The
effect of the pattern of investment contributions and returns on lump sum values: or
The Importance of Being Average
While employer models of 401(k) proposals generally assume a flat, fixed rate of
return (and steady contributions,) actual contributions and returns in the stock market vary wildly. The variation has
a significant impact on how much money is in a an individual 401(k) account at the time of distribution.
Dow Jones Industrial One Year Returns (Year start - Year end
change),
1980 - 2005*
Average Return was 11.17%
*http://www.djindexes.com/mdsidx/downloads/xlspages/DJIA_Hist_Perf.xls
If you put in $10,000 on the first day, and never put another penny in, with these
returns, averaging 11.17% annually, you'd end up with $127,684.
If, instead, you put in the same $10,000 on the first day and left it for the same 25 years, and the return was exactly
11.17% every year, you would have
had $156,920.
($29,236 more than with actual, variable returns)
The "average" return doesn't tell very much about
the actual return over time . . .
I designed
a program to generate annual returns that remained positive and negative in the same years as the Dow, and chose an investment
pattern that had an average return of 11.20%*
*My program made it hard to hit exactly 11.17%, but it makes little practical difference for purposes of this illustration.
With this pattern, you'd have ended up with only $97,306.
($30,378 less than the actual returns under the Dow, even though the average return is higher.)
Then . . .
(To illustrate
the fact that there are a lot of ways to get to "average" that look nothing like the Dow's actual historical
returns)
I designed another program to
generate hypothetical "returns" that didn't track the Dow up and down, but got pretty close to an 11.17% average:
Two different patterns of return, one averaging 11.14%, the
other, 11.19%:
Starting with $10,000, here's
what is in the account on the last day, with each of these returns profiles:
- The Dow (11.17% average): $127,684
- 11.20% average return: $97,306
- 11.14%
average return: $113,222
- 11.19% average return:
$118,948
So. Even if you
can guess what the stock market's "average" return will be for the next 25 years, can you guess what pattern
of returns it will make, year by year, to get to that average?
then this is another risk factor that should be considered in bargaining for account-based retirement plans to take
the place of Defined Benefit
Add
some further complications: Instead of putting in $10,000 and leaving it, Edward Participant put in $1000 every year on the
first day of the year, and got his annual return on the last day . . .
Based on the returns on the Dow, he ended with $119,293
If the returns had been at the 11.20% average and pattern suggested above, he would end with only $76,845:
With the 11.19% return pattern above, he'd have had $139,611
Dow and 11.20% returns, superimposed:
Note the importance of the pattern: Even with
an 11.20% average Ed has $32,526 less money in 2005 then under the Dow assumptions.
Also note how much more was in Edward's account in 1999
than in 2004:
Of Course
- We rarely know to get our money out before the market will crash; and
- Most people have only limited flexibility on when they will retire.
Edward could have been lucky, and his investments might have
done particularly well in the years before his retirement. (Say he retired in 1999 . . .)
But
Some people retired in 2004.
Do working people really want to play The Retirement Lottery Game?
Now, we'll add one last set of complications: Actual
patterns
of 401(k) contributions.
In
2006, the Government Accounting Office released a survey of Utilization by American Workers of Tax-Advantaged Retirement Savings
Accounts.
This is a rough approximation
of the findings on typical employee deferrals (in 1997 dollars) for workers earning roughly $60,000/year in (1997 dollars):
Apply the Dow's pattern of returns to this pattern of deferrals,
and Ed would have ended up with
$202,947
Apply the 11.20% pattern, and Ed would have had only
$138,546
Applying these investments to the returns that led to an 11.14% average, Ed would have had
$223,872*
(More money, even though the average return is lower)
With the 11.19% pattern, and these investments, he would have had
$266,142
The combination of when you put money in and the pattern in
which returns are earned, along with when you retire and take money out of the 401(k) account makes a huge difference in ending
lump sum values, and interact in extremely unpredictable ways.
Movement from Defined Benefit plans to account-based retirement imposes enormous new risks on American workers.
Some people will benefit; others will suffer.
Our job is to negotiate solutions that minimize the
risks and protects the nest egg.
Ellen M. Kelman.
