In a large study of individual retirement accounts, the Employee Benefit Research Institute (EBRI) found that IRA investment decisions have been very similar to those seen in employer-provided 401(k) plans. In both cases, there is substantial evidence that people understand the need to diversify their holdings and are reducing the riskiness of their investments as they get older. Both behaviors are highly recommended by investment professionals.
IRAs account for 25 percent of total U.S. retirement assets. These are arguably the investment assets most directly controlled by investors who often have little formal financial expertise or investment experience. Historically, there has been concern that retirement investors do not make wise choices with either IRAs or 401(k)s.
Recent changes in 401(k) rules, triggered by the Pension Protection Act of 2006, have employed lessons from behavioral economics to force employees to increase their participation in the plans and also place their funds in default investment accounts that hold diversified mutual funds. These funds, most commonly called target-date funds, are designed to reflect the risk and diversification needs of participants depending on their ages. Older participants have funds with lower percentages of stocks than younger participants. Over time, the funds automatically shift their risk profiles to match the advancing ages of their owners.
No such formal requirement or discipline governs IRA accounts. Yet the EBRI study found strong evidence that individual investors were adjusting their holdings over time, and also diversifying their investments. "A decreasing percentage of equities and an increasing percentage of bond and other assets were found as age increased," it reported.
"The asset allocation found in IRAs is very similar to that in 401(k) plans," the EBRI study added. "When comparing the overall percentage held in equities in 401(k) plans ... the numbers match closely with those found in the IRA accounts (37.4 percent in 401(k) plans and 38.5 percent in IRAs). The bond and balanced funds percentages are also similar (12.3 percent and 13.6 percent for bonds and 12.3 percent and 12.1 percent in balanced funds, respectively).
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Money market funds and CDs are significantly higher in IRAs, the report added, "but if money is combined with GICs [guaranteed investment contracts] and stable value funds in 401(k) plans, 22.3 percent of the assets are represented, compared with the same percentage for money in IRAs. However, it does appear that individuals in IRAs are more likely to have more than 90 percent or more of their assets in equities than are 401(k) participants."
Such "extreme" investment patterns also showed up within IRA accounts. EBRI tracks more than 14 million IRAs. At the end of 2008, when these investment patterns were identified, about a third of all IRAs were in traditional accounts, a third in rollovers from other retirement plans, about 10 percent in plans for self-employed people and employees of small companies, and 23 percent in Roth IRAs.
Unlike the other types of IRAs, Roths are funded with post-tax dollars but their owners pay no taxes when they withdraw funds. Traditional IRAs are funded with pre-tax dollars that are allowed to grow tax-free. However, when funds are withdrawn, they are taxed as ordinary income.
Roth holders are the group most likely to have 90 percent or more of their account assets in stocks, according to EBRI. It noted that Roth owners tended to be younger and Roth accounts normally are not used for core retirement needs, but supplemental spending. Both facts help explain why there is a higher risk profile in Roth accounts.
"As the age of the IRA owner increases," EBRI said, "the less likely they are to have more than 90 percent in equities and less than 10 percent in bonds and money. This follows the standard investment guide to reduce the allocation to assets with high variability in returns (equities) as one ages. A finding that does not follow this guide is the approximate 20 percent of those under age 35 having more than 90 percent in money."
The study also found that IRA owners with more money in their accounts displayed a more conservative investment pattern than account holders with smaller balances. "IRAs with the largest balances ($250,000 or more) had more of the assets diversified across all the asset categories—with the highest percentage of assets in bonds, money, and other assets—than IRAs in any of the smaller-account balance categories."
EBRI noted that its findings were about accounts, not account holders, and that many people control multiple IRAs. Its next wave of research will look at multiple accounts and build a profile of individuals' overall IRA investment decisions. It also said it hoped to eventually look at IRA and 401(k) accounts of the same individuals and thus create a more comprehensive look at investor behavior.