There is currently $5 Trillion invested in Individual Retirement Accounts (IRAs), $4.7 Trillion invested in self-directed retirement plans provided by employers (401(k), 457, and 403(b) plans), and $2.3 Trillion invested in traditional pension plans offered by private companies. These numbers are stunning for a number of reasons. First, self-directed retirement plans (IRAs, 401(k)’s, etc.) dramatically dwarf the amounts invested in traditional pensions. This is part of a long-term trend, as employers move away from traditional pensions, but the magnitude of the shift is striking. With the assets in IRA’s surpassing the $5 Trillion mark earlier this year, the amount of money in individual accounts is moving ahead of employer-sponsored plans. What’s more, it is anticipated that IRA’s will continue to grow relative to employer-sponsored plans as people retire and roll their savings from their ex-employer’s plan into an IRA. This matters because investors in IRA’s have even less help in creating and maintaining their portfolios than investors in employer-sponsored plans.
One encouraging trend here is that the investor population as a whole will pay less in intermediation costs when they invest in IRAs simply because the overhead associated with an IRA is lower than for 401(k)’s and related plans. This is simply a fact of life. Employer-sponsored pensions have additional overhead associated with meeting regulations on record keeping and related administrative costs.
Where do investors who own a piece of the $5 Trillion invested in IRA’s get help in figuring out whether their portfolios are well-designed and have an appropriate risk level for their needs? This is an enormously important question.
There is evidence that investors, left entirely to their own devices, often end up with poorly-performing portfolios due to either being substantially under-diversified or because they create portfolios with risk levels that are radically inappropriate to their needs. An important research study that identified these two common issues as key issues in a study of over 400,000 investor accounts also found that investors who get some form of assistance—either by using Target Date funds, online advice, or managed accounts—out-performed investors who go it alone by 2.9% per year. While it should be noted that this study was sponsored by FinancialEngines, a firm that provides online advice (and thus has a vested interest in reaching the conclusion that investors who get help out-perform those who do not), their results are consistent with other analyses that find that the average self-directed individual investor often makes incredibly poor choices and suffers the consequences. In the 20-year period through 2011, individual investors in mutual funds under-performed what they could have achieved with a simple allocation to a stock index fund or bond index fund by more than 4% per year. Much of this under-performance comes from investors trying to choose which sectors are going to do well and moving their money around, as opposed to staying invested in a broadly diversified portfolio. Target Date funds or other consistent investments in a diversified portfolio remedy this particular problem.
The good news with regard to improving investors’ portfolio choices in their self-directed accounts is that there are a variety of ways that this can be achieved at little or no cost. Online brokerage firms including Folio Investing, E*Trade, and others provide web-based tools to assist in selecting a portfolio or a Target Date, lifestyle, or asset allocation fund. Note: in the spirit of disclosure, the author is a consultant to Folio Investing. There is also a group of relatively young companies that provide online advice for a fee. Some examples are Wealthfront.com, Personalcapital.com, Jemstep.com, FutureAdvisor.com and Betterment.com. The longest-lived firm in this space is the aforementioned FinancialEngines.com. These firms range in services and costs dramatically. Some charge fees comparable to a human advisor, while others focus on providing low-cost advice and portfolio tracking.
How much of the $5 Trillion that is in IRAs is invested based on any type of advice, whether it is computer-based, human-based, or directed through the investments in a vehicle such as a Target Date fund? ICI, an investment industry trade group, estimates that less than 20% of IRA assets belonging to investors in their 30’s are in Target Date funds or other asset allocation funds. Less than 12% of IRA assets belonging to investors in their 60’s are in such funds. It is not known how many investors with IRAs also have investment advisors to help them manage their portfolios.
Having described the current state of affairs, I am now going to offer my predictions. These are, of course, largely based on my subjective assessments.
The business of online advice or assistance in portfolio selection is young. Investment advisors provide a range of services beyond portfolio design and the vast majority of individuals who are getting help in their investment choices are choosing either a Target Date fund or a human advisor. I do not foresee a dramatic reduction in the role of human financial advisors. I do, however, see a substantial opportunity for low-cost online decision support and advice for investors who have insufficient assets to attract the interest of an investment advisor. Many advisors simply do not want to handle investors with portfolios below a certain size or feel that they need to charge a higher rate (in terms of the percentage of assets under management) to make managing a smaller portfolio worthwhile. The problem is that managing a $100,000 portfolio is quite likely to be just as time consuming as managing a $1,000,000 portfolio, so the advisor needs to charge more per dollar managed for the smaller portfolio.
There is considerable evidence that investors who get no assistance in choosing their investments have generated lower returns relative to benchmarks than they could have. The future of investing ‘help’ for investors—especially for the growing number of people with entirely self-directed individual accounts—will be determined by a number of factors. First, there is the question of whether investors can get comfortable with a steady investment in a diversified asset allocation, such as provided by Target Date funds or other sources. Sometimes a solution can ‘feel’ too simple and, even though some simple portfolios have a long record of outstanding performance, investors may feel more comfortable with the idea that a human or team of humans is regularly re-evaluating the best asset allocations. Second, we have the question of whether investors will feel as though generic asset allocations or online questionnaires can provide them with a suitably tailored portfolio. Third, there is the question of whether people can get comfortable with replacing a living, breathing human advisor with a website in making potentially life-altering financial decisions.
Looking forward, I believe that we will see technology solutions that enable individual investors to make better investment decisions. The research by DALBAR, in particular, suggests that the needed improvements in investor decisions are both fairly straightforward and enormously financially significant. Whether the dominant models of investment help for investors with small portfolios (below $100,000-$200,000) will be entirely automated or have some form of human element remains to be seen. Investors with portfolios in the range of $250,000-$500,000 are more likely to attract the interest of traditional investment advisors, but it is also possible that largely-automated investment help will be attractive due to its very low cost. Investors with assets in the range of $500,000-$1,000,000 are a challenging portion of the wealth spectrum because they are more likely to expect a higher level of service and to feel that an automated solution is not sufficiently customized. For investors with portfolios larger than $1,000,000, I predict that traditional advisors will hold sway for the foreseeable future. My sense is that wealthier people are more likely to put a premium on the ‘concierge’ element that human advisors can provide. Furthermore, there are many advisors who are actively seeking out and pitching these clients with a range of services. The old saying that financial products and services are ‘sold not bought’ applies here.
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