Study of Nearly One Million 401(k) Portfolios Shows Lower Paid, Older Employees Making the Most Costly Mistakes
PALO ALTO, Calif. May 12, 2008 – Financial Engines, a leading provider of independent investment advice and managed accounts, today released The Financial Engines National 401(k) Evaluation, a new report that assesses nearly one million 401(k) participant portfolios (964,118) to determine how well Americans are handling their 401(k) plans. The report also estimates the costs associated with common investing mistakes. According to the National 401(k) Evaluation, 69 percent of participants in the study have 401(k) portfolios with inappropriate risk and/or diversification, 36 percent hold high concentrations of company stock, and 33 percent fail to contribute enough to receive the full company match. While groups of participants are taking full advantage of their 401(k) plans, participants with lower salaries, lower plan balances, and those closer to retirement tend to make the most costly mistakes.
"Millions of Americans will rely on their 401(k)s as a primary source of income in retirement, and until now, it's been challenging for plan sponsors to determine which participant groups are doing well and which groups need the most help," explained Jeff Maggioncalda, president and CEO of Financial Engines. "Throughout this report, the data show that those who need the 401(k) the most are benefiting from it the least. It is our hope that 401(k) plan sponsors and providers will use this data to inform plan design, ensuring that the 401(k) works well for all employees."
Older Participants More Likely to Have High Company Stock Concentrations
According to the report, 36 percent of participants in plans with company stock as an investment option hold more than 20 percent of their portfolios in unrestricted company stock. Eleven percent hold between 10-20 percent in company stock, and 53 percent hold less than 10 percent of their portfolios in unrestricted company stock.
In general, the older the participant, the more company stock they are likely to hold. Forty-three percent of those over age 60 hold more than 20 percent of their 401(k) portfolios in company stock, compared to only 28 percent of those under age 30. Extreme company stock concentrations follow a similar trend, with 25 percent of participants over age 60 holding portfolios with 50 percent or more invested in company stock, compared to just 13 percent of those under age 30. Fifteen percent of participants over age 60 hold 80 percent or more of their portfolios in company stock.
Holding high company stock concentrations has a negative impact on the expected growth of a portfolio, according to the report. Portfolios with more than 20 percent in company stock could expect an average of 18 percent less projected retirement wealth after 20 years, compared to those holding less than 10 percent in company stock (given the same starting balance and assuming no future contributions).1 In addition, portfolios holding 80 percent or more company stock can expect an average of 42 percent less projected retirement wealth after 20 years than those holding less than 20 percent in company stock (given the same staring balance and assuming no future contributions)2.
"Despite recent company collapses and market volatility, many Americans still discount or underestimate the high risk levels associated with holding high concentrations of company stock," explained Maggioncalda. "Unfortunately, the older employees holding the highest amounts of company stock have the least amount of time to recover if their company's stock happens to take a hit. Many participants don't realize that holding large amounts of company stock is actually a drag on the long-term growth of their portfolios."
Lowest Salaried Participants Making the Worst Investing Mistakes
While company stock is often a factor in participants not having appropriately diversified portfolios, participants are making other investing mistakes that are costing them projected retirement wealth. Of the 69 percent of participants in the report with inappropriate risk or inefficient portfolios, 38 percent have very risk-inappropriate or very inefficient portfolios. Just over thirty percent have portfolios that are both risk-appropriate and efficient.
Participants earning the lowest salaries are the most likely to make investing mistakes. More than half (53 percent) of participants with annual salaries below $25,000 have portfolios with very inappropriate risk and/or diversification, compared to 33 percent of those earning more than $100,000 per year. Common reasons for inappropriate risk or diversification include high money market or stable value concentrations, age-inappropriate portfolios (i.e. too conservative for younger employees or too aggressive for older employees) or concentrations in a single asset class.
Investing mistakes may cost participants real money in retirement. According to the report, portfolios with very inappropriate risk and diversification could expect to have 22 percent less projected retirement wealth after 20 years, compared to those with appropriate risk and diversification (given the same starting balance and assuming no future contributions).
