Who Says We Can't Handle Private Accounts?
We ordinary folks generally do a better job of managing retirement assets than we get credit for
By Walter Updegrave

(MONEY Magazine) – As the debate over Social Security and private accounts heats up, one big concern is clear: Some people believe that individuals like you and me just aren't up to the task of investing a portion of our Social Security payroll taxes for retirement. After all, the thinking goes, investing is risky and we're not professionals. There's too big a chance we'll make mistakes. The overall message: "Don't try this complicated investing stuff at home, boys and girls. The markets are too dangerous. You might hurt yourself."

There are lots of legitimate reasons to question whether the Social Security system should be revamped to include private investment accounts. (For an analysis of the pros and cons of restructuring the Social Security system along these lines, see "What Every Family Needs to Know About Social Security" on page 150.) But the notion that we're incapable of making our own investing decisions--or, worse yet, that we need to be protected from our own investing incompetence--isn't one of them.

In fact, I'd argue the exact opposite. The more involved we are in deciding how our retirement money is invested, the more involved we'll be in planning our retirement. And the more involved we are, the greater our chances of achieving long-term financial security.

The view that we can't handle the challenge of investing is based largely on the assumption that we already do such a poor job with our 401(k)s. One of our biggest putative shortcomings is that we don't have a clue about how to diversify our retirement assets. Statistics seem to support that conclusion. Naysayers note, for example, that 38.3% of participants in their twenties own no equity funds at all in their 401(k)s, while just over 16.4% of participants in their sixties keep more than 80% of their money in stock funds. In other words, a substantial percentage of younger workers aren't taking enough risk, while a sizable number of oldsters are taking too much.

The truth behind the numbers But these stats don't tell the whole story. In fact, almost half of those younger investors without equity funds do own stock within their 401(k)s, either through company shares or balanced funds (a category that includes sound choices like asset-allocation and target retirement funds). That leaves less than 20% of twentysomethings with no equities. And while older investors stashing 80% or more of their 401(k)s in stock funds may seem extreme, that choice could be appropriate if, for example, they have most of their savings outside their 401(k)s in conservative CDs and bonds.

Furthermore, if you look at the breakdown of stock holdings by the age of 401(k) participants (shown below), the overall percentages devoted to equities are in keeping with conventional investing wisdom. Younger investors who are better able to tolerate ups and downs in their account balances in return for long-term growth potential do indeed put more of their money into stocks; older investors, who should seek greater stability, do focus less on equities.

The performance factor The other big knock against us 401(k) investors is that our results simply aren't as good as the pros'. In a recent survey of companies that have both a 401(k) plan and a traditional pension plan overseen by a professional investment manager, consulting firm Watson Wyatt Worldwide found that from 1990 through 2002 the median annual return for the pension plans averaged 7.42% vs. 6.86% for the 401(k) plans. In other words, the professionally run pensions outperformed 401(k)s on average by 0.56% percentage points a year.

But this study isn't as damning as it looks. By long tradition, pension fund managers tend to limit their stock holdings to 50% to 60% of their portfolio. So you would expect them to outperform 401(k)s in periods when stocks falter and to underperform when stocks do well. And that's largely what happened. The 401(k)s took the lead from 1990 through 1999, outperforming the pensions with an average gain of 11.3% vs. 10.9%. But the pensions surged ahead during the bear market. In the end, the study seems more a sign of how portfolios with varying percentages of stock perform under different market conditions than it is a gauge of raw investing skill.

Room for improvement This is not to say that 401(k) investors are paragons of investing prudence. We're not. We don't rebalance our portfolios as often as we should, and even after the Enron debacle, many of us still overdo investments in company stock. For example, almost 23% of 401(k) participants whose plans offer company stock as an option have half or more of their money in their employer's shares. (Since less than half of people are in plans that offer company stock, however, these investors represent only about 11% of all 401(k) participants.) But these mistakes aren't evidence that 401(k) owners overall are failures as investors. Rather, they show that many of us, particularly younger workers, need more information about how to invest properly and more experience doing it. Because ultimately, the way people become better investors is by actually investing--and yes, even making mistakes.

There will always be people who don't want to make their own investment decisions. Fine. Let them stick with something akin to the present Social Security system. And doubtless there are others who like the idea of having a say in how their money is invested but just don't want to put lots of time and effort into choosing and monitoring investments. A system of personal accounts could easily accommodate these people by providing good default choices like asset-allocation and life-cycle funds.

But to deny us the opportunity to invest our resources because we might make the wrong choices? That, somehow, seems like the biggest mistake of all.

Acting Their Age

While equity holdings can vary considerably from person to person, the overall percentage of 401(k) assets invested in stocks by age group shows that many of us do indeed know what we're doing: Younger workers generally have more of their money invested in stocks than older people.

NOTE: [1]Includes equity funds, company stock and estimate of equity holdings in balanced funds. SOURCE: MONEY calculations based on 2003 EBRI/ICI data.