Paying too much attention to fund performance in a defined contribution plan is a major error, according to research by Putnam Institute. The organization’s analysis shows that fund performance is a much less powerful variable compared with higher deferral rates and asset allocation.
In “Defined contribution plans: Missing the forest for the trees?” Putnam examined different plan design scenarios on a person’s retirement income if they made $25,000 a year in 1982 and received a 3 percent cost-of-living increase. It found that the biggest driver of an individual’s wealth accumulation is higher deferral rates.
In the test scenario, the individual had a 401(k) plan available to them with a match of 50 cents on the dollar up to 6 percent offered by their employer. They also were invested in a conservative asset allocation across six asset classes. Each scenario was tested for 29 years.
“It should come as no surprise that if one saves and invests more, then one might be more likely to accumulate greater wealth,” the report stated. But the size difference in terminal wealth can be dramatic.
The report’s author, W. Van Harlow, director of research for Putnam Institute, dialed up the individual’s contribution from 3 percent of income to 4 percent, 6 percent and 8 percent. As he did so, the final retirement account balance after 29 years of investing jumped dramatically from $136,000 to $181,000, $272,000 and $334,000 respectively.
Putnam concluded that overcoming employee inertia when it comes to investing is the biggest challenge the industry faces. Helping eligible employees enroll and increase their deferrals into their DC plan is a good way to help boost wealth accumulation potential. Auto enrollment and auto deferral increases are two critical best practices plan sponsors should consider implementing, the report said.