Study suggests plan sponsors should redirect focus from fund performance to increasing deferrals

A recent study from the Putnam Institute suggests that plan sponsors should direct their focus from fund performance to increased deferral rates as a means of increasing plan participants’ retirement assets. While fund performance is important, the fund-centric focus may not be the best means of preparing participants for retirement, according to the Putnam research.

Fund selection

Putnam started with a base case scenario of a 28-year old employee in 1982, earning $25,000 per year (with a 3% cost-of-living increase), participating in a 401(k) plan that offered a match of $0.50 on the dollar up to 6% of compensation. The individual deferred 3% of gross salary into the plan. Contributions were invested in a fund ranking among the bottom 25%, based on three-year performance data. No asset allocation changes or rebalancings of account assets were made over the 29-year period. Under the scenario, the participant, at age 57, would be earning $57,198 per year, with a 401(k) plan balance of $136,400.

In looking at fund selection methods that would best increase the participant’s account balance, Putnam considered:

(1) replacing the lower performing funds with funds in the top 25% of performance;

(2) replacing funds that had dropped out of the top 25% over a three-year period; and

(3) redirecting the focus from actively managed to index funds.

Putnam found that, regardless of the fund selection strategy, fund selection generated roughly the same amount of retirement wealth.

Asset allocation

Putnam next examined the impact of switching from a conservative portfolio allocation (centered on fixed income investments) to a more balanced strategy with increased equity holdings. Adjusting the asset allocation from a conservative model (30% equities) to a balanced model (60% equities) improved performance by nearly $14,000. Similarly, adding a growth model (80% equities) increased performance by nearly $23,000. Putnam cautioned, however, that while asset allocation can be a bigger driver of portfolio return than the composition of the underlying funds, changing asset allocations carries the material risk of a severe decline in uncooperative and volatile markets.

Account rebalancing

Putnam noted that rebalancing a portfolio produced a slight increase in retirement wealth, but with considerably reduced volatility. The moderate growth and better return/risk ratio placed account rebalancing between asset allocation changes and fund selection as a driver of long range returns.

Deferral rates

In the most noteworthy finding of the analysis, Putnam determined that even incremental increases in participant deferral rates can be one of the most effective drivers of long-term return. An increase by the hypothetical test subject of the deferral rate from 3% of income to 4%, 6%, and 8%, would increase the participant’s account balance after 29 years from $136,000 to $181,000, $272,000, and $334,000, respectively. Significantly, Putnam noted that a slight increase in deferrals to 4% would generate a wealth accumulation 30% larger than the hypothetically ideal fund selection scenario, 100% larger that the growth allocation strategy, and nearly 2,000% larger than rebalancing. Thus, the performance of underlying funds and rebalancing have far less of an effect on retirement wealth accumulation than the impact of higher deferral rates, Putnam concluded.

Source: Putnam Institute.

For more information, visit http://www.wolterskluwerlb.com/rbcs.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer’s Benefits Reports.

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