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401(k) Investors Need to Act on What They Can Control to Build Retirement Income

A recent report by the Congressional Research Service (CRS) is notable not so much because it provides a definitive answer on how much money workers will need when they retire, as its title implies, but because it confirms many observations that have become gospel for those in the 401(k) field. The report, “Retirement Savings: How Much Will Workers Have When They Retire,” is commendable because it brings these observations into the retirement policy debate.

Two out of Three Isn’t Bad
CRS observes, “Starting to save while young and doing so consistently every year is perhaps the single most effective way to assure that one reaches retirement with adequate savings.” CRS reports that Americans have significant control over two out of three factors in retirement savings: their contribution rate and the age at which they begin to save. In fact, Putnam Investments reached a similar conclusion in its 2003 and 2004 studies. They said that participant deferral rates were the most important determinant in building retirement wealth.

The Wild Ones: What Investors Can’t Control CRS cautions, “Unfortunately, we cannot safely assume that the rates of return over the next 20, 30, 40 years will be ‘average.’” Some investment experts are sounding alarm bells to wake investors up to even more vexing complexities that make building a retirement nest egg difficult.

Vanguard’s founder, John C. Bogle, says, “The investment community is ignoring the reality that the costs of financial intermediation are devastating the net return actually delivered to investors,” in his article, “The Relentless Rules of Humble Arithmetic," published last December in the Financial Analysts Journal. He explains that, “From 1983 to 2003, the average investor in mutual funds received only 24 percent of the return before taxes and inflation that was indicated by the S&P Index growth. In other words, 76 percent of the returns were eaten up by the costs of intermediation.”

While Bogle points to the erosive effect that fees can have on 401(k) balances, other gurus like Jeremy Siegel, the author of Stocks for the Long Run, Third Edition, believe that the equity premium, the return premium for taking on the increased risk of investing in stocks, is overstated and will not live up to historical averages. Siegel writes, “The implication of this finding, which many investors have not come to grips with, is that future returns on equities are going to be lower than in the past.” He postulates, “The abnormally high equity premium since 1926 of 6.5 percent is not sustainable…As stocks and bonds become more correctly priced, the equity premium certainly will shrink.”

Some of the leading financial theorists have presented strong evidence that challenges the conventional wisdom of asset allocation: the longer the investment horizon, the larger the allocation to higher risk and, thus, higher returning assets such as stocks. “These results compound the sobering evidence in recent work that the equity risk premium is lower than suggested by post-1926 data. We confirm analytically that parameter uncertainty, properly incorporated, produces optimal asset allocations, in stark contrast to conventional wisdom. Longer investment horizons require lower, not higher, allocations to risky assets,” reports Eric Jacquier, Alex Kane, and Alan Marcus report in their article, “Optimal Estimation of the Risk Premium for the Long Run and Asset Allocation: A Case of Compounded Estimation Risk,” in the Journal of Financial Ecometrics.

Putting It in Pictures
CRS’s illustrations demonstrate the impact that 401(k) investors can make on retirement wealth by making a few fundamental decisions. Deciding when and how much to contribute to a 401(k) plan is the first step in tackling the very real complexities of investing.

These complexities are the reasons why investors find stable value funds valuable and why they consistently allocate 20 percent of their assets to stable value when it is offered as an investment. 401(k) investors intuitively ‘get’ stable value even if they do not understand how stable value addresses the complexities that are inherent in investing. They appreciate stable value’s:

• Safety of principal;
• Bond-like returns without the volatility associated with bonds;
• Stability and steady growth of principal and earned income;
• Benefit-responsive liquidity, so that plan participants may transact at “book value” – that is, principal plus accumulated interest – at any time.
• Competitive net returns (stable value management and wrap fees average 41 basis points) with low risk;
• Diversified, high-credit, quality bond portfolio that is ‘wrapped’ to protect investors against interest rate volatility.

As Bogle’s, Seigel’s, Jacquier’s, Kane’s. and Marcus’s assertions becomes more mainstream, stable value funds should discover new investors and solidify their use with the innovators who have relied upon their stable value fund for the more than the 30-plus years that stable value funds have been offered.

About the Report
The CRS January 29, 2007 report takes data from the 2004 Survey of Consumer Finances and looks at retirement savings patterns for households. Using this data as the baseline, CRS projects retirement savings based on two changing variables: individual contributions: 6 percent, 8 percent, and 10 percent; and time horizons: 20 years, 30 years, and 40 years. They assume an asset allocation of 65 percent to the Standard & Poor’s 500 Index of Stocks from the ages of 25 to 34, 60 percent to stocks from 35 to 44, and 50 percent to stocks after age 55. The remainder of the portfolio was invested in AAA-rated bonds. Additionally, the accounts were rebalanced each year to reflect the chosen asset allocation for each age grouping. Lastly, rather than assume an average rate of return for the investment period, CRS used a Monte Carlo simulation process that selected the rate of return each year from a range of returns implied by the historical returns on stocks and bonds. Based on their simulation, they found a median real rate of return was 5.5 percent. They also found a 5 percent chance that the average annual real rate of return could be 1.7 percent or less, or conversely, that the average annual rate of return could be 9.3 percent or more.

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