What factors are most important to the success of defined contribution plan participants? Putnam Investments’ latest iteration of its “Missing the Forest for the Trees” white paper found that deferral rates have a greater impact on a portfolio than fund selection, asset allocation or rebalancing.
Putnam established a base case on which to base its conclusions. They assumed that a 28-year-old in 1982 earned $25,000 per year with a 3% cost-of-living increase. The worker contributes 3% of gross salary to a 401(k) plan that receives a 50-cent match on the dollar up to 6% and has a conservative asset allocation across six asset classes. The hypothetical 401(k) also invests in funds in the bottom 25% of their Lipper peer group. By the time the worker turns 57 in 2011, income is $57,198, and the 401(k) balance is $136,400.
To determine which factors were the biggest wealth drivers, Putnam first changed the funds used in four hypothetical situations: the fourth-quartile fund was changed to a first-quartile fund; funds that fell out of the first quartile were replaced every three years; the plan sponsors used index funds instead of actively managed funds; and the sponsor used a crystal ball to predict which funds would be in the first quartile.
Regardless of the changes to the fund strategy, the account accumulated roughly the same amount of wealth (the crystal-ball strategy fared a little better, but Putnam acknowledged it’s an unrealistically perfect strategy). While there was little difference between the realistic strategies, the base portfolio was the most successful. The base portfolio earned about $5,000 more than the index portfolio and almost $10,000 more than the first-quartile portfolio.
Putnam also adjusted the asset allocation in the portfolio to see how it affects wealth accumulation. In this case, they retained the fourth-quartile funds, but increased equities from 30% to 60% and to 85%. With the expected higher returns in the 60% and 85% portfolios ($14,000 and $23,000 more, respectively), there was also higher risk.
The third factor Putnam examined was account rebalancing. They found the rebalanced account had a higher balance, slightly better annual returns and less volatility. The white paper noted, though, that the better return/risk ratio “does not carry an outsize benefit in terms of absolute annualized return.”
Finally, Putnam examined the effect of higher deferral rates on wealth accumulation and found “it becomes clear that the incremental impact of higher deferral rates can be one of the most significant drivers of long-term returns.” By increasing deferral rates from 3% to 4%, 6% and 8%, the final balance increased from $136,000 to $181,000, $272,000 and $334,000, respectively.
The paper noted that even the lowest of the increased deferral rates had better results than the other hypothetical strategies. The 4% deferral rate resulted in 30% more wealth than the crystal-ball strategy, and 100% more than the 85% allocation portfolio. Compared to the rebalanced portfolio, the 4% deferral rate resulted in 2,000% more wealth. “Putting deferral rate changes in these terms, the performance of underlying funds and rebalancing, in particular, appear to become far less meaningful when compared with the impact of higher deferral rates,” according to the paper.
Consequently, Putnam asserts that sponsors should focus on helping participants increase their deferral rates, taking advantage of automatic escalation to counter inertia.
Putnam also noted that auto-escalation and auto-enrollment don’t carry a high fiduciary risk. “Compared with the practice of offering employee education and/or advisory services in an attempt to migrate participants toward more aggressive asset mixes — activities that carry higher fiduciary risk and may require expensive or complicated communication initiatives whose potential is uncertain — a focus on higher deferral rates has a low total cost to the plan sponsor and enormous upside potential for participants.”
Over 74% of sponsors offer automatic enrollment with a deferral rate of 3%, Putnam found. However, increasing deferral rates from 3% to 10% by one percentage point annually has a similar effect on balances as the 8% deferral rate over the hypothetical 29-year investing period in the examples above.