Save well when young; allocate well when old (or rather, not young). Both investor contributions and investment returns influence retirement plan outcomes, but they have distinctive effects over the investor’s lifecycle, new research from Newport Beach, Calif.-based Research Affiliates demonstrates.
When it comes to target-date funds (TDFs) in 401(k) plans, contributions are the primary determinant of portfolio balances in the early stage, whereas allocations have very little impact, the firm reports in its paper, titled “Two Determinants of Lifecycle Investment Success.”
In the later stage, returns—and therefore asset allocation decisions—are the principal driver of ending portfolio values. These findings imply that defined contribution plan sponsors should encourage young workers to start contributing to their 401(k) accounts early, consistently, and at a high level.
In addition, Research Affiliates recommend seeking TDFs which do not initially take on excessive equity risk, because a heavy loss might have lasting adverse effects on young workers’ attitudes toward investing, and equity-heavy allocations tend to have higher fees. The firm further suggests that plan sponsors’ asset allocation decisions center on the years near retirement, when returns have the greatest impact.
“In the early years of a retirement portfolio, new contributions impel much of the year-over-year increase in account balances; investment gains or losses have a muted impact by comparison,” the authors note. “Asset allocation decisions are an appreciably more important driver of 401(k) balances close to retirement than they are early in a worker’s investment life cycle.”
For example, they explain that a $5,000 one-time contribution to a 401(k) account with a $20,000 account balance represents a 25% increase in account value. In contrast, a 10% return would only increase the account balance by $2,000. When the 401(k) portfolio grows to $100,000, the same $5,000 contribution represents only a 5% increase to the account balance, while a 10% return would increase the portfolio value by $10,000.
“Thus, with respect to the variability of the ending balance of a 401(k) portfolio, investment allocations near retirement matter considerably more to both risk and return than they do when an investor is first starting her portfolio.”
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With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.
