Original article: http://www.plansponsor.com/DC_Plan_Sponsors_Should_Focus_More_on_Deferral_Rates.aspx
By Kevin Coppola
The July 2012 study published by the Putman Institute concludes that getting plan participants to increase their contributions to their retirement plan is the “most important thing they can do” to help their participants grow their retirement plan. Well, not so fast! The Putnam Study—an unintended and indirect condemnation of traditional asset allocation—considered four factors when coming to this conclusion. Unfortunately for plan participants depending on their employers to use this information to help them reach Retirement Income Security, the research ignored the most important factor of all! Read on…
After careful review and study of the report findings I can report that the study firmly supports FOUR of the conclusions that the Compass Institute made over a decade ago!
1. Traditional asset allocation is insufficient. The study highlighted that no matter what you do to a traditional asset allocation strategy, the participant can only make a real difference in their final plan balance by increasing their CONTRIBUTION amount. NOTE: The study did NOT consider the impact of improving investment return.
2. The asset allocation mix of stocks to bonds has minimal impact on the long-term results. As we know and can see by looking at the best and worst Target Date Funds (TDF) over time, the selection of the YEAR of your retirement—and therefore your asset allocation mix—has less to do with final plan balance than what the MARKET is doing in the year you retire. Furthermore, the definition of “best” and “worse” varies over time depending on market conditions.
3. The value of good fund selection is minimal. The study determined the impact on final portfolio value if an investment committee were able to apply 20/20 foresight to the selection of plan fund options and included only those funds that outperformed 75% of their corresponding asset class. The resulting improvement was minimal. The Compass Institute concluded that what is most important is not the FUNDS in a plan, but rather the asset class MIXTURE that you have available to you. The Putnam study validated this by showing minimal gains even when 20/20 foresight was available.
4. Account rebalancing. The study concluded that more frequent rebalancing did lead to “slightly greater” results which confirms the second premise of Adaptive Asset Allocation™ that you must reallocate more often. However, they were still rebalancing into a FIXED asset mix, therefore leading to the only “slightly” better results.
The study takes a “base” case and applies various portfolio strategies against it. The “base” case assumed a contribution rate of 4.5% (3% plan participant contribution, 1.5% company match) and grew to $136,400. Their “best” case scenario was obtained by increasing overall contributions by 244% to 11% (8% contribution, 3% company match) growing the portfolio to $334,00. So, as we already knew it would since contributions are a linear function, the 244% increase in contributions led to a 244% increase in final plan balance.
Since it was not provided in the report, I calculated the average annual return on their portfolio for the scenarios they provided. I ran their assumptions through our calculator (i.e., a 28-year old, saving for 29 years, making $25,000 with a 3% annual increase, contributing 8% of their salary, with a company match of 3%, worth $334,000). Their “best”-case portfolio calculates to a 6.4% average annual return. Note that this is a reasonable, yet somewhat on the high side seeing as the range between the best and worst Fidelity TDF fund over the last 15 years is between 5.6% and 6.5%.
However, keeping the “base” case contributions FIXED at 4.5%, but instead increasing the average annual return by the same amount (244% from 6.4% to 15.6%), the portfolio would have grown to $1,519,903, or a 1,110% increase in the customer’s plan value at retirement.
Let's look back at our example person again. With the 3% annual raise (and/or inflation) assumption the person would be making $57,000 when they wanted to retire. To be able to replace 100% of that amount and guarantee they would never run out of money (a 5% guaranteed investment payout is assumed) the person would need to have amassed a plan balance of $1,144,000. Maintaining the contribution rate, this can be accomplished with a 14.5% investment return. The difference between what they have (6.4%) and what they need (14.5%) is what the Compass Institute calls the Investment Return Gap.
Bottom-line. No permutation of a traditional asset allocation strategy has as great an impact on closing the Investment Return Gap as increasing contributions. However, the study ignored the impact of increased investment return, whose impact dwarfs that of increasing contributions.
Knowing these things, the Compass Institute concluded that you have to do something other than traditional asset allocation and maxing out contributions to impact final plan balance enough to reach Retirement Income Security. Plan participants who want the best possible tools for having a financially secure retirement should ask their employers for help in closing the Investment Return Gap which can be found, Adaptive Asset Allocation™. To see how you are doing on your own path the Retirement Income Security and to see how large YOUR investment return gap is, download our Retirement Goal Calculator.
Kevin L. Coppola
President, Compass Investors, LLC