The No. 1 flaw in America’s biggest 401(k) plans
Reprinted courtesy of MarketWatch.com.
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After studying the 401(k) plans of 100 of the largest U.S. corporations and foreign companies with American subsidiaries, I’ve come to the conclusion that the vast majority of them fail one test — a good menu of investment choices.
Virtually every large 401(k) plan makes it impossible for its participants to invest in each of the 10 asset classes that have demonstrated superior performance over time.
For more than 15 years, I have been recommending 10 equity asset classes for long-term investors: U.S. large-cap stocks, U.S. large-cap value stocks, U.S. small-cap stocks, U.S. small-cap value stocks, international large-cap stocks, international large-cap value stocks, international small-cap stocks, international small-cap value stocks, emerging markets stocks and real-estate investment trusts.
Over time, a combination of these asset classes outperformed the Standard & Poor’s 500 Index SPX, -0.85% by two percentage points a year, without adding risk.
When I reviewed the 100 large company plans, International Business Machines IBM, -1.08% was the only plan that included them all.
When I previously wrote 7 fatal flaws in America’s 401(k) plans, I found much to criticize. But this inability to invest across all of the asset classes mentioned above, in my opinion, is the biggest flaw of all.
Most academics and others who have studied investing agree that the greatest determinant of long-term results is the investor’s choice of asset classes.
Despite all the hype about people who seem to have a knack for buying and selling at just the right times, and about those who seem to know how to buy and sell the “right” stocks, decades of research has led leading academics to believe they can predict more than 90% of your long-term investment returns just from knowing what kind of assets you invest in.
If that’s true, as I believe it is, then the most important feature of a retirement plan is how well it lets workers choose the most productive and efficient asset classes.
You might think 401(k) plan trustees would have learned a lesson from Warren Buffett, who has been famously successful. And you might think those trustees would want to offer their participants an opportunity to invest in U.S. value stocks, the asset class that has benefited Buffett and his followers. But if you thought that, I’m sorry to report that you would be largely wrong. I found that asset class in only 42% of the 100 biggest corporate plans.
Based on data provided to us last year by retirement-plan analyst BrightScope, and direct consultation with individual companies, here are a few of our findings:
U.S. small-cap value stocks, over the past 50 calendar years, returned more than five percentage points than the S&P 500. But only a third of the 100 plans give participants that choice.
International small-cap value stocks have had similar returns, but if you’re in one of the 100 biggest plans, there’s only a 10% chance you can find an international small-cap value fund.
While 88% of these plans offer U.S. small-cap stocks (another very productive asset class), fewer than one-quarter of them offer the equally attractive international small-cap asset class.
Fewer than 40% of plans offer an emerging markets fund, even though many believe this asset class will have the best future long-term returns.
Only about one-third of these plans offer a real-estate investment trust (REIT) option. That’s too bad because REITs have outperformed the S&P 500 by 0.5% while moving up and down at different times, giving investors more return with less volatility.
Most plans offer target-date funds, which are fine for people who want simple solutions and are willing to give up a percentage point or two of long-term return. But participants who want to pick from individual funds must navigate some quirks.
Costco’s COST, -0.64% plan doesn’t offer any international funds or value funds. Verizon VZ, +0.24% offers its employees a bewildering 130 options; at American Electric Power AEP, -0.43% the choices total more than 600. I think this hurts more people than it helps, even though the company’s attorneys can argue that the plan gives a full range of choices.
Exxon Mobil’s XOM, -0.56% plan has no small-cap, value, emerging markets or REIT funds.
Participants in the Royal Dutch Shell RDS.A, +3.89% plan and that of privately held Fidelity Investments have access to all my recommended asset classes except international small-cap value. However, Shell’s plan has too many choices (more than 340).
While individual 401(k) participants can’t fix these shortcomings, those who care can make the most of the options available to them.
My recommendations for the specific plans I have studied are based on the asset allocation strategy I’ve been recommending for more than 15 years. It’s summarized and detailed in a previous article that I highly recommend to all investors.
For each retirement plan, I’ve done the best job I can of implementing the principles in that article with the choices available to the plan’s participants.
The recommendations in each plan are divided in three parts: One for conservative investors (probably those who are older or very risk-averse), one for aggressive investors (probably those who are younger), and one for those with moderate risk tolerance. If you’re not sure which right is for you, choose the moderate plan. The only difference in each case is the ratio of equity funds to bond funds.
If your plan isn’t among those listed here, all isn’t lost. Study this article, then do your best to identify the funds in your plan that correspond to the asset classes you want.
Apply my recommended percentages to them, depending on how aggressive or conservative you want to be. The result will probably fall short of perfect, but it’s likely to be much better than whatever default choices your plan offers.
Richard Buck contributed to this article.