A little extra risk can help boost retirement savings

NEW YORK, 7 Sept 2017: 

A little thought experiment for retirement savers:

Pretend we are at the race track and I pick your pocket, take a US$10 bill, replace the wallet surreptitiously – and then ‘give’ you the money with instructions to put the funds on a horse.

Now pretend that I also instruct you to take another US$10 of your own money and make a second bet.

I’ll bet, with my own money, that you pick a riskier horse with longer odds for the ‘gift’ tenner than the one you actually had to fish out of your wallet.

After all, if you are playing with house money, why not shoot for the stars, right?

That, in essence, is the situation many defined contribution (DC) retirement savers face and taking fewer risks with ‘their’ money is how they respond, according to a new study.

The results don’t just confirm some truism of behavioural economics but perhaps point to important conclusions about the pitfalls of our system of self-directed retirement savings.

The study looked at how employees allocate defined benefit plan (DB) investments in plans which are entirely funded by their employer as compared to how they invest money in ones funded by forgone take-home pay, in this instance 403b plans for employees at a state university.

The upshot is that savers take fewer risks and have lower allocations to theoretically higher-return assets in retirement plans in which they’ve chosen to enjoy less take-home pay as a funding source – as against ‘automatic’ plans in which the entire amount is contributed by the employer.

“These findings are consistent with the notion of a house money effect, with the employer contribution as the house money,” Andrea Anthony of Golden Gate University and Kristine Beck and Inga Chira of California State University- Northridge wrote in the study.

“Employees appear be more willing to take risk with the employer money, or ‘free money,’ than their own salary reduction contribution to the 403(b) account.”

The study used data from Oregon State University employees, meaning the typical participant was both better educated and better off than an average retirement saver.

Remember, all funds put into retirement savings are earnings, not gifts; they are the result of market forces and negotiation rather than largesse by employers.

The salient difference between the two main types of plans studied is that the 403b ones were elective and funded by a sacrifice of take-home pay today for retirement money in the future.

The study isn’t useful just because it demonstrates that we become more risk-averse if we feel it is ‘our’ money at stake, but also that it points out some fundamental flaws in the system in the US – which is dominated by self-directed retirement savings accounts in which the beneficiary makes the decision about how to invest.

That move, from DB plans to DC ones, shifted risk to individual employees from companies and other employees. It also meant that most retirement savers must now rely on an amateur – themselves – who is prone to many self-destructive behavioural biases.

Retirement savers should be investing in equities and other high-risk, high-reward assets if they meet their own risk profile well – not avoiding them because it would be painful to lose what feels like your own hard-earned money.

A 2015 study from Boston College showed that defined benefit plans, which are managed by professionals, had a weighted average return of 7.9% annually between 1990 and 2012, compared to 7% for defined contribution plans.

While that underperformance was in part driven by paying higher fees, it excludes the impact of Individual Retirement Accounts, which are also self-managed, and which own about half as many more assets as DC accounts.

Geometric rates of return for DB plans were 4.7% from 2000-2012, compared to 3.1% for DC plans and just 2.2% for IRAs.

The typical IRA is not only charged higher fees than DB ones but holds a whopping 11% of assets in low-yielding money market accounts.

Individuals are just not very good at this game, and it will be individuals who suffer due to low returns compounded over decades.

In moving to individually managed retirement savings we’ve democratized investing, but it is very much like the H.L. Mencken quip: “Democracy is the theory that the common people know what they want, and deserve to get it good and hard.”

– Reuters

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