Time for Naïve 401k Millennials Opting for “Safe” Investments to Stop Hurting Themselves
Enthusiastic young employees don’t trust the old ways of corporate retirement benefit plans. Enthusiastic young employees seize the opportunity to control their own destiny. Enthusiastic young employees naïvely think the “safe” investment is the better investment. Naïve young employees end up hurting their long-term retirement savings prospects.
If this sounds familiar, it’s because we’ve already been to this dance once before. Only, this time, there’s a twist. And not the good kind of twist. Why have these people failed to learn from history and what can be done to prevent them from hurting themselves?
Why Do We See this Fatal Attraction to “Safe” Investments?
For many millennials (or Gen-Y, as they are also called), their vicarious living experience of our equity markets is tarnished at best. “There are many reasons that many Millennials like holding large cash balances,” says Kendrick Wakeman, CEO of FinMason in Boston, Massachusetts, “chief amongst them is that many Millennials witnessed 2008 and the impact that had on their parents.”
The apparent “failure” (the word is in quotes because, unlike the headline indices, most active investments prospered in the first ten years of the millennium) of equity markets is but one of these reasons. Robert R. Johnson, President and CEO, The American College of Financial Services located in Bryn Mawr, Pennsylvania, says, “I think that people have been scarred by some of the horror stories in recent years and they are plentiful. They include: 1) People who lost a large portion of their retirement savings in the crisis of 2008, became overly conservative, and had to either continue working or pare back their lifestyle in retirement; b) People who lost money to Madoff and other Ponzi schemes – The show American Greed is helping people regain confidence in financial advisors, [but] people aren’t hearing on a daily basis all of the stories of people who are happy with the financial advice they are receiving; and, 3) People who had large portions of their retirement savings in own-company stock such as Enron.”
There’s a behavioral phenomenon known as “recency.” It is defined as the tendency for people to overweight more recent events, even if, in the long-run, it’s clear those recent events are anomalies. This can have a detrimental impact on long-term investors. “Investors do not like the unpredictability of equities in the short to near term,” says Paul Ruedi, CEO of Ruedi Wealth Management, Inc. in Champaign, Illinois. “If they understood that in an efficient market, premium returns are a rational result of premium volatility.”
This short-term volatility can cause people to see “safe” short-term investments as a “safe” long-term investment alternative. Jason P. Mardinly, a Financial Advisor at Cordasco Financial Network in Philadelphia, Pennsylvania, says, “The attraction to ‘safe’ investments is that many people have experienced stock market corrections/crashes in recent years and are afraid of the potential losses in the market. There is also a lack of education about the benefits of long term investing.”
Maybe it’s not “education” in the usual sense of the word. Millennials can’t claim “the lack of education never hurt me none.” It’s hurt them in more ways than one. “Among the key driver’s behind the desire for ‘safe’ investments is the education level of investor’s in the Gen Y demographic,” says Bob Alimena, a New York based Financial Advisor with Beaumont Financial Partners. “Gen Y investors have almost all gone to college and likely studied some form of finance and/or investing and know about the correlation between return and risk. They may also struggled to land their first well-paying job. As such, this experience has instilled a ‘save vs. invest’ mentality which leads them to lower returning ‘safe’ vehicles.”
Who – or What – is Most Responsible for the Desire for “Safe” Investments?
We all know events of recent history have made “safe” investment more attractive. “The dramatic stock market drops over the last 15 years are the cause for younger investors being so risk averse,” says Mardinly. “The Gen Y group has lived through the dot com bubble, 9/11, and the financial crisis of 2008, which has made them focus on principal safety as their number one objective.”
Beyond these actual events, however, lies a deeper psychological motive. “It is human nature to want an investment that is safe,” says Michael Clark of Keiron in Orlando, Florida. “You have worked hard to accumulate money and the last thing you want to do is lose it.”
Holmes Osborne, Principal of Osborne Global Investors, Inc. in Odessa, Missouri, agrees. He says, “The issue is not financial, it’s emotional. People don’t like losing money and will not invest unless their statements are in the black. The last time this generation saw a bull market, they were in diapers. You can hardly blame the Y Generation for being suspicious of the markets with two crashes in the last 15 years.”
Fanning the flames, as usual, are sensationalist journalists. “One factor is the media coverage of markets and the need to have story lines,” says Alimena. “A lot of financial shows on the major networks talk in a short term nature of things. When you talk about investing in asset classes that may have higher expected returns, they also have higher expected volatility. If you talk about these types of investments every day, it is much easier to see the volatility versus the returns. As such, there may be a layer of fear instilled in investing in long term higher returning asset classes like stocks over investing in more conservative investments like annuities. After all, it takes a while to see the effects of purchasing power risk where as you can see an equity portfolio’s balance move around daily.”
