Are 401(k) Plans Discriminatory? Hamilton on Yield Disparity
Posted on May 25, 2006 by Her and tagged 401k, retirement
If everyone is offered the same 401(k) plan and is free to make all the decisions themselves, then everyone has an equal shot at success, right? Not according to Brooks Hamilton, a Benefits Consultant with fifty years of experience and tons of historic 401(k) participant data at his fingertips. He sees a pattern in the data: people with higher incomes tend to make better financial decisions regarding their 401(k) plans, and earn a higher ate of return. People with lower incomes tend to make poorer decisions regarding their 401(k) plans and earn much lower rates of return. The group with the lowest 20% of income earned about 4% per year in gains. The group with the highest 20% of income earned about 25% returns per year. This means that the rich are getting richer while the poor are barely keeping up with inflation. Hamilton calls his theory "Yield Disparity".
I think there are two reasons for this: education and access to professional financial management. The poorer employees are probably less financially savvy and less able to afford quality financial advice (read The Number by Lee Eisenberg for more on this topic). Wealthier clients may have more experience with financial planning and have better access to a qualified financial planner.
Hamilton dreams of the day when employees are required to contribute an adequate amount to their 401(k) and have the money professionally managed, courtesy of their employer. But he acknowledges that probably isn't going to happen anytime soon. In the meantime, if you aren't getting the returns you want on your 401(k) investments, see if your company's plan includes access to a certified financial planner.
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I'm going to have to agree with MB. The less educated a person is about risk, the more likely they will stick to lower-yielding investments that preserve principal.
I think higher income wage earners seek out financial education more often and are more comfortable with risk. I've got about 80% equity exposure in my portfolio versus someone entirely in bonds and money market funds. I'm very comfortable with risk, even when I was earning a low-wage because I was educated about the risk I was taking (see my blog post about Jeremy Siegel's book, 'Stocks for the Long Run').
This is fascinating, great post and links.
MiserlyBastard, your point about risk tolerance is a good one to add to Her's reasons (education and access to advisers). But regardless, it doesn't have to be intentionally discriminatory to be a problem. You can still ask whether we want a retirement system based on voluntary self-managed 401(k)s if it works best for people who are doing best already, while lower income folks end up with retirement savings that will be gone in a handful of years.
Major | May 30, 2006
I think another factor is the "loss avoidance" mentality. If you lose 10,000 in your 401(k) it hurts. When you are putting that much in per year it hurts a lot less than when you are only putting in 2,000 a year. So people will tend to migrate towards investments where their losses can easily be covered by their contributions. Furthermore, the folks in the higher quartiles of income will likely have investments outside of their 401(k) that are more likely to be more stable with hints towards capital preservation, and then utilize the tax deferred benefits of aggressive investing within their retirement plans.
I don't think companies will be able to have a rote policy on how they invest for their employees. Unfortunately in today's litigous society that just leaves them entirely too vulnerable. However, what they do need to do is provide a little bit of training and financial advising (hopefully third party - outside advisor). I find companies more at fault of this than anything, especially in the day and age where pensions are on the decline. A little education and information goes a long way. One other study found that by having too many options it confuses employees and they move towards the most cautious investment option.
MiserlyBastard | May 25, 2006
I'm assuming you recently saw the Frontline episode on retirement. This so-called yield disparity has nothing to do with discriminatory practices. It comes from the fact that higher wage earners are more risk-seeking than lower wage earners, and consequently have more equity exposure. The lowest wage earners tend to take ultra conservative, money market or short duration bond investments, because they are the most risk-averse to losing hard-saved money.
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