Inertia Ruled 401(k)s Last Year

This bloody market hasn't called too many 401(k) participants to arms.

At least that's what a recent study by Hewitt Associates shows. Last year was particularly difficult for 401(k) plans because of market volatility and controversