The Downsides of 401(k) Plans
Thursday, May 2, 2013
Charles Rotblut, CFA
AAII Journal Editor

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  1. “Combining Quality Growth With Value and Momentum”
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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 31.0%, up 2.7 points
  Neutral: 33.1%, up 0.2 points
  Bearish: 35.9%, down 2.9 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

Spots for our 2013 AAII Investor Conference are selling out quickly. As of this week, 65% of the hotel rooms we have reserved for attendees at the conference hotel—the Loews Royal Pacific Resort in Orlando, Florida—have already been booked by AAII members. If you are considering attending, it would be wise to register sooner than later. Plus, the $50 early bird discount on registration will expire soon.

We have an impressive list of speakers. I think you’ll particularly enjoy our keynote luncheon speaker, Yale professor Robert Shiller. He will speak about market valuations, his widely followed cyclically adjusted price-earnings indicator and his widely followed Case-Shiller housing price index. I’m personally excited to hear Dr. Shiller speak.

You can find out more information about the conference and register for it on here. I hope to see you there.

A recent episode of the PBS program Frontline focused on 401(k) plans. Entitled “The Retirement Gamble,” the program discussed both the risks and the costs of retirement saving plans.

A 401(k) plan is a defined-contribution plan: employers can choose to contribute a specified amount to the employee’s savings. In contrast, a pension is a defined-benefit plan: employers agree to provide a specified level of income throughout an employee’s retirement.

Another big difference between defined-contribution and defined-benefit plans is who manages the future liability. Pension plans hire professional money managers to oversee the investment choices and the portfolio allocation strategy. Actuaries are also hired to provide an expert analysis of whether the plans’ assets are sufficient enough to cover anticipated future payments. Individuals overseeing their 401(k) plans, and individual retirement accounts (IRAs), must make these decisions and analyses themselves. Though individuals can hire advisers, individual investors lack the access to the team of professionals that pension plans consult.

An individual who is exposed to financial theory and time-tested investment practices, as AAII members are, can make informed decisions regarding his retirement savings. Many workers, however, are left to make important decisions without any or just minimal exposure to key investment concepts. Retirement savings is one of the few areas where individuals are expected to make critical decisions regardless of their knowledge of how to do so. Factor in inadequate savings rates and it is easy to see how a dangerous mix exists for many people.

Compounding matters is the construction of 401(k) plans. Though some employers offer a good selection of mutual funds with low expenses, others operate plans with a limited selection of funds and high expenses. Hidden and not so obvious costs worsen matters. A fund could have a back-end load (a fee for selling shares within a certain period of time) that an investor may not be aware of. Alternatively, lower-cost versions of certain funds may be excluded from the offerings. For example, Vanguard does not allow me to buy shares of its lower-cost Admiral funds in my 403(b) account. (A 403(b) is a defined-contribution plan for nonprofit organizations.)

Too much choice can also be a problem. A person with limited investing knowledge can have difficulty determining how to allocate his savings or deciding which funds to invest in. Similarly, an investor with an IRA may find his thought process paralyzed by the presence of too many investment options. Behavioral scientists have shown that when presented with too many options, humans tend to make fewer choices than when presented with just a few choices.

And none of this even addresses the evidence that workers do not necessarily understand what they are investing in. Last year, I saw a study detailing how 401(k) participants were investing in target date funds even though they did not know how these funds were constructed or what they were actually designed to do.

Unfortunately, there is no easy solution to this problem. More education is obviously a good step. Default savings programs that increase 401(k) contribution rates over time are also helpful. But, behavioral errors, a lack of interest in learning about investing, time commitments and individual financial constraints all pose long-term threats.

What you can do is save as much as is reasonably possible and make the best choices based on what is offered in your plan. Start with a basic allocation mix of stocks and bonds that are appropriate for your age and financial situation and then look for funds that meet those goals. Key items to look for in the plan documentation are fees (including any loads), long-term performance figures and the fund objective. (Going solely by fund names or classifications can be misleading.) If you are nearing or in retirement or are in the process of changing your job, realize that you also have the option to move your savings elsewhere as opposed to keeping it with your former employer’s plan sponsor. Finally, if you consider yourself to be a sophisticated investor and you have children or grandchildren, offer to help them review their 401(k) plans.

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The Week Ahead

Earnings season will stay busy, as many mid-cap and small-cap companies report quarterly results. There will also be reports from more than 40 S&P 500 members, including Dow component Walt Disney Company (DIS). Disney will report on Tuesday afternoon.

In a calendar quirk, the only economic report of note scheduled for next week will be weekly initial jobless claims, which will be released on Thursday morning.

The Treasury Department will auction $32 billion of three-year notes on Tuesday, $24 billion of 10-year notes on Wednesday and $16 billion of 30-year bonds on Thursday.

AAII Sentiment Survey

Even with a modest increase in optimism and a modest decrease in pessimism, many individual investors continue to fret that stocks are overbought at current levels according to the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 2.7 percentage points to 31.0%. Though above 30% for the first time in four weeks, optimism is below its historical average of 39.0% for the seventh consecutive week. This is the longest such streak since August 30, 2012, through November 22, 2012.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, edged up 0.2 percentage points to 33.1%. The historical average is 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, declined 2.9 percentage points to 35.9%. Even with the decline, pessimism is above its historical average of 30.5% for the ninth time in 11 weeks.

We are continuing to see a decline in bearish sentiment. Since spiking to 54.5% on April 11, 2013, pessimism has pulled back by a cumulative 18.6 percentage points. The pendulum has not fully swung back the other way, however, with bullish sentiment only rising by a cumulative 11.7 percentage points over the same time frame. This week's readings are, however, well within the normal ranges we have seen throughout the survey's history.

Some individual investors do remain hopeful that stocks can continue their upward run. Many others are concerned that stock prices have moved too far, too fast, particularly given the pace of economic growth. Frustration with Washington is also playing a role in keeping some investors pessimistic.

This week’s special question asked AAII members for their opinion of Apple (AAPL) becoming the largest dividend payer in the S&P 500. Approximately 40% of respondents said the recent increase is good for shareholders or was overdue. More than 10% viewed the large dividend as a sign either that the company's days of strong growth are over or that the market will start viewing Apple as a value stock. About 15% of respondents were apathetic, saying the news does not affect their portfolios. Other responses varied from those who thought Apple was pressured to raise the dividend to a few who wonder if the company has lost its ability to innovate.

Here is a sampling of the responses:

  • “A good move for the company.”
  • “Returning value to shareholders is important.”
  • “Good news. If they can't use the cash for a better return through investments, then they should return it to shareholders.”
  • “Would prefer investing in new products. Apple needs a new hit; something everybody wants before they even know they want it.”
  • “A sign of successful and maturing company. Is its growth sustainable?.”
  • “Growth slows; Apple is becoming a value stock.”

» Take the sentiment survey

AAII Asset Allocation Survey

April Asset Allocation Survey results:
Stocks/Stock Funds:
    61.7%, up 2.2 points
Bonds/Bond Funds:
    19.7%, up 2.0 points
    18.5%, down 4.3 points

Asset Allocation details:
    29.5%, down 2.3 points
Stock Funds:
    32.2%, up 4.5 points
    3.8%, down 1.5 points
Bond Funds:
    15.9%, up 3.5 points

Take the survey »

Equity and fixed-income allocations increased last month, as individual investors shifted money back out of cash according to the April AAII Asset Allocation Survey.

Stock and stock fund allocations rose 2.2 percentage points to 61.7%. The increase puts equity allocations back above their historical average of 60% for the third time in four months.

Bond and bond fund allocations rebounded by 2.0 percentage points to 19.7%. Even with the increase, this is the first time since April 2009 through June 2009 that fixed-income allocations have been below 20% for three consecutive months. Even with this occurrence, bond and bond fund allocations are above their historical average of 16% for the 46th consecutive month.

Cash allocations pulled back by 4.3 percentage points to 18.5%. The April reading is similar to the levels that existed earlier this year, in January and February. April was also the 16th consecutive month that cash allocations remained below their historical average of 24%.

A sharp increase in pessimism about the six-month outlook for stock prices in the weekly AAII Sentiment Survey did not deter AAII members from investing in stocks. Rather, their allocations rose as the market continued its rally. One reason is the continued low interest rates, which continue to frustrate individual investors. It should be noted that many AAII members do have concerns that stocks are presently overbought and susceptible to a pullback in prices.

This month’s special question asked AAII members what would prompt them to increase their allocations to stocks. Approximately 27% said they were looking for a drop in stock prices, with many saying they were looking for a drop of greater than 10%. Another 25% said there was no catalyst that would cause them to increase their equity allocation. A sizeable portion of respondents in this group listed their satisfaction with their current portfolio allocation as the reason why. The next largest group, representing 7.5% of respondents, said better economic growth would cause them to buy more stocks. A small number listed their age as the reason why they are allocating more to equities, but indicated they would buy more stocks if they were younger.

Here is a sampling of the responses:

  • “I am waiting for a correction. Most quality stocks look overvalued to me.”
  • “After a large correction of 10% or more, I would allocate a large percentage of my cash to stocks and stock ETFs.”
  • “Nothing. I have an asset allocation plan and I am not deviating from it.”
  • “Nothing. I believe my current allocation is the maximum appropriate allocation for my and my wife’s age.”
  • “For me to be 10 years younger and further from retirement, which is not likely to happen.”
  • “Convincing my wife that we should change our allocation to reduce the bond component. I have been unsuccessful so far.”

» Take the Asset Allocation Survey