Christine Benz: Hi, I’m Christine Benz for Morningstar.com. I recently attended the Morningstar Ibbotson Conference and had the chance to sit down with John Ameriks who focuses on retirement research for Vanguard. We discussed the role of equities in 401(k) participants' plans.
John, thank you so much for being here.
John Ameriks: It's great as always to see you Christine.
Benz: So, you have over your career been following trends in terms of how participants allocate their 401(k) plans. Let’s look specifically at how the trends have evolved. How have people changed in terms of their positioning, specifically in relation to their equity holdings?
Ameriks: Sure. That’s a topic that I’ve been looking at as you say for about 15 years. So, the trends there are pretty striking. We've put together data at Vanguard, and others have looked at this. I think over the last 15 to 20 years, you’ve really seen the emergence of a pattern of asset allocation in retirement accounts that lines up much better with what most academics or theorists would say is the right way, or at least in a first-order sense, the right way for asset allocations to look for people saving for retirement.
Generally, that means higher equity allocations for people that are younger and then decreasing equity allocations as people get older and begin to enter retirement. That pattern is actually relatively new in the data. I first observed that kind of pattern about 10 years ago when I was looking at some data from TIAA-CREF at the time. That same pattern has emerged in the Vanguard data that I now look at, and other academics and researchers have seen this elsewhere.
It’s new. It's something that did emerge over this time period, and one of the interesting questions that a lot of folks are asking is, "Is that a permanent feature now of how people save for retirement?" My guess is that it is, and target-date funds, I think, are one big reason for that.
Benz: Well, let’s talk about that target-date or target retirement funds have grown dramatically in popularity over the past decade and over the past five years or so in particular. What role have target-date funds had in shaping people's asset allocations?
Ameriks: It really is all about the default allocation that someone gets when they enter into a retirement plan, and target-date funds now have a structure that reflects that "higher equity allocation when young, lower when older" pattern. The defaults that were used in many retirement plans in the United States 15 and 20 years ago were very, very conservative, and those defaults also had affected the age profile of equity exposure, how much risk people were taking in their plans.
Benz: So, if you did nothing in the past, you might have been opted in automatically into the stable value fund or some other very conservative option?
Ameriks: Absolutely. That's exactly what we saw, and it led to when you looked at a plan population in terms of its overall asset allocation, you would see a lot of younger investors with significant amounts of cash or stable value in their portfolios. That would tend to rise as people got older for a variety of different reasons, one of which just being inertia. And in general the trend that risky asset classes would tend to provide higher returns than those conservative asset classes, so over time equity allocations would tend to rise. But that pattern has changed now really fundamentally with the introduction of target-date funds that start people off entering the plan at higher levels of equity allocation and then comes down.
Benz: And you mentioned inertia and you noted in your presentation here that actually inertia is a major factor in how people handle their 401(k) allocations. Let’s talk a little bit about that and what the research data show about that issue of inertia.
Ameriks: Well this does go back to all of the behavioral finance work that's been done on 401(k) plans in the last 15 to 20 years. Some of that early work, I was participating in, and there were lots of other people that were doing this at the time. Basically we know that in 401(k) plans, people are very reluctant to do anything.
In my work, for example, in the study we looked at, we looked at participants in a very large retirement system that were contributing to that system over a period of 10 years, we found about half of them making active contributions never change their asset allocation. They had never altered the flow of new contributions into their accounts.
So, that tendency to just stick with what I did the day that I signed the plan documents and enrolled in the plans is something that stays with people a long, long time. We have learned over 15 or 20 years now to try to use that to people's benefit and to think very, very carefully about the structure of plans in order to leverage that as opposed to just accepting it for what it is and trying largely unsuccessfully to get people to overcome that inertia within plans.
Benz: So, that’s why we have auto-enroll for example, and that’s why we have people auto-enrolled into target retirement vehicles that are more age appropriate than perhaps other [plans].
Ameriks: Absolutely. I mean that's driving all of this, and it still stuns me sometimes when we look at plans in transition that are either introducing auto features or they are doing a re-enrollment. The number of people that opt out of those changes is at the upper extreme, say 20 percentage points, but that's atypical, that’s a large opt-out amount. We are usually seeing opt-outs of less than that. And if you take a step back and put on my hat as an academic researcher and think about all the economics we’re taught about rational decision-making, you can still maintain that rational decisions are being made. But then you have to assume that the transactions costs and the level of investment in financial knowledge or in time and effort to pay attention are just much, much larger than we think that they are.
I think it's a combination of both things. There is a real element of cost, and people have lots of other priorities than thinking about retirement accounts, especially when younger. But then there is also an element of lots of people making decisions that are not necessarily rational, and we know that people don't always act like they should.
Benz: Right. I want to focus specifically on a period that might have been an opportunity for people to feel irrational, the financial crisis. What do your data show about how participants behaved during that period. Did people go way into very insecure options or did they generally stick with what they have?
Ameriks: Two very important points about that. One is that the research on inertia held true during that time period. We still saw very little activity in plans. In general, we’re talking single-digit percentage points, about 3%, of our record-kept plan population of Vanguard did anything during the financial crisis. We focused explicitly on those people who might've abandoned the equity markets, and those numbers were very low. So that's point number two.
Benz: They didn’t necessarily add to equities, though, either during that period, right? It just sort of was no one doing anything?
Ameriks: That’s correct. There was just not a lot of activity. So point number one is inertia and kind of still ruled the day even in the worst market environment that we've seen in 70 years. The second point is that when we did look at people who were making changes probably, not unsurprisingly, those people did tend to be older. The older you were, the more likely you were to make changes to abandon equities, and I think that makes sense.
One of my colleagues says it's because there are more zeros at the end of those numbers that people are looking at it. It matters more to them. That's certainly got to be a factor. And we did some economic work to try to control for the size of balances, and the age effect still shows up. But certainly that's a part of it. And I think that has real implications for how you design plans. There has been some work done focusing on the equity risk premium and the need for people to stay in stocks over long periods of time to realize high returns. I’m a big believer in the equity risk premium, but people need to understand it is a risk premium not a return premium. And so there is a risk that comes with it. And as people get older they do get more sensitive to that risk. That’s the logic for the declining equity allocation in target-date funds and the rationale for why most economics will tell you the right answer to pull people gradually out of the market as they get closer to retirement.
Benz: John, thank you so much for sharing your insights. It's really a fascinating research.
Ameriks: Thank you very much, Christine.