Of course, after pointing the finger at the media, the next favorite group to blame is the industry itself. Ruedi says, “Wall Street and their sales people are more than willing to pander to investors even though they know that the only sane definition of a ‘safe’ investment for a long-term goal such as retirement is one that offers the possibility of strong returns net of taxes and inflation. Investments that do that are safe, investments that do not are not. But Wall Street would rather pander and give people what they want instead of what they need.”
With the constant thumping of an accusatory media, and the straw man of Madoff, who could fault Gen Y for feeling the way it does. “Given the anxiety millennials feel towards investing, the problems they have with trusting other people’s advice, and their general opinion that financial institutions are more-or-less evil, it is not surprising that they take comfort in hording cash,” says Wakeman. “At the same time, the costs of holding cash are often not well understood by millennials because the downside is often described to them in generalities, which millennials find easy to dismiss or marginalize. What is required is a practical, hands-on lesson that uses their specific circumstances: a formal retirement plan.”
Why Millennials Should Avoid Traditionally “Safe” Investments
Let’s start by stating the inconvenient truth some millennials seem not to accept. “First of all,” says Ruedi, “traditionally ‘safe’ investments are not safe for retirement investing. Investors need to understand the ‘owners’ (shareholders) of companies have earned two to three times the return of ‘lenders’ to businesses (bond holders). Younger retirement savers that ignore this historical fact do so at their peril.”
Translation: There’s an unfortunate ignorance regarding the single most important wind young savers have behind their investment sails. “Younger retirement savers have a huge opportunity in front of them with the amount of time they have to invest,” says Clark. “When riskier investments are used the time factor is magnified because earlier gains snowball on top of one another.”
Said another way, “safe” investments don’t have a snowball’s chance to meet the long-term investment needs of millennials. Mardinly says, “Younger savers should avoid the traditional ‘safe’ investments because they have such a long time horizon until retirement and can withstand market volatility. Also, the ‘safe’ investments provide the least opportunity for long term growth. Over such a long period of time it will be challenging for investors to keep up with inflation in safe investments such as a money market.”
Specifically, the numbers just don’t look good for so-called “safe” investments. They’re just not a good way to invest for the long-term, especially given the advantage of time. “When you have decades to accumulate wealth,” says Johnson, “the best way to do so is to invest in a diversified portfolio of common stocks. The Ibbotson studies show that since 1926 a diversified portfolio of common stocks has returned in excess of 10% compounded annually. Corporate and government bonds have returned less than two-thirds that of stocks on an annual basis. That is a huge difference annually, but when compounded is incredible.”
What makes matter worse are the other lifestyle factors occurring right now in the lives of many millennials. These factors make “safe” investments an even greater issue. “One concern is the opportunity cost,” says Alimena. “If, for example, a Gen Y investor has student loan debt or a mortgage or savings account for their children’s college costs, all of those interest rates – or growth rate in the case of college costs – outpace current ‘safe’ investments’ interest rates. As such, saving in these vehicles would be better spent paying off these obligations directly. Another reason for Gen Y to avoid these ‘safe’ investments and focus on long-term investments like equities is the expected return and their long-term time horizon to weather volatility. When saving for a goal like retirement in a qualified account, in most situations, the saver will not touch this account until at least age 59½. As such, a person in Gen Y has over a thirty year time horizon for their assets to grow, or in the case of ‘safer’ investments, lose purchasing power. With current interest rate environment and inflation rates, it is likely that the yield fixed-income bonds and fixed annuities are paying today may be out of favor in the next 2, 3, 4, or 5 years and cause an investor locked into such vehicles to either lose purchasing power in the future or have to take a hit on the principal value in order to exit the investment. Both of these create a potentially risky asset out of a ‘safe’ investment given the potential time horizon on needing these funds.”
How Plan Sponsors Can Design Plans to Subtly Guide Younger Investors
As we alluded to at the beginning of this article, this isn’t the first time a cohort of retirement savers confused ‘safety’ with long-term investing. As you may recall, this same issue occurred during the 1990s and early 2000s. Indeed, as recorded in the hearing before the Senate Committee of Finance on September 9, 1998, Richard Ippolito noted in his unpublished 1993 report (“Pensions, Public Policy and the Capital Market” (Pension Benefit Guaranty Corporation, March 1998), only half of 401k plan assets were invested in equity funds. One of the intentions in passing the 2006 Pension Protection act was to address this problem by permitting the use of Qualified Default Investment Alternatives that automatically placed younger investors’ savings into equity-oriented investments.
Some say target date funds – one of the primary consequences of the 2006 PPA – represent the cure-all. But they’re not without their own problems. “While target funds have some benefits, and some surveys show that investors in them behave better than most investors,” says Ruedi, “target date funds are not the best way to invest for retirement. Goals based investing works much better and will drive the most appropriate asset allocation.”
