The Investor Behavior Gap: Are your DIY behaviors hurting your returns, and is it worth paying an advisor to overcome them?

Behavior Gap: difference between expected and actual investor outcome

I recently got an email from a fellow physician finance enthusiast/professional, Dr. Kenneth Kim.  Kenny is a physician, an enrolled agent (EA), a professional tax strategist, and a blogger who does a great job teaching other doctors about taxes.   I encourage you to check out his blog here. Anyway, he sent me a couple of interesting articles comparing the investment returns of the two major types of retirement benefit accounts:  defined benefit plans and defined contribution plans.  The results were quite interesting and may indicate that a DIY investing strategy may not always work out in your favor.  The likely reason? Investor behavior. 

First, let me explain the difference between these retirement plans for those who may not be familiar with the terminology.  A defined benefit (DB) plan is more commonly recognized as a pension plan.  As the name would imply, this type of retirement plan provides a predetermined benefit to an employee at the time of their retirement, typically a monthly stipend for the remainder of their life (although a lump sum cash balance is an alternative).

The benefit amount is based on a formula usually based on the highest salary years times the number of years they were with the company.  The projected amount that the company will need to have available for that employee is calculated by an actuary annually, and the company is required by ERISA law to pay it. 

The funding of a DB plan is entirely the responsibility of the employer. The employee does not contribute anything from their salary.  The employer also makes all the investment decisions and assumes all investment risks.  They typically hire professional money managers to invest and manage the assets within the plan to ensure that there will always be enough resources to pay current retirees and to accumulate enough for future retirees.

Defined contribution (DC) plans are what most of us are familiar with and have access to.  The most common type is a 401(k).  Employees contribute to this plan from elective salary deferrals, and employers often match part of their contribution. The contribution is voluntary on the part of the employee.   And the employee has full discretion on how to invest their assets, although the options are typically restricted by the employer to a relatively small number of index or mutual funds.  Many DC plans also allow for loans and early withdrawals under certain circumstances, none of which is allowed with a DB plan.

Bottom line:  DB plans are completely controlled by the employer and invested by professional money managers--and typically invested relatively conservatively to ensure adequate liquidity to pay out the pensions to current retirees. DC plans are controlled by the employee who determines how much to contribute and what to invest it in, with opportunities for early access if needed.

Which type of plan do you suppose has a higher return?

I would have predicted a DC plan.  Why? Because DC plans typically favor younger employees, and younger employees have more risk capacity since they may have decades before they retire.  So, they can afford to invest more aggressively in stocks with expected long-term higher returns. 

What did those papers that Dr. Kim sent me say? (references below) The DB plans do better by about 0.8% per year. AND individual retirement accounts (IRAs) do about 1% worse than DC plans. 

According to these authors, the reasons include:

1.      DC plans have higher investment fees (mutual funds with high expense ratios)

2.      IRA allocations are often too conservative with a significantly higher proportion invested in low return money market funds.

3.      Employees must voluntarily contribute to DC accounts and may not be doing enough on a consistent basis.

4.      Employees may remove funds from their retirement accounts for loans and hardship withdrawals.

Some other important, and telling, statistics quoted in the papers?

1.      26% of all employees eligible to participate in 401(k) plans choose not to do so.

2.      Only 10% of all eligible participants choose to contribute the maximum amount.

3.      Between 1984-2002, the average equity mutual fund investor earned only 2.6% per year on average, compared to a 12.2% return for the S&P 500 index.

4.      During the same year, the average fixed income (bond) mutual fund investor earned only 4.2% annually, compared to a long-term government bond return of 11.7%.

The Behavior Gap

The last couple of points in the above list are a great demonstration of how investor behaviors reduce expected returns. This is described very nicely by Carl Richards in his book, The Behavior Gap. I highly recommend reading it.  The behavior gap is the difference in returns that an individual investor should be getting if invested in a particular index or portfolio compared to their actual returns.  The actual return is invariably lower—sometimes by a lot.  Why?  Because investor behavior gets in the way.  And it is not helping.

The great advantage of a DB plan is that employers are required to have a disciplined, long-term, low-cost approach to investing to ensure that their employees, both current retirees and future retirees, will get what they were promised.  

Many DC plan and IRA investors, on the other hand, are inconsistent at best and incompetent at worst in managing their own retirement savings accounts. They make day-to-day or year-to-year decisions faced with many competing interests for that money, be it unavoidable expenses or undisciplined spending habits.  They too frequently exercise the option to take money out of the account when they feel like they need it for other things, not related to retirement.  They are expected to make investment choices but may not really understand how to vet those wisely or in the context of an overall investment strategy. This often leads to higher than necessary fees (expense ratios) for underperforming funds or an inappropriate asset allocation based on their risk tolerance.  They likely don’t even know what their risk tolerance is and how the number of years before retirement should affect that. 

Final Thoughts

Overcoming the behavior gap is why personal financial education is so important and why a trusted financial advisor can be so valuable. Both are intended to save you from your own mistakes.  When evaluating if you should hire someone to help you with your finances, don’t just look at expected index fund returns vs. the advisor fee.  You should also consider the size of your behavior gap and figure out the most efficient way to narrow it.  In my mind, the value of a fee-only advisor is not trying to help you beat the market. Rather, it is helping you stop hurting yourself by making the kinds of mistakes that are so common among DIY investors.  These mistakes can cost you hundreds of thousands of dollars down the road and can be the difference between a successful retirement outcome and one where finances are still a struggle. 

If you are interested in learning more about how we can help you make smart investment decisions in your workplace DC plan, within the framework of a comprehensive financial plan, please visit us at www.targetedwealthsolutions.com, or you can contact me directly at bryan@targetedwealthsolutions.com.  

References:

[i] McCourt, SP. Defined Benefit and Defined Contribution Plans: a history, market overview and comparative analysis. Benefits & Compensation Digest. Vol. 43, No 2, Feb 2006, pp1-7. www.ifebp.org.

[ii] Munnell AH, Aubry JP, Crawford CV. Investment Returns: Defined Benefit vs Defined Contribution Plans. Center for Retirement Research at Boston College. December 2015, Number 15-21.