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Letter from the US: Bad deal from IRAs

Americans are saving more in Individual Retirement Accounts (IRAs), but this vehicle has the highest fees and the lowest returns, according to a new study by the Center for Retirement Research (CRR) at Boston College. This means trouble for retirees. 

“Forgoing returns over long time periods means that assets at retirement will be sharply reduced. Saving is too hard to have fees eat up such a large portion of investment earnings,” note the authors of the study, CRR director Alicia Munnell and her colleagues and researchers Jean-Pierre Aubry and Caroline Crawford.

Assets in IRAs were $7.6trn (€7trn) as of June 2015, according to the Investment Company Institute (ICI), up from $7.3trn a year before; 401k(s) and other defined contribution (DC) plans had assets of $6.8trn, up from $6.5trn, while private sector defined benefit (DB) plans remained static with assets of $3trn. IRA growth is due mostly to money rolled over from employer plans. In contrast, many DB plans have been frozen. According to the ICI, the annual rate of return has been only 2.2% for IRAs from 2000 to 2012, compared with 3.1% for DC plans and 4.7% for DB.

The lower returns on IRAs “may be due to two factors – asset allocation and fees”, write the researchers. In fact, 11% of assets in traditional IRAs are invested in money market funds compared with 4% for DC plans. “Since money market accounts produce safe but low returns, this difference in allocation can be part of the explanation for the low return on IRAs,” the researchers add. “The rest of the explanation must be that owners of IRAs are being sold many high-fee products.”

The issue of fees is even more important in analysing the difference in results between DB and DC plans, according to Munnell and colleagues, because size and asset allocation do not explain why, during the period 1990-2012, DB plans outperformed DC plans by 70bps.

Asset allocations in DC and DB plans are indeed different, the researchers admit, but the outcome is not, as often expected, that riskier investments perform better in the long run. In 1990, both DC and DB plans had 40-50% of assets invested in equities. Then DB plans “appear to have rebalanced during the run-up in equities during the bull market of the 1990s and, since the turn of the century, have reduced equity holdings (down to less than 5%) to match liabilities as companies have frozen their plans”, explain the researchers. “In contrast, in DC plans, the share of assets in equities increased sharply during the 1990s and has more or less stayed at that level (over 60%) since then”. 

De-risking by DB plans has saved their members from some nasty surprises. In the long run (1926-2014) the average annual return on equities has been 10.1% versus 6.1% achieved by long-term corporate bonds. But corporate bonds performed better in the periods 1990-2012 (8.7% versus 8.6% for equities) and 2003-2012 (7.8% against 7.1% achieved by equities). Over the period 1990-2012, “asset allocation would be expected to have only a modest effect on returns”, conclude the researchers.

If neither size nor asset allocation is behind the differences in returns for DC versus DB plans the explanation must involve investment fees, the researchers claim. The key difference is that 401(k) plans invest in mutual funds, whose fees vary significantly.

“When weighted by assets, fees for equity funds, bond funds, and hybrid funds, while declining over time, accounted for about 0.8% of assets under management between 2000 and 2014, and were probably substantially higher before that time,” the CRR study authors say. 

The conclusion of the CRR study authors is that “individuals are not very good at investing their own money and face high fees”, which was their initial supposition. For workers it’s a warning to pay much more attention to the costs of the mutual funds they choose.

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