EXPERT TAKE

It’s Not the Returns, How Much You Save Matters Most for Your Sunset Years 

 

  Whether it’s a retirement planning system or your personal nest egg, saving a lot and saving early is crucial. Recently, I came across a study that tried to figure out what factors were the most influential in ensuring that a long-term, retirementoriented savings plan had the best outcome for the participants. The study itself and its conclusion were interesting and have some bearing on retirement savings in India, and even on how individuals plan their long-term savings. The study was conducted by Putnam Research Institute, the research wing of an American mutual fund. 

 

  The study looked at a typical American retirement plan — the so-called 401(k) — and simulated the effect of various factors that would normally affect the eventual size of the retirement kitty the participants ended up with. The study, with a hypothetical base case in 1982, consisted of a set of mutual funds that were in the fourth quartile (bottom 25%) over the previous three years.

In other words, the base case was a fairly poor choice, the kind that an investor acting carelessly might actually make. In the base case, that’s all the investor did. He chose these funds and kept investing in them over the next 30 years. The study simulated a realistic increase in income over these years and an investment of 3% of that income into the plan.

Then, the study picked various scenarios that tested four changing factors that can make a difference to the returns and final outcome. Three of these are what you would expect — fund selection, asset allocation, and asset rebalancing. The fourth is what they call deferral rates, which is a way of saying how much income the participants were putting into their 401(k) plans.

As part of the fund selection driver, the study mostly simulated different methods of choosing the best funds based on past performance. Also, just for comparison, it tried out what it calls the ‘crystal ball’ method of fund selection whereby it assumed that those choosing the funds could see into the future.

The outcome was interesting. By far the biggest impact was that of the deferral rate — the amount that was saved. The best impact from other methods was a 15% increase in the size of the retirement nest egg over that of the base case. It should be clear that this modest increase is easily exceeded by the 33% increase that would result if the deduction from income were to be increased from 3% to 4%.

At one level, this is obvious — larger inputs will lead to larger outputs. With this sort of an investment pattern, it will result in a larger output in exactly the same proportion as the inputs. The surprise is that the other methods of enhancing returns yielded so little over a long period. However, that’s not the point.

This seemingly obvious nature of the conclusion hides a more interesting lesson, which is this: whether it’s the design of a retirement pension system like the NPS, or whether it’s your own personal retirement kitty, the best impact on the final outcome comes from expending effort on participation. The higher the participation and the earlier it starts, the more the eventual benefit will be. This is interesting in the context of the NPS. The NPS is widely praised as a very well-designed system with an excellent strategy for arriving upon the right investment strategy as well as involves very low cost. However, the system has very low participation levels, certainly much lower than desired. In effect, in terms of the final outcome, the entire budget of effort has been expended on optimising the inputs that matter less and none on the input that matters most. If something else has to be compromised a bit to get more people into the NPS, then that would have been better.

Similar is the case with personal savings for many of us. Perhaps we obsess a little too much about which funds to choose and how to fine-tune our portfolio in which we invest our savings. It would be better to put that same effort into seeing how the quantum of those savings can be enhanced.

Source - Dhirendra Kumar - The Economic Times - 18/12/2012