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While the average U.S. household invests about 55 percent of its 401(k) or other defined contribution plan assets in common stocks and stock funds (referred to as "equities"), many Americans are investing all or nothing in equities because of a host of factors including education level and marital status, according to a
new analysis of government data by HR consultancy Watson Wyatt Worldwide. Insufficient retirement savings invested in equities can cast into doubt when (or whether) employees will retire, robbing workers of expected leisure and well-being during their golden years and creating workforce planning headaches for employers.
Why does investing in equities matter so much? Over a long-term period, such as 10 to 20 years, equities typically outperform by a substantial margin other asset classes, such as bonds ("fixed income") and low-interest/low-risk money market and stable-value funds. But equities are subject to higher volatility and can suffer sharp plunges over the short term.
Consequently, employees with a longer time horizon until retirement are typically advised to hold a substantial share of their retirement fund investments in equities in order to grow their retirement portfolios, but then to decrease their equity holdings as retirement age nears. (So-called “target-date funds” are one way to do so automatically, as long as funds are available with relatively low administrative fees.)
Too Little or Too Much?
The problem: Watson Wyatt's analysis of the Federal Reserve’s
Survey of Consumer Finances found a wide variation in investment behavior. For example, almost 20 percent of working households allocated nothing to equities in their retirement accounts and thus risk inadequate capital growth to fund their retirement. Meanwhile, more than 25 percent were “all in,” allocating 100 percent of their defined contribution plan assets to equities and thus face substantial short-term losses that require a high degree of "risk tolerance" to avoid panic selling when prices fall and re-purchasing equities after prices have recovered. (Such “buy high, sell low” behavior greatly reduces the value of a retirement portfolio over time.)
The key question, says Mark Warshawsky, head of retirement research at Watson Wyatt, is “Do we really want so much variation in investment behavior in retirement accounts, especially at the extremes? These investing differences can easily translate into either too much or too little risk taking,” resulting in the loss of “tens of thousands of dollars in retirement savings—even more for some workers.”
An Issue for Employers
Various factors are correlated with the likelihood of 401(k) plan participants’ investing in equities, according to the analysis, as detailed in the table that follows below.
Alan Glickstein, a senior retirement consultant with Watson Wyatt, says the findings raise particularly pressing questions for employers. “With the shift to employee-directed retirement investments, companies are clearly less able to predict when and how their workers will be able to retire. To some extent, the problem can be addressed through better 401(k) plan design and employee education,” he notes.
To put this into context, another recent Watson Wyatt study suggests that the timing of retirement for workers whose non-Social Security retirement incomes are primarily derived from 401(k) plans is often influenced directly by the ebb and flow of the stock market, with employees whose 401(k) accounts have suffered a significant investment loss much less likely to retire (roughly 1 percent less likely to retire for every 10 percent drop in the stock markets, according to Watson Wyatt's data).
Glickstein says that new U.S. Department of Labor default investment regulations, which focus on the use of target-date funds in 401(k)s, will help (see
DOL Issues Final 401(k) Investment Default Rule: Stable-value Funds Excluded). But, he cautions,“absent the security of a traditional pension or cash-balance-type plan, workforce planning becomes a much more expensive proposition.”
Adds Warshawsky, “Some of the investment behavior, such as older workers taking on less risk, follows what investment advisers have long suggested. But the influence of other personal factors—such as individuals’ education level or health status or whether they have a pension plan at work—raises important issues for policymakers and employers alike.”
Which Factors Influence 401(k) Investing?Below are the characteristics found to have a high correlation with equity investing in defined contribution plans.
Stephen Miller is manager of SHRM Online's
Compensation & Benefits Focus Area.
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