By James Saft
Sept 13 (Reuters) - Few advisers want to say it, and no client wants to hear it, but your best bet isn’t obsessing over funds and strategies but simply raising your savings rate.
The investment industry - and clients - are intensely focused on how to maximize returns, with much ink, brain power and tears spent on trying to divine which fund to choose and what strategy to adopt.
While this is entirely appropriate, and sometimes even fruitful, it is also, in many ways, a self-defeating diversion.
The truth is that the primary generator of wealth is earnings, and the only earnings that really count are those you don’t spend but invest.
Deferring consumption is a much tougher sell than the alchemy of fund selection, and so the industry, with clients and advisers both complicit, spends far more time thinking of one than the other.
Putnam Institute has done a well-constructed study which looks at the impact of fund selection, asset allocation, rebalancing and simply saving more, and finds that over the long term delaying gratification is the name of the game.
The Putnam study was concerned with defined contribution plans, under which employees save by allocating their money among an array of funds with different strategies and profiles. I’d argue that the findings broadly apply to anyone saving and investing through any vehicle or plan.
"Putting fund performance front and center in terms of the plan sponsor's priorities is an error with far-reaching implications. That is not to say that fund performance does not matter, but our analysis suggests it is a much less powerful variable compared with asset allocation and, most of all, higher deferral rates," W. Van Harlow, director of research at the Putnam Institute, which is sponsored by the fund firm, wrote in the study. here
To look at the variables, the study hypothesized an individual who began saving through a defined contribution plan in 1982, at the age of 25 and who got annual 3 percent raises and chose to contribute 3 percent of income. The plan offers 50 percent matching up to 6 percent.
The base case is a saver who chooses a conservative asset mix of 60 percent bonds, 30 stocks, 10 cash, and who selected funds which were in the bottom 25 percent of their Lipper peer group, never rebalanced and never made asset allocation changes. The results were pretty grim. In 2011 our saver finds herself 57 years old, earning an income of $57,198 per year, and possessed of a 401(k) balance of $136,400.
Now, let’s assume our saver did her research and only chose top quartile funds at the outset. Sadly, the winners at the outset proved dogs over the long run, and returned only $126,700. If you choose top quartile funds but rotate into other top quartile funds every three years you do slightly better, ending up with $130,600. Index funds do better still, at $131,500, but still below the level of the bottom quartile.
In fact, even if you could see the future and choose, in advance, funds every three years which would end up in the top quartile you’d only improve your outcome, over 29 years, by 22 percent, ending up with $166,200.
Increasing risk in the portfolio by using a balanced asset mix (60 percent equities) or aggressive mix (80 percent equities) improves returns by far more, returning $150,000 and $159,000, respectively. The cost, of course, is volatility, which makes cowards of us all and often prompts plan participants to bail out at exactly the worst time.
Periodic rebalancing, the study finds, can goose returns slightly and also mitigate volatility, meaning our investor gets a lot more return for her risk. This again was using bottom quartile funds, selected at the beginning.
It is important to note that the study constructed the portfolios using funds which existed throughout the entire period, and where possible opted for the fund which was most commonly offered in 401(k) plans within a given category.
All well and good, but the really significant gains come when our saver simply bags a few more lunches and ups her contribution rate. If the individual’s contribution rises to 4 percent from 3, her final balance jumps to $181,000 from $136,400. Take that to 6 or 8 percent and you get $272,000 and $334,000, respectively. Now in part the lesson here is always take advantage of the maximum matching amount, but it also clearly illustrates the power of contributions, no matter whose money it is.
“Interestingly, even a 4 percent deferral - which represents a 1 percent increase that does not take advantage of the plan’s full matching contribution - would have had a wealth accumulation impact 30 percent larger than the crystal ball fund selection strategy, nearly 100 percent larger than the growth allocation strategy, and approximately 2,000 percent larger than rebalancing,” according to Van Harlow.
If anything, the importance of this kind of math may grow over the coming decade, if, as many anticipate, the post-financial crisis landscape leads to an extended period of low returns.
To best serve clients, the investment industry needs to change, moving from mostly selling hope to increasingly counseling deferred consumption and higher rates of saving.