CHAPEL HILL, N.C. (MarketWatch) – Think twice, even thrice, before rolling your 401(k) into an IRA when you retire.
I know, I know—this is directly contrary to conventional financial planning wisdom. And I don’t deny that there are compelling reasons for doing such rollovers—including, for example, the much larger array of investment options available to you in an IRA.
But this conventional advice also contains an Achilles’ heel, which rarely gets any attention. And it can end up leading to a significant reduction in retirees’ standard of living.
This flaw traces to what retirees typically do to their portfolios when rolling them over from a 401(k) into an IRA. Rather than maintain their previous equity allocation, they more often than not dramatically cut it. That can have huge consequences for their retirement portfolios’ long-term expected returns.
We have insight into what retirees do when rolling over their 401(k)s because of a recent study from the Employee Benefit Research Institute (EBRI) and JPMorgan Chase. The authors analyzed the EBRI’s database of more than 23 million 401(k) and IRA accounts as well as JPMorgan Chase’s database for about 62 million households. They found that “75% of retirees reduce their equity exposure after they roll over their assets from a 401(k) to an IRA.”
The authors say that they were surprised by how large this majority was.
The reduction was not insignificant, furthermore—the median was 17 percentage points, in fact. To appreciate how costly that could be, assume that a retiree increases his bond holdings by the amount he reduces his equity exposure. Assuming the IRA is worth $1 million when the rollover occurs, and that equities outperform bonds by their long-term historical average, this lower exposure level would cost him more than $100,000 over the course of his retirement.
Why rollovers lead to lower equity exposures
It initially seems surprising that retirees would reduce their equity exposure when rolling over their 401(k) into an IRA. After all, a retiree is perfectly able to maintain the same portfolio within the IRA as he had in the 401(k); nothing requires him to reduce his equity exposure. The reason that it nevertheless often happens traces to the decisions a retiree is forced to make when doing the rollover, in contrast to those he would have to make (or, actually, not make) if he decided to keep his assets in his 401(k).
Consider first the retiree who chooses to keep his 401(k). Assuming the retiree has been following a typical glide path, his equity exposure has been declining by about one percentage point a year leading up to his retirement. If he stays on that glide path, his equity exposure will continue to decline by about the same rate in retirement. The retiree is unlikely to make any big changes at retirement.
That’s because inertia is a powerful force in human nature. Making a change would require the retiree to explicitly determine whether stocks are overvalued or undervalued, both in their own right and relative to bonds. Since that is impossible to do with any certainty, many if not most retirees will default to staying the course.
The situation facing the retiree who rolls his 401(k) over to an IRA is far different. With the rollover he immediately will be presented with an indefinitely large array of investment options, compared to the handful of mutual funds that are available in the typical 401(k).
Furthermore, in some cases the retiree will be forced to rebuild his portfolio from scratch after the rollover. That will be the case when the 401(k) administrator transfers the assets to the rollover IRA in the form of cash rather than doing an in-kind transfer of current holdings. In that case it is doubly unlikely the retiree will end up with as high an equity exposure as before.
The difference between sticking with your 401(k) and rolling over into an IRA is analogous to that between incremental and zero-based budgeting. With the former approach, this year’s budget is likely to look a lot like last year’s—differing just incrementally, in other words. With the latter approach, in which this year’s budget is built from the ground up without reference to last year’s, the two years’ budgets stand a good chance of being significantly different.
Behavioral economists have often noted how the framing of a decision has a big impact on the outcome, referring to this branch of decision theory as “choice architecture.” Dan Ariely, a professor of psychology and behavioral economics at Duke University and a leading scholar of choice architecture, goes so far as to argue that our decisions are often made for us, since how choices are framed can have a bigger impact on our answers than the thought process we go through in coming up with those answers.
I’ve written before about the impact of choice architecture for retirees. Last year, for example, I pointed out that a mere rewording of a question about when to claim Social Security can lead to significant differences in when retirees do so. Though the issues surrounding rolling over a 401(k) into an IRA might not initially seem similar, they very much are.
This discussion doesn’t automatically mean you should not roll over your 401(k). But if you do, pay close attention to how it can unwittingly lead you into reducing your equity exposure. If your 401(k) administrator allows it, get them to transfer your current holdings directly into your rollover IRA rather than converting your portfolio to cash and transferring the proceeds.
In any case, a good rule of thumb in your rollover IRA might be to replicate your previous 401(k) portfolio, and then to wait a decent interval before making any changes. That way the choice architecture you face in your IRA will be the same as it had been in your 401(k).
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at firstname.lastname@example.org