Low Contributions Most Common Among Younger, Lower Salaried Participants
When it comes to 401(k) savings, 33 percent of active participants fail to save enough to receive the full company match. Sixty percent save enough to receive the full employer match but are saving below the IRS or plan limits, and only 7 percent of all active participants save enough to come within $500 of the IRS or plan maximum allowed. Still, many participants are saving at healthy rates, with 25 percent of the entire sample saving 10 percent or more of salary. Across the sample, the most common employer match was 50 cents per dollar up to six percent of pay.
Younger participants and those with lower salaries or lower account balances tend to save the least. Nearly half (48 percent) of those under age 30 are failing to save enough to receive the full employer match, compared with 35 percent of those in their 30s, 31 percent of those in their 40s, 26 percent of those in their 50s and 28 percent of those over age 60.
In terms of salary, 63 percent of those earning less than $25,000 per year fail to save enough to receive the full employer match, compared to 24 percent of those with salaries between $50,000 and $75,000 and 12 percent of those with salaries greater than $100,000 per year.
Saving at least enough to receive the full employer match has a significant impact on projected retirement wealth. For example, if the average participant not saving enough to receive the full employer match (saving 1.9 percent of salary) and a median account balance of $5,872 continued contributing at that same rate and receiving the partial employer match, that participant is projected to have approximately $46,800 after 20 years. However, if they increased their contribution to 6 percent of salary (enough to receive the full typical employer match in the report), the participant is projected to have approximately $120,900 after 20 years - a difference of 158 percent.
"While this report outlines the challenges facing today's plan sponsors and participants, plan sponsors can have a dramatic impact on participant portfolios through making plan design changes, such as adopting the Automatic 401(k)," explained Maggioncalda. "While most plan sponsors typically apply the Auto 401(k) to new hires, applying automatic features to existing participants who have made investing mistakes will turn the power of participant inertia to the benefit of participants, increasing their chances of achieving their retirement goals."
About The Financial Engines National 401(k) Evaluation
The Financial Engines National 401(k) Evaluation looked at 964,118 401(k) portfolios from 82 mostly large plan sponsors across five 401(k) providers, and rated each portfolio in terms of Risk and Diversification, Company Stock and Participant Contributions. Using the metaphor of a traffic stoplight, each participant portfolio was given an evaluation of red, yellow, or green. A red stoplight indicates that the participant should definitely consider making a change to their 401(k), a yellow stoplight indicates that the participant might consider making a change, and green indicates that the participant is taking good advantage of their plan options. Portfolios were then analyzed and segmented by age, salary, and account balance to determine which groups of participants were making the most of their 401(k), and which were making the most mistakes. In addition, Financial Engines calculated the expected growth rate of each portfolio to quantify the impact of participant investment and savings decisions on estimated wealth at retirement.
Copies of the report can be downloaded at no charge at www.financialengines.com.
About Financial Engines
Financial Engines is a leading provider of independent investment advice and managed accounts to defined contribution plans. Founded by Nobel Prize-winning economist, William F. Sharpe, Financial Engines serves millions of employees at many of America's largest corporations. Patented advice technology and institutional-quality investment methodology allow Financial Engines to offer an array of advisory services to meet the needs of a wide range of investors. For more information, please visit www.financialengines.com.
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1 Calculations use expected growth as a way to quantify the impact of participant investment decisions on retirement portfolio outcomes. The expected return of a portfolio is defined as the mean return expected over a single year for that portfolio. Expected growth, on the other hand, is defined as the median return expected over multiple years for the portfolio. The relationship between the two concepts is:
Expected Growth = Expected Return - ½ (portfolio variance)
Thus, the difference between expected growth and return is one-half the variance of the portfolio , which can be viewed as a "risk penalty" that applies to portfolio growth. Using expected growth to compare portfolios across individuals allows one to explicitly recognize the risk-reward tradeoff inherent in investments. In contrast, ranking high expected return portfolios as "better" would ignore the fact that more risk is generally required to achieve higher expected return. Keeping expected return constant, an increase in risk by itself will decrease the long-term growth rate of a portfolio.
Expected growth does not represent actual results nor adjustments made to a portfolio over time. Expected growth is not a guarantee of actual future returns and a portfolio with higher expected growth may not be better for all investors in all cases.
2 Projected retirement wealth estimates generated by compounding the average expected growth rate of two different portfolios over 20 years (net of inflation) and comparing the difference.