401(k) Asset Allocation
According to the US Census, roughly 32% of all Americans are actively utilizing a 401(k) plan to save for retirement. Given that social security is currently on track to become insolvent by 2034, per the Social Security Administration Trustee Board, this overall participation rate is alarmingly low. Regardless of where you are in the age/career spectrum, and particularly due to the erosion of social security, participation in some sort of employer-sponsored retirement plan is critical to securing your financial future. That being said, it’s not enough to simply stash money away over time and expect a pot of gold at the end of your retirement rainbow. At least as important as how much you invest is how to allocate the assets you put away.
As we discuss the general philosophy behind optimizing your 401(k) investment portfolio, it will be helpful to draw on some of the lessons we learned from the most recent recession. The financial crisis of 2008 had an indelible impact on the global investment community. That year, the S&P 500, a primary index for measuring stock market performance, declined by roughly 37%. At the same time, 401(k) account balances declined by an average of more than 30%, which contributed to roughly $2.4 trillion of total losses in retirement savings. Among the hardest hit by the crisis were older investors who had accumulated rather large balances over a lifetime of saving. While it’s true that equity markets have more than recovered over the past ten years, the epic bear market of ’08 had lasting repercussions on the retirement aspirations of these more seasoned investors, particularly those whose investment choices did not accurately reflect their evolving risk tolerance needs.
For this investor class, typically characterized by larger account balances ($200,000 or more) and a close proximity to retirement (five years or less), severe economic downturns can have a material negative impact on their post-employment financial security. On the one hand, higher asset levels result in greater nominal losses for each percent decline. More importantly, these investors have fewer years left in their careers to recover lost assets. The general principle here is that as we get older, and subsequently accumulate more wealth, there is a greater need to protect what we have. As such, our risk tolerance actually decreases over time, and must therefore be reflected in our investment choices. For this demographic, the appropriate strategy is geared more towards preservation of capital than growth. Specifically, the optimal allocation is heavily weighted in low-risk fixed income securities. That’s not to say that equity positions should be avoided entirely, but rather modified to reflect a smaller percentage of the overall allocation strategy. For someone a year or two away from retirement, an equity concentration of around 10% (or less) is preferable.
401(k) Allocation of People Age 56-65 in 2008
That being said, this was largely not the case during the last downturn. According to the Employee Benefit Research Institute, nearly 1 in 4 people aged 56-65 had equity concentrations of over 90% in their 401(k) accounts. Further, more than 2 in 5 had equity concentrations of over 70%. Consequently, many in this peer group were unable to fully recoup their losses, and therefore had to settle for retirements inferior to prior expectations. Although total loss avoidance is never guaranteed when there’s exposure to market risk, a more conservatively allocated portfolio could have mitigated losses for these investors, and in many cases prevented the need to accept sub-optimal retirement outcomes.
Ironically, this conservative approach to retirement planning seems to have been adopted most readily by the investor class it is least appropriate for… millennials. According to a 2017 Merrill Edge Report, 85% of millennials claim to “play it safe” with their day-to-day investments. Additionally, when asked what they’d be able to rely on in 20 years, 66% referenced their personal savings account as preferential to a 401(k). In contrast, 71% of Gen-Xers identified 401(k) plans as their primary option. While factors such as availability and affordability certainly contribute to this new trend, the report indicates that a primary reason for this philosophical shift among younger investors is tied to the ’08 financial crisis. Specifically, having witnessed the struggles endured by their parents and grandparents, millennials are generally less trusting of financial markets, and more comfortable retaining stewardship of their financial future than seeking guidance from investment professionals.
Unfortunately for millennials, not recognizing the earning power inherent to employer-sponsored retirement plans will limit their long-term financial prospects. To begin with, interest rates attached to most savings accounts are typically lower than annual inflation rates. As a result, money being saved in these vehicles is effectively losing relative value every year. Similarly, younger investors who opt for more conservative 401(k) allocations are significantly hindering their ability to unlock the full long-term growth potential of these accounts. Given that they typically have fewer assets, the consequences of a severe economic downturn would likely be minimal to their long-term financial condition. Furthermore, the automatic contribution feature inherent to 401(k) plans allows for built-in dollar-cost averaging. As a result, staying the course during a downturn can actually prove to be very profitable for younger investors, as it enables them to purchase larger amounts of the same positions at deeply discounted prices.
To illustrate this point, we can again use the most recent financial crisis as a reference point. For the calendar year 2008, 401(k) account values of $10,000 or less saw positive returns in excess of 40%. In contrast, accounts valuing $200,000 or more experienced average declines of roughly 25% during this same period. This data suggests that, while initially experiencing similar percentage declines as accounts with higher asset balances, accounts with lower asset balances recovered at a much faster rate once markets leveled off and began growing again. This is because new contributions made after the initial crash represented a larger proportion of overall assets in smaller accounts than they did in larger ones. As a result, young investors who maintained their pre-crash contribution levels likely generated the largest single year ROI they will ever experience during one of the worst market environments in history.
Rather than worry about preparing for the next market downturn, millennials would be far better served embracing the unique investment opportunities afforded by their youth. In contrast to their older counterparts, the optimal investment mix for younger investors is geared more towards growth, and should therefore have a higher concentration of equity investments. For people in their 20’s just starting out, equities should account for roughly 90% (or more) of their 401(k) allocation.
Risk in 401(k) Allocation
Regardless of where you are in the age/career spectrum, the theme expressed in the previous two examples should be pretty evident. In general, the further you are from retirement, the more aggressive you should be when allocating your 401(k) assets. Over time, as your account balance grows and you inch closer to retirement age, your asset mix should gradually become more conservative. This is because the optimal allocation strategy is not static. Instead, it evolves over time along with the circumstances of your life. Whereas at age 25 a 90% equity concentration is most appropriate, the preferred equity mix in your 40’s may be closer to 50%. While fixed income positions may not be as appealing at the start of your career, they should comprise the vast majority of your portfolio towards the end of it.
Although relative age is not the only factor to consider when determining how to invest your 401(k), it is the most appropriate place to begin your assessment. This is where a fiduciary advisor can be very useful. Through an analysis of your unique goals, preferences and profile traits (age, income, existing assets, etc.), an advisor can develop a customized asset allocation strategy specifically tailored to help you achieve the optimal retirement outcome.