Optimizing Your Retirement Plan Asset Allocation

Is your 401(k) working as hard for you as you do for it?

Building a good balance in your retirement plan through consistently maximizing your contributions is only half the story. The rationale for making the shift from pensions to retirement accounts was to use 10, 20, or even 30 years of market growth – potentially outpacing a guaranteed pension but also allowing for the freedom to change jobs and still keep your retirement benefits. 

The problem for many people is that setting up your asset allocation can be complex, confusing, and time-consuming. A recent study found that 40% of Americans don't know how their investments are allocated.¹  And if you don't know what your asset allocation looks like, it's likely not being rebalanced regularly. 

Another considerable concern is Americans who change jobs and leave behind "forgotten" 401(k). Research from Capitalize concluded that nearly 2.8 million 401(k) accounts are left behind by people who change jobs each year and that this can cost an individual up to $700,000 in foregone retirement savings compared to consolidating in a single low-fee, optimally allocated retirement account.²

The other side of the coin is that because retirement accounts are tax-advantaged and shifting an allocation does not incur tax costs, some investors move things around frequently. Whether trying to time the market for gain or simply attempting to avoid a downturn and then not getting re-invested, this in time can be very costly to performance. 

The following statistics illustrate three investment scenarios ranging from 1926 to 2000, where each investor starts with $1,000.³

Investor A plays it very safe and puts it all in Treasury Bills. End result: $16,644 

Investor B likes her some risk and puts it on equities to ride. End result: $2,562,976

Investor C timed the market but missed the best 40 months (out of 900 months). End result: $15,050. 

While that's an extreme example, it does illustrate the risks of not having a structured, comprehensive approach to asset allocation. However, creating such an approach with the tools most plans offer is complex. Very often, the only salient characteristic for an investor is the historical return. Beyond the apparent notion that past performance does not equate to future returns, it's difficult to understand how investments performed over time by just looking at a return number.   Trying to create an allocation that can perform consistently over time often falls victim to market forces and the emotional bias that all investors have to some degree. 

One way investors try to solve for a rebalancing protocol with some theoretical underpinning is to use Target Date Funds (TDFs). These are structured asset allocations that start with the investor's retirement date and then build an allocation based on how far away the investor is. The allocation automatically readjusts over time, without any input from the investor. 

At the simplest, an investor with 20 years to go would be in 80% stocks while an investor approaching retirement would be around 60% invested in equities. The path to making the changes is slow and gradual – it's referred to as a "glide path" as the incremental changes over decades create a gentle slope. The funds often offer further refinements, such as choosing a "high, medium or low" risk profile. 

While they are certainly convenient, and many plans offer them, they do have drawbacks. The funds are simple to understand – but challenging to know what is actually in them. As such, they exist in a vacuum – there's no way to automatically coordinate or combine any other investments with the target date fund. So if you have a 70/30 allocation in the fund but are holding a significant amount of money in short-term investments – well, your total risk profile could be much lower. While in that case, it might be an easy fix to up the risk of the TDF, other scenarios aren't so clear. What if you're holding real estate? Or have a significant concentrated stock position? 

Our Solution

So what is the solution? We think we've created one that works – and we've been applying it within the limits of 401(k) allocations.

As discussed above, the problems are that portfolios are often either not rebalanced enough (or at all) or fall victim to too-frequent changes driven by emotional bias. However, an automated approach must be able to include disparate investments and adhere to a given risk profile that takes everything into account. 

Our solution is a rules-based systematic investing process that focuses not on historical returns but rather on historical risk. The determinant to capturing return isn’t purely seeking outperformance – it’s avoiding the impact of downturns. Consistency of return stream, over time, is what can lead to higher return potential. 

Let’s break that down a bit. Rules-based investing is the impartial screening and rebalancing of portfolio assets or positions. This process removes emotion, bias, and subjectivity from the investment decision-making process. 

The process analyzes the volatility of individual funds or securities and correlations across the funds or securities. One of the primary tenets of asset allocation is to find – and maintain – a given set of portfolio investments that are less correlated to each other and not all moving in the same direction at the same time.  By constraining the limits at the asset class, sector, and fund/security level weights, allowing the system to encompass risk tolerances more precisely.

Our results demonstrate that even with a supposedly automated investment like a target-date fund, there is room for improvement. Bias still creeps in, and the lack of ability to quantify risk precisely can impact long-term performance consistency.

1. Malito, Alessandra. 40% Of Americans Don’t Know How Their Investments Are Allocated; Here’s Help. MarketWatch. December 4, 2016.
2. Anderson, Brian. More than a trillion dollars stuck in forgotten 401(k)s. 401specialistmag.com. 

3. Nurture Your 401k Portfolio Using Asset Allocation. 401k helpcenter.com.