performance of 401(k) Plans
- Explaining the Poor Investment Returns
- Other Causes of Low Returns
- The Threat of Future Liability
- Goals for an Effective Retirement System
- Building a Better Retirement System
- About the Authors
Explaining the Poor Investment Returns
The authors have had the opportunity to examine actual plan records over several years for a number of large plans in assorted, geographically dispersed industries. Company names are withheld because of confidentiality, but we can discuss the data. One feature that stands out in most of them is a remarkable difference among individual yields in the same plan. To cite a typical example:
- One plan, with 2,113 participants, had a yield of 18.3 percent for the plan as a whole.20
- However, within the plan, one participant's individual yield was 52.1 percent and another's was a negative 12.8 percent.
"In a typical plan, the higher a participant's average pay, the higher the return on 401(k) investments."
A related feature that stands out in the plans we examined is the pattern of returns by wage income. When the participants are arrayed by income and divided into five groups, the higher a quintile's average pay, the higher the return on its 401(k) investments. An explanation of this pattern is suggested by Figure III, which shows the asset allocation made by each income quintile in a typical plan. Participants in this plan could allocate their contributions among six funds: money market, fixed income, balanced, value equity, growth equity and aggressive equity. The money market and fixed income funds, and 50 percent of the balanced fund, are considered fixed-type investments. The three equity funds and 50 percent of the balanced fund are considered equity-type investments.
- Almost two-thirds of the money in the lowest-income quintile was in the money market fund or other fixed-type investments.
- By contrast, about 85 percent of the money in the highest-income quintile was in equity-type investments.
Why was so much of the money from the lowest-income quintile in fixed-type, low-return investments? Many participants who enroll in 401(k) plans do not choose where their contributions are to be invested, leaving it up to the plan sponsor. This is called a "default election." In the above plan, as in many 401(k) plans, the money market fund - perhaps the least appropriate retirement investment - is automatically designated by the plan sponsor as the default investment. Between one-third and one-half of the employees in the fifth quintile made no choice. Plans that do have money market funds as the default investment reason that these investments will never lose money and therefore relieve the plan of possible liability claims. Of course, this ignores the loss of purchasing power caused by inflation. Meanwhile, those with higher incomes are receiving higher returns.
"Many lower-income employees do not choose where to invest, and their contributions are placed in money market funds, where they tend to stay."
As time goes on, there is a good possibility that the gap between the returns to the highest- and lowest-paid will widen. Research by Hewitt Associates, in conjunction with Harvard University and the University of Chicago, has found that employees who make a default election tend to remain at the same contribution rate and keep the same funds for years, ultimately losing the opportunity to have more money at retirement.21
If 401(k) plans sponsored by major financial services firms can manage only below-average returns, is it reasonable to hope that ordinary 401(k) participants will be able to better manage the investment of their retirement funds? In 1998, the index of 60 percent stocks, 40 percent bonds had a return of 20.8 percent. A database we constructed of 401(k) plans with 500,000 participants (approximately 1 percent to 2 percent of the 401(k) market) showed an average return of 8 percent on the plans' assets in 1998 - another indication that most plans performed below the market averages.