401(k) Participants Afflicted with Account Inertia

February 23, 2005 (PLANSPONSOR.com) - If a typical 401(k) account was a luxury liner, and the account's owner the captain, the captain would watch idly as the boat quickly ran aground.

In fact, asserted a new research study from the Pension Research Council at the WhartonSchool at the University of Pennsylvania, that strong trend of investor inertia should signal that 401(k) savers may need more help in managing their assets as they approach retirement. Olivia Mitchell, executive director of the Pension Research Council; Stephen Utkus, principal, Vanguard Center for Retirement Research; Gary Mottola, a Vanguard Center researcher; and Takeshi Yamaguchi, a Wharton doctoral student label those in 401(k) plans “The Inattentive Participant.”

“When it comes to managing their portfolio on an ongoing basis,” said Utkus, “participants are otherwise occupied.”

According to the study of retirement accounts managed by The Vanguard Group in 2003 and 2004, participants in 401(k) plans made little effort to tend to their defined-contribution plans once they were set up: Eight in 10 participants made no trades at all in the time period, while another 10% made only one . Even among those who did trade regularly, turnover rates were one-third that of professional money managers.

One interpretation is that the portfolio inertia identified here suggests that participants may require additional help managing their portfolios,” the paper states. Utkus noted the emergence of tools in recent months to help investors better manage their 401(k) holdings:

  • lifecycle funds, which are structured to reallocate assets as the participant comes closer to retirement,
  • automatic rebalancing services, which reallocate assets to maintain a balance determined by the participant, and
  • managed accounts, which reallocate for a fee.

But there are some good aspects of the portfolio management inertia. Participants showed no inclination to engage in risky trades based on market timing or other short-term strategies. “To me, it was comforting to show that most people don’t day-trade in their pension plans,” said Mitchell, adding that studies indicate investors trading through brokerage accounts tend to buy high, sell low, and spend a great deal on commissions. “Our finding of low turnover in pension accounts builds confidence in the ability of 401(k) participants to invest for the long run.”

Inertia Problems

While It is possible to get away with a minimum amount of “steering” a typical 401(k) plan, the researchers pointed out that it could also be problematic. Such a “no involvement” attitude can leave portfolios out of balance if market conditions shift. Inertia investing might also leave the plan out of sync with projected retirement age targets.

One factor that plays an important role in 401(k) trading patterns is company stock, the report noted. The probability that a participant will trade is more than 10% higher if company stock is offered. While 15% of plans offer employer stock, those tend to be the larger firms with a bigger employee base. As a result, 52% of the participants in the database studied have access to employer stock and about one-third, or 32%, hold an employer’s stock in their 401(k) plan.

Prior research by Mitchell and Utkus has indicated that employees tend to be more likely to buy and sell their own company’s stock because they feel they have “inside information” about the firm’s prospects. Even after learning how employees at Enron Corp. were financially wiped out after the company collapsed, many investors still hold too much company stock, says Utkus.

Not Big on Borrowing

The average plan reviewed in the study had 776 active participant accounts with assets of $38.4 million. While it offered over 17 investment choices, plan participants used only 3.5 of the available options. Almost all participants have access to equity index funds (99%) and international funds (98%), but only half of the workers (53%) actually invested in equity funds and only one-fifth (20%) chose international options.

The research also indicates that offering more funds does not increase the level of active trading, where including a brokerage option does. “Offering a brokerage option within the 401(k) plan has a large impact on trading activity and turnover rates, though the impact in practical terms is still small since only 3% of participants are currently offered such an option,” the report stated.

One additional finding that suggests either inertia or caution is that, while 85% of participants have access to a 401(k) loan feature, only 11% have a loan outstanding.

The study sample examined the accounts of 1.2 million participants in 1,500 pension plans. The average plan participant had an account balance of $86,000, was 44 years old, has been on the job for eight years, and has an average household income of just over $88,000, according to the research paper.

The report is here .