Pension Trends   Volume IX, No. 1, February 2008    

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In this issue...

You Can Lead a Horse to Water, But...
          

You Can Lead a Horse to Water, But...

We all know the end of the title of this article: you can lead a horse to water, but you can’t make him drink. An analogy for us humans is that you can only do so much to get someone to make a wise decision, and despite your best advice, sometimes that person will still make an unwise choice.

So it is with managing retirement plan assets. We at Independent Actuaries, Inc. (IAI) are not investment advisors. We do not sell investments nor provide investment advice. We do, however, on an everyday basis see the results of investment decisions made by hundreds of retirement plan sponsors and thousands of individual plan participants involving tens of millions of dollars. What we have noticed is that there is plenty of sound investment advice available, but plan sponsors and individual plan participants continue to make some unwise investment choices.

Here, from your non-investment advisor friends at IAI, is some investment advice we wish more plan sponsors and plan participants would heed:

If you want a bigger nest egg when you retire, don’t pick your own 401(k) plan investments. Leave the investment decisions to the investment experts.

Studies have consistently shown that participants in plans where the assets are managed by an investment expert outperform the plans in which participants choose their own investment mix from a menu of investment options (a self-directed plan). The difference is material. One study of mutual fund investor behavior from 1984-2004 (Dalbar, Inc. Quantitative Analysis of Investor Behavior) showed that the spread between the average return for a growth and income fund and the actual return earned by individual equity fund investors was over 8% - per year!

 

Despite this common knowledge, most 401(k) plans remain self-directed. The average number of investment options made available to plan participants has increased to a mind-boggling 19. Is it any wonder that participants are having trouble keeping up with the investment results produced by full-time investment professionals?

 

If your 401(k) plan offers lifecycle (a.k.a. target maturity) funds as an investment option, choose one.

One, not two, not three, and don’t add the lifecycle fund to your current mix of funds. It is meant to be a standalone choice.*

 

A lifecycle fund is a diversified portfolio of equity, fixed income, and cash equivalent investments. Typically, a lifecycle fund is named according to the projected retirement year for someone selecting that fund; e.g., an "XYZ 2030 Target Maturity Fund" has the mix of equity, fixed income and cash equivalent investments that a professional investment advisor thinks is appropriate for someone planning to retire in or near the year 2030.

 

As 2030 draws closer, the investment advisor will re-balance the mix of equity, fixed income, and cash equivalent investments to be more conservative. Between now and 2030, the investment advisor will monitor and select the appropriate underlying investments (typically a diversified mix of domestic and international stock and fixed income mutual funds), perhaps changing the allocation among the funds to take advantage of changing market conditions. In short, the investment advisor is doing all the work. The participant in the lifecycle fund is getting the advantage of a professionally managed fund, customized to his or her retirement expectations.

 

Lifecycle funds are the fastest growing new investment option of the 401(k) marketplace. A recent survey from the Profit Sharing Council of America reported that 60% of 401(k) plans now offer lifecycle funds as an option.

 

Don’t invest in an already tax-advantaged investment.

One of the most valuable attributes of contributing to a retirement plan is that the investment income earned on the plan assets accumulates tax free until distributed. Applying the wonder of compound interest in a tax-free environment is what leads to (hoped for) large retirement nest eggs.

 

Qualified retirement plans are not the only tax-advantaged vehicle for accumulating money for retirement. Many annuities offer tax-free accumulations. No taxes are due on appreciating real estate until the gains are realized. There are mutual funds that invest in tax-free municipal bonds. Each of these and other tax-advantaged investments have their place in a retirement portfolio, but it is unlikely that any of them belong in a qualified retirement plan.

 

If the investment gain in an annuity is not taxed until distribution, why would you put the annuity in a retirement plan? You cannot avoid current taxation twice. Keep the annuity outside the plan and do your stock, bond, mutual fund, etc. investing inside the plan to take advantage of the tax-free accumulation characteristic of the plan.

 

Investing in real estate inside a plan has potential pitfalls. In general, gains on real estate held long enough qualify for capital gains tax treatment. Gains on real estate held inside a qualified retirement plan, on the other hand, will ultimately be taxed at ordinary income rates. Why trade capital gains tax for ordinary income tax? Depreciation, tax deductible interest, and 1031 exchanges are other real estate related tax advantages that disappear when the real estate is owned by a qualified retirement plan.

 

Fortunately, most of our clients rely upon the advice of qualified investment advisors when making investment decisions and as a result have had long-term success. The results are less encouraging for individual participants in 401(k) plans. The rising popularity of lifecycle funds may be an indication that more individual participants will reap the advantages of professional money management over the long term.

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* The concept behind a lifecycle fund is that it already has an optimal weighting of equity, fixed income and cash equivalent investments for your scheduled retirement data. If you put some of your money into a different mutual fund, you will end up overweighting your 401(k) account toward the style of that different mutual fund thereby adding unnecessary risk and/or reducing the likelihood you will maximize the return on your 401(k) account between now and retirement.

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This newsletter has been published in order to share general information with our professional contacts. The information presented in this newsletter should not be acted upon without first seeking the advice of a CPA, attorney or other benefit professional. 

Pension Trends, Volume IX, No. 1, February 2008
Copyright © 2008 Independent Actuaries, Inc.