Caution: When Used as Directed, 401(k)s are Hazardous to Your Financial Health

Economic Snapshot for March 9, 2009

Caution: When Used as Directed, 401(k)s are Hazardous to Your Financial Health

by Monique Morrissey

Retirement accounts have lost roughly a third of their value since October 2007, forcing many older workers to scrap their retirement plans. Could this have been averted? Were 401(k) participants to blame for poor investment choices?

401(k) participants are often told they can minimize risk by investing in lifecycle or target-date funds that automatically decrease their investment in stocks as they approach retirement. But research by the Congressional Research Service shows that even those who adopt this approach, gradually reducing their stock allocations from 65% to 50% of assets, face a significant risk of not being able to maintain their standard of living in retirement. Using measures of risk and return derived from historical data, the unluckiest 5% of participants would not have enough to replace even a quarter of their pre-retirement earnings (see Chart). Meanwhile, the luckiest 5% would end up with more than four times as much-enough to replace all of their pre-retirement earnings even without Social Security.¹

Contrary to conventional wisdom, lifecycle investors face the same risk-return tradeoff as investors who maintain fixed portfolio allocations; they simply take on more risk at the beginning and less at the end. As they approach retirement and shift toward more conservative investments, lifecycle investors are as likely to lock in low returns as high ones. Simply put, aside from ordinary diversification, there is no magic trick that will reduce risk for individual investors without also reducing expected returns. To protect workers against financial risk, the solution is to pool the retirement savings of workers who retire at different times, as pension funds do.

Endnote
1. This is a best-case scenario: simulations (using randomly generated rates of return derived from historical data) are based on median earners who contribute 8% of pay over 30 years, gradually decrease their stock allocations from 65% to 50% (with the remainder invested in AAA-rated corporate bonds), and convert their final account balances to annuities. In the real world, few participants contribute 8% steadily over 30 years; returns are eroded by high fees; investments are not well diversified across asset classes; and most participants withdraw their money in lump sums.