Many investors thought they had the investment world by the tail during the middle of 2007. The markets’ performance in 2008 radically changed investors’ views about market risk as it decimated many portfolios. And 401k plans also suffered huge losses. Since the markets’ peak in October 2007, 401k plans have lost a collective $1 trillion in value. That equals one third of the value of all 401k plans. Many employees have begun referring to their plans as “201k” plans. The market has come up from its lows since March of this year, but there are still valuable lessons to learn from all of this.
The performance of 401k plans in 2008 verified that they don’t come with any guarantees. The recession brought this message home for millions of investors. The bear market left many retirement dreams in ruins because uneducated, unsophisticated investors had been in charge of their participant-directed 401k accounts. In other words, many investors made bad investment choices.
The 2009 Quantitative Analysis of Investor Behavior report, conducted by Dalbar, Inc., summed up the situation with the phrase, “When the going gets tough, investors panic.” This study found that for the 20-year period ending in 2008, the annualized return of the S&P 500 was 8.35 percent, while the average equity investor return was only 1.87 percent. What would cause this much of a difference in outcomes? The answer: Emotions and lack of understanding.
The principles of behavioral finance help to explain why investors let their emotions get the better of them. Some investors confuse the familiar with the safe. Many make investment decisions without understanding all the implications. Others abandon their investment strategy when the market starts to decline, thereby contributing to the “buy high, sell low” outcome. And finally, some just don’t comprehend how all this stock market stuff works and what it means to have a diversified portfolio.
The evidence is growing that 401k plans that provide an extensive menu of mutual funds and/or self-directed brokerage accounts are likely to underperform the market. Participants just don’t have a grasp on investing principles, including proper asset allocation. Invariably, they’ll chase fund performance or seek help from a friend or coworker. They build a portfolio that isn’t well diversified. Then they let their emotions dictate how their 401k should be managed. All these factors contribute to underperforming accounts. And with underperforming accounts, it wouldn’t be out of the ordinary to see some participants sue their employer for the losses incurred since late 2007 because of the lack of the plan’s prudent fiduciary oversight and adequate participant education.
A solution to this problem is to have plans move away from the menu of investment options and into portfolio options. An investment manager (as defined by the ERISA rules) is hired to create these portfolios for the plan participants. These portfolios are comprised of passively managed mutual funds across multiple asset classes. Generally, five portfolios are all that are needed to achieve the desired effect. This platform makes it much simpler for the participants, because they only need to look at their retirement horizons and risk tolerance—issues that they can understand. They no longer need to worry about individual investment choices or how to create a diversified portfolio. It’s already done for them.
The benefit to employers is that they can reduce some of their fiduciary liability by shifting from participant-managed portfolios to adviser-managed portfolios. These days, any time liability can be reduced is always viewed as a good thing. The benefits to the participants are a better chance of achieving long-term investment success and peace of mind. In the end, this becomes a win-win situation that can make a difference to the future of many investors’ retirement years.
Timothy J. Delaney is managing director of JDH Wealth Management, LLC, in Santa Rosa. Tim works with 401k plans and high net worth clients who want to simplify their financial life so they can pursue their retirement dreams. You can reach him at (707) 542-1110 or at tdelaney@JDHWealth.com.
