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Help for the Irrational Investor
This study of buying habits was often mislabeled as behavioral when in fact, it was no more understood that the mouse in the maze is conditioned to its surrounding. With the hope of reward, the thinking went, the mouse/client would continue to search for an investment nirvana.
The reward would be returns (less the broker's fee of course). But what was actually bubbling beneath the surface was a genuine mistrust of the securities industry which drove over half of the potential clients away from any type of meaningful investment. It also deprived the brokerage houses of half of the clients that had full access to their services but choose instead not to tap the resource.
That resource was the 401(k) or defined contribution. With some workplaces still offering pensions and those that didn't, offering a plan that allows the employee to take advantage of directing their own financial fate, a huge client base was behaving irrationally and right before their noses.
How do you encourage these investors to take their own retirement seriously? You could ask politicians to strip the most comprehensive and possibly the greatest social safety net this country is likely to have (social health insurance would be nice but may not ever become a reality our lifetimes). Once you begin to discredit Social Security, younger workers will flock to their own savings and run to the polls to vote to have the program privatized.
But that didn¹t happen.
Enter the Pension Protection Act, the single most insidious way for the government to enter into your retirement savings and force you to save. The PPA, according to those that support it, namely Wall Street, doubts your ability to put aside a portion of your pay has now made your retirement savings easier. With a handful of facts and figures to back them up, their doubts would seem to be well founded.
The government now requires that your employer set aside pre-tax money for you and deposit it in an account that is designed to keep pace with the markets and also be based on your age. Lifestyle funds will begin proliferate as the default fund. Employees will do a simple calculation based on your age and determine which fund is appropriate for you. A twenty-five year old employee may be given a fund that rebalances periodically until his targeted retirement age 40 years hence.
This bandaid fix to the problem of employee underinvestment will create a worker whose future is once again assigned to a third party. Without the proper skills, and more importantly, knowledge, the worker will be left trusting that the decisions made are the right ones.
Companies should offer their employees the full explanation of what is important about retirement at the onset of their employment. The belief that investment behavior cannot be modified unless the solution is force-fed is not fully embracing the intelligence of the worker.
The deductions the PPA requires of companies to make for their employees if they have such a plan already in place will amount to a pre-tax, mandatory contribution of 3% the first year, 4% the next and so on. While seemingly generous, these contributions will allow the company to offset pay raises now labeled as contributions and eventually offer less matching contributions as a way to court employee loyalty.
The offer of investment advice will also come with a cost, one the employee may indirectly pay in the form of higher fees. The less-than-savvy employee will right this off as a cost-of-doing-business expense. This expense however, did not exist prior to the signing of the Act into law.
Employees shouldn't be lulled into thinking these percentages (or the advice offered) will be enough to retire on. The employee should still contribute at least 7% of your income to your retirement (the national average based on the national average annual income of $45,000), more if you can. In a 401(k), the plan offers the employee much higher contribution limits that IRAs held outside of the workplace.
While using a lifestyle fund is okay but there are other ways to diversify your potential, especially if your employer is already doing so. Understand the tax implications that come with those lifestyle offerings. How high is the turnover? In a fund designed to mimic an index or two, the amount of times the fund turnover (how often the trading of stocks within the fund are bought or sold) usually leads to higher tax bills.
While these types of funds should be kept in a tax-deferred account, there is no reason why they should have such a high turnover. Annual rebalancing should keep fees down. If you are paying more than 1.50% in fees, look around for something else.
The best defense against simply allowing your future to be directed by firms focused on their profits is to create your own offense. Self-education can help you overcome the default behavior they assume you have. Irrational investing in another phrase for herd mentality and the PPA will not change how employees think. Only workers who understand that your own best interest is best kept under your direction will benefit in the end.
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