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2 Bright Spots for 401(k) Investors

Christine Benz

Note: This video is one of several interviews that Morningstar director of personal finance Christine Benz had with Vanguard officials at this year's Bogleheads event. See all of the interviews here.

Christine Benz: Hi I'm Christine Benz from Morningstar.com. Investors in Vanguard-managed 401(k) plans are increasingly receiving some type of investment advice, according to the annual How America Saves study. Joining me to discuss some of the key takeaways from that research is Jean Young, she's a senior research associate with the Vanguard Center for Investor Research.

Jean, thank you so much for being here.

Jean Young: Thank you.

Benz: Jean let's talk about that headline. We've seen kind of a transformation in the percentage of 401(k) or company retirement plan investors who are getting some advice component. In fact, the data point that jumped out at me is that back in 2003 just 1 in 10 of the participants in a Vanguard managed plan were getting an advice component, now it's 6 in 10. Can you talk about the factors that have driven that change?

Young: That is actually a phenomenal change. And you are right it has been the headline in How America Saves for a few years. You are talking about the statistic we describe as a professionally managed allocation. Now a criticism of 401(k) plans is that many individuals don't have the knowledge or the skill and they are not interested in figuring it out or acquiring the knowledge or the skill to construct a good portfolio for their retirement savings. So the industry has responded with solutions and products to assist there. The biggest product that you see there is the target-date fund. So it really simplifies it for the participant. They just need to know when they are going to retire. You also have target risk balance funds and you have the Vanguard Managed Account Program, which is you hire an advisor to manage your money--in our case you are hiring financial engines.

The uptick in utilization of that has been phenomenal. It's driven by two things. Everybody always attributes it to auto enrollment, where very often the default is the target-date fund. That is contributing. But what's more important is we've simplified the investment portfolio construction tasks for individuals by offering the target-date fund. If you think about a voluntary enrollment plan the first thing you have to do is you have to cut your pay and contribute. That's hard enough. You get through that hurdle and then you are faced with an array of investments that you need to use to construct your portfolio. 

Today you have the option of saying here is a portfolio that all I need to know to know which one is for me is when do I plan to retire. There is data in How America Saves, more people chose target-date funds than are currently defaulted into them. It's the offering of the option and the simplifying the decision making for participants it really matters there.

Benz: Let's talk about how participants have responded and how much of their target-date funds' returns they are actually capturing. Are you able to look, I am sure you are able to look at participant behavior and see has the trend toward people getting advice embedded in their 401(k) plans led to better outcomes? That's really the goal obviously.

Young: The group of participants that are taking advantage are professionally managed options do have better portfolio outcomes. We analyze this every year in How America Saves, and we do it by looking at five-year annualized returns for a random sample of participants that are using target-date funds, using a single balanced fund, using the Vanguard Managed Account Program and then the rest are the ones that are still doing it themselves. When you look at the returns over a five-year period and you compare those to what the broad market indices did, the returns, the age-based returns are exactly what you would want to see as somebody that cares about people getting this right. If you care about retirement savings in America.

If you are somebody that studies this like myself, if you are a plan sponsor, these are the returns you would like to see for your employees. Now if you look at the returns for the folks that are doing it on their own, it's a bit of a scattershot. It's all over the board, a lot of people seem to be taking a lot of risk to no additional return, and then some younger people are quite conservative. It's really all over the board. It's a scattershot. Now some people do appear to be getting it right, but then the question becomes is that skill or is that luck.

Benz: Right. Another thing that you and the team examine in this research is you look at contribution rates. Let's talk about trends that you observed there. It doesn't sound like you've seen a lot of change in terms of participant contribution rates.

Young: The number I like to focus on is the aggregate plan contribution rate. Most of the plan sponsors we are working with have a match or they have with another contribution like a variable profit sharing. A third of the time they have both. Most participants we're working with, yes they are making employee elective deferrals. But they also have that employer contribution as well. If you look at that number over the past 15 years on average it's been about 10.5, 10.7 and at the median it's been 9.7 or so. So, let's call it 10%. What that says is that for last 10 years the people saving for retirement in these plans are saving 10%. And you are right that's been pretty steady.

How America Saves is analysis of cross sectional data. And the challenge that comes into play is that during this period we have rising adoption of automatic enrollment where the dominant default for a long time was three. And then any annual increase of perhaps one. The other phenomena is, is that new employees to firms don't last. When we look at the turnover rate among the employees at these firms that we're working with, by the third year about half of folks have left. There is this constant churn in the data, fueled by the people that are coming in, many are being defaulted at three. I am actually thrilled that we've managed to have so many more people in these plans through automatic enrollment, but yet we've maintained that deferral rate--10%, 11% is not the 12% to 15% Vanguard would tell you, these folks ought to be saving, but, frankly, if everybody in the U.S. was saving 10% we wouldn't be sitting here talking about this.

Benz: That’s another thing I want to talk about. Because you supply median, company retirement plan balances as well as average. The averages look good, trending up, but let's talk about the medians because I think when you look at that and if you are concerned about the state of retirement fundedness in this country it's a little bit dispiriting when you look at those median balances. Let's talk about that differential, why you've got a lot of people who are apparently extremely undersaved for retirement.

Young: We don't know if they are undersaved or not. The challenge we face with this data is it is cross-sectional data analysis. People are leaving these employers, people are coming into these employers.

Benz: They could be rolling over assets to other places.

Young: You have new folks with auto enrollment. More new folks coming in at smaller balances. When you look at the 401(k) balance and the current employer plan, it's very much a partial picture. Let me take a step back and tell you a little bit about our typical participant. First of all he is male--59% of the participants on our platform are men. He earns $67,000 a year. He is 45 years old, he has six years of tenure with that current employer. He's 45--we just talked about the fact that he's saving 10%. We also talked about the fact that he likely has a balanced investment portfolio. 

If I take that guy even with his $26,000 median balance and project him forward, factor in Social Security, he's going to be fine. He's tracking to a decent replacement ratio. He's got another 20 years to go, we can make a reasonable assumption on what markets might give him. He's on track he will be fine. But you are right this is the one number in How America Saves that is least understood, because everybody looks at and says wow, the system is not working.

Benz: This is bad.

Young: Right. So, he's 45, he's probably got retirement plans with former employers he probably has aftertax savings. He could even have IRAs. He owns his home. If he's married take all of that times two. When you look at the current 401(k) balance you are very much looking at a partial picture.

Benz: One other thing I want to hit on, briefly because it's of high interest to a lot of our Morningstar.com users is this aftertax 401(k) option. What kind of uptake are you seeing there in terms of plans allowing for aftertax 401(k) contributions? How about participants actually taking advantage of it.

Young: That comes into play for a very high wage population. You can get more money into these plans and with the ability to immediately, or within a month or a quarter, convert those to Roth.

Benz: Assuming your plan allows the in-plan conversion.

Young: And the plans that are allowing aftertax and really understand this are allowing the conversions. That's a strategy for very high paid work forces. We certainly have clients that do that. But again, as with anything else the individual has to engage and chose it. They have to engage, they have to chose it. Adoption or take up is not that high.

Benz: Okay, Jean fascinating research. Thank you so much for being here to discuss it with us.

Young: Thank you, Christine.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.