You’re investing your 401(k) all wrong

Wealth is a hard habit to break.
Wealth is a hard habit to break.
Image: Reuters/Mike Segar
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Sorry, America. You’ve gotten some bad advice. The finance industry has led you astray on how to invest for retirement. I am not talking about steering you into high-fee investment funds (though that’s important). It’s something more fundamental: your investment strategy is chasing the wrong goal and hedging the wrong risk. The odds are you are investing for wealth instead of income.

Like it or not, pension accounts (401(k)s, IRAs, 403(b)s and the like) have replaced traditional pensions. These pensions, called defined-benefit plans, provided a paycheck for life—at your employers expense. It was an expensive promise to make, which is why few private employers offer them anymore. Over the years the pension funds figured out the most effective way to invest their assets in order to pay pensions’ promises (even if they didn’t always follow it). They invested in risky assets, which sometimes got them in trouble, to try and make up for what they were not contributing. And when they had enough money, they bought bonds that paid-out what they needed to pay pensioners each year. It’s a form of goal-based investing. The idea is defining and targeting a clear investment goal (or any goal in life) increases your odds of achieving what you want.

For some reason this clear-headed thinking doesn’t apply to 401(k)s. Retirement accounts are also supposed to provide a comfortable retirement income, but most of us invest our 401(k)s like it’s a mini trust fund. We invest to grow wealth, not income. Wealth and income goals are related (more wealth means more income), and the most effective strategy for each is sometimes the same. But other times it is totally different.

Take the popular target date fund, how many 401(k) accounts are invested. It starts people nearly all in stock when they are young and moves them partially into short-duration bonds as they get older, typically around half bonds when people retire. Unloading risk as you age is probably a good idea. But target date funds hedge the wrong risk: keeping your account balance from falling too much, while keeping soon-to-be retirees in the stock market. An income strategy would include buying annuities (where you hand over your wealth to an insurance company and they make regular payments until you die) or buying bonds that will payout when you need income. Both annuity prices and bond pay-outs depend on long-term interest rates. From a wealth perspective, long term bonds are very risky. If interest rates go up, their prices will drop more than short term bonds will. If you want to keep your wealth from falling, long term bonds are a risky place to be, but from an income perspective they are relatively safe because their prices move with the annuity you plan to buy. (Disclosure: I’ve worked in the finance industry on an investment strategy that hedged buying an annuity at retirement.)

You can’t entirely blame the finance industry for Americans’ wrongheaded investment strategies. Most people have been conditioned to judge investment performance by looking at the size of their account, not the income it could generate. Interest rates are very low, which makes annuities expensive and bonds unappealing. Most people don’t have much saved anyway. According to the 2013 Survey of Consumer Finances, median retirement savings among people nearing retirement (age 55 to 65) is only about $100,000, which only buys $5,000 a year of inflation-protected annuity income. $100,000 sounds much better than $5,000.

But the government is trying to change how people think. As of last year, it’s now easier for 401(k) plan providers to offer deferred annuities as an investment option. The Department of Labor also proposed that 401(k) account statements should include income projections, estimates of how much annuity income their wealth would buy. It may help, but a wealth goal is a hard habit to break.