To be sure, even if the target date appears right for all other reasons, it’s important to look under the hood to see if it’s really capable of performing as ordered. Johnson says, “I believe that in many cases, target date funds have overly conservative asset allocations. While I do believe that they help many uninitiated investors by getting them closer to a reasonable asset allocation, many have overly conservative allocations throughout the life of the investor. I believe that in the early years and well into someone’s mid-50s, an asset allocation of up to 100% stocks might be appropriate. The major fallacy in target date funds is that they treat everyone the same. And, we all know that two individuals the same age can have dramatically different abilities and willingness to accept risk.”
The 2006 PPA does have positive repercussions. “One of the results of the Pension Protection act is the shift from DB plans to DC plans offered by employers,” says Alimena. “This shows that the ability to fund and grow assets for retirement does require a level of risk in order to hit a desired growth rate. This level of risk is determined by the individual under DC plans and how they choose to allocate their accounts. As such, a Gen Y investor would be the participant with the biggest opportunity to take risk due to the majority of their working career ahead of them and the ability to save and endure volatility in order to end their working years with enough assets to fund retirement. Since some employers automatically enroll employees unless they opt out and establish a default fund, employees should know what they are investing in and the benefits. Education is the best way to allow employees to understand how saving and investing can put them in a great position for retirement.”
The importance of employee education cannot be understated. “A strong education program is key in order to subtly encourage younger investors to invest appropriately,” says Clark says.
Education programs can be designed more as “hands-on” than as a lecture. “It certainly is all about education,” says Johnson. “Providing example asset allocations as someone is in different stages of their life would be beneficial.”
While education programs can addressed many concerns, we can’t assume it is a panacea. “There are some potentially more sinister agents at work: anxiety, mistrust and an unfavorable view of financial institutions,” says Wakeman.
Some of these “sinister agents” may only be alleviated through one-on-one meetings. Mardinly says participants should “meet with an adviser to review the investment options.”
But not just any adviser. Ruedi has some specific criteria when working with and adviser. He says the adviser must have: “1) An adult memory; and 2) Understand that volatility is not risk. Risk is not earning the returns needed to retire when you want and how you want.”
What it boils down to, is what an objective adviser can best do. Wakeman says, “Developing a formal retirement plan illustrates the importance of saving and investing. Perhaps young people do not think often of retirement, but when they do they tend to dream large. There is nothing wrong with this, but when they transfer those large dreams to a formal plan, they quickly realize that providing for that retirement is not going to be easy. They will quickly see that every dollar will need to pull its weight. Suddenly, the cost of holding cash, or the value of increasing risk, come distinctly into focus.”
Annuities and Millennials: A Dangerous Mixture?
There is a time and a place for annuities. “Having a portion of retirement savings in annuities is appropriate for most individuals in order to cover their essential living costs in retirement,” says Johnson, who adds, “Annuities may not be appropriate for those high net worth individuals who have very large retirement savings and can essentially self-insure.”
But many disagree. Ruedi “can’t think of any right reasons for millennials to invest in annuities. If history is any guide, the returns after taxes and inflation will cause them to work many years longer than investors in stock mutual funds.” He goes on to say, tongue firmly planted in cheek, that millennials should consider purchasing annuities only if “they wish to work years longer than otherwise required (had they invested in equities) and if they wish to always worry about their independence and dignity in three decades of retirement.”
Seriously, though, annuities do present some significant logistical drawbacks. Mardinly says, “Annuities typically lack liquidity and tend to have higher fees than a traditional indexed mutual fund. Over time the higher fees will eat away at the long term returns.”
It really comes down to the investment needs of the millennial. “A fixed annuity today may not pay enough return over the investment life of the millennial for them to accumulate assets to sustain their lifestyle in retirement,” says Alimena. “A variable annuity, while it may take advantage of growth in various asset classes, often has additional costs, which over the life of the investor, will significantly impact their total return and their ability to accumulate assets that a non-annuity investment with similar growth would provide.”
Still, everyone circumstances are unique, and Alimena can imagine a scenario where an annuity might make sense for someone in Generation Y. “If a millennial is the beneficiary of a windfall in which they accumulated enough assets to be projected to live on with modest or dampened returns, an annuity may make sense if experiencing any kind of volatility is a concern of the investor,” he says. “The other side of this argument is that if a millennial accumulated this amount of assets early in their career, they have more flexibility to take on the volatility and higher expected returns associated with a diversified long-term investment strategy which incorporates equities.”
Many millennials graciously accept and take advantage of the time they have until retirement by investing in traditional long-term assets like equities. The notion that some millennials are attracted to “safe” investments presents a major concerns to experienced financial professionals. It’s as if, collectively, they realize “those who don’t learn history are condemned to repeat it.”
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