What's the biggest determinant of successful retirement planning? One might guess it's asset allocation because of the famous paper published in 1986 concluding that asset allocation is the primary determinant of a portfolio's return variability. But a recent paper by the Putnam Institute suggests asset allocation plays a relatively minor role in the scheme of things when it comes to saving enough for retirement. So does rebalancing a portfolio on a quarterly basis.
So what else could it be, then? You might guess fund performance. But that's not the case either, according to the paper titled "Defined contribution plans: Missing the forest for the trees?"
Individual fund performance would be the trees blocking the view of the metaphorical forest.
I can't help but wonder if the Putnam Institute is trying to minimize the importance of fund performance because it so happens that many Putnam funds have lagged their peer groups. At best, Putnam funds perform at the middle of the pack for one-year returns, landing in the 51st percentile on average, according to Morningstar. Long-term performance is even worse: For five-, 10- and 15-year returns, Putnam funds rank in the 60th, 63rd and 68th percentile, respectively, on average (1=best and 100=worst).
Looking in the weeds of the study
The base case in the study uses funds that have been around for at least 29 years, and that ranked in the bottom quartile for performance. Translation: They stunk in 1982.
Someone -- let's call her Sally -- who deferred 3 percent of her pay since 1982 into a conservative mix of stock and bond funds would have had a 401(k) balance of $136,400 at the end of 2011, according to the study. Assumptions: Sally started out with a salary of $25,000, received 3 percent annual pay raises, never rebalanced the portfolio or changed the asset allocation and just coasted along for 29 years in a portfolio consisting of 30 percent stocks, 60 percent bonds and 10 percent cash, allocated among six funds of various styles and market capitalizations.
The study also looked at four other fund scenarios. What would have happened if Sally had invested in top-quartile funds back in 1982 and held for the long term? What if the plan sponsor switched the lineup every three years so that Sally could invest in the top-quartile funds at three-year intervals? What if Sally only invested in index funds? And four: What if the plan sponsor could accurately predict the top quartile funds in advance every three years, and Sally invested in these at three-year intervals? That last scenario, dubbed "crystal ball," obviously is not accessible to anyone without the benefit of hindsight.
Surprisingly, the portfolio values didn't deviate that much from the base case. In fact, only the crystal ball scenario resulted in a portfolio that was larger, by about $30,000, than the base case. All the other scenarios yielded results that were lower by anywhere from $5,000 to about $10,000 -- including the index fund strategy.
So what determines success?
OK, so if asset allocation, rebalancing and individual fund performance are not the main determinants of retirement success, what is? According to the study, it turns out that the amount deferred in the retirement plan by the plan participant makes the most difference. If Sally had deferred 4 percent, 6 percent or 8 percent instead of 3 percent, she'd have a much fatter nest egg after 29 years. Here's what she'd have:
- 3 percent deferral: $136,400
- 4 percent deferral: $181,800
- 6 percent deferral: $272,700
- 8 percent deferral: $334,000
This is something over which plan participants -- you and me -- have control. The study's author suggests that plan sponsors adopt a more aggressive auto-escalation feature in their plans, hiking deferral rates automatically by a percentage point each year until participants are contributing 10 percent.
But don't wait for your employer to make this decision for you. Start contributing 10 percent -- or as much as you can -- from the get-go.
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