In difficult times professionals tend to beat amateurs at the game of managing retirement savings. One of the reasons for this is the inertia that characterises investor behaviour.
This emerges clearly from two reports about US defined benefit (DB) and defined contribution (DC) plans’ performance during the past few years, elaborated by consultancy firm Watson Wyatt Worldwide and mutual fund giant Vanguard.
The results show the potential for independent advisory services - allowed by the US Labour Department in December 2001 – aimed at participants of 401(k) plans, the individual DC schemes.
According to Watson Wyatt, from 2000-2002, both DB and 401(k) plans lost money, but the latter performed worse because investment decisions were made by individuals who did not regularly rebalance their portfolios, whereas professional money managers in charge of traditional pension plans were obliged to do so.
As the figures show, DB plans beat 401(k)s by 4.3 percentage points in 2000 (0% return vs 4.3 %); 3.5 points in 2001
(-3.8% vs 7.3%); and 3.8 points in 2002 (-8.4% vs 12.2%). Consultants analysed data filed with the government by more than 2,000 publicly traded US companies that sponsor both one DB and one 401(k) plan. These performances are a reversal of fortunes compared to what happened in the late 1990s, when the 401(k) beat DB by 0.8 percentage points in 1997 (17.3% return vs 16.5%); two points in 1998 (14.3% vs 12.3%); and five points in 1999 (16% vs 11%).
The varying performances can be explained with different behavioural patterns and different asset allocation strategies. In 1999, DB plans had 58% of assets in equities, compared with the 72% that DC plans such as 401(k)s had in equities, according to the Federal Reserve Board’s recent Flow of Funds report.
The higher percentage of equities in 401(k) portfolios was due to the rising value of stocks and to individuals’ unwillingness to sell them in order to re-balance their portfolios. When the market plummeted so did 401(k) performances, while the more broadly diversified DB assets helped smooth the blow.
Looking at the years from 1990 to 2002, DB plans’ median annual return was 7.4% and 401(k) plans’ performance was 6.8%: a difference of half a percentage point can mean a lot in the long run thanks to the effects of the compounding growth. “A lesson to be learned here is that 401(k) participants need to maintain a well-diversified portfolio, so they can weather the market’s ups and downs more smoothly,” says Watson Wyatt’s report. “Employers can help by clearly communicating the benefits of diversification and other principles of sound investing to participants.”
Other data shows frequent mistakes made by 401(k) participants’ when investing their money, such as taking too little or too much risk for their particular age group. For example, in 2003, 38% of 401(k) accounts held by workers in their twenties had no money in stock funds and another 22% had 50% or less, according to a study by the not for profit Employee Benefit Research Institute and the Investment Company’s Institute, the mutual-fund industry’s association. Meanwhile, 13% of workers in their sixties had more than 90% of their 401(k) accounts in stocks.
Vanguard’s study of its 2.5m DC plan participants gives a deep insight into investor behaviour: only 14% of them made an exchange in their accounts during 2003. “Inertia was widespread and trading infrequent with few participants rebalancing their portfolios or making other investment changes,” says the report.
On a net basis, it is true that in 2003 people began to shift assets back into equities, but that move represents only 0.1% of average assets. From 2000-2003, equities lost weight both in asset allocation and contribution allocation of Vanguard DC plans: they fell from around 77% to around 68%. But that change was due more to the conservative attitude of the newly enrolled participants than to a shift in strategy of the old ones. In fact participants who enrolled in 2003 allocated 58% of their contributions to equities. Meanwhile those who enrolled at the top of the bull market still allocated 72% of their 2003 contributions to equities.
“This result is one example of the beneficial impacts of inertia on participant decision-making,” Vanguard comments. Participants who enrolled in the past were less likely to make an active choice and modify their contribution allocations in response to short-term market turmoil.
“New plan members, who were already making an active decision to enrol, were perhaps too willing to overreact to volatile market conditions and adopt a more conservative contribution allocation.”
But Vanguard admits that “old” members “may have taken on high-risk position naively, perhaps because of high equity market returns in the 1990s”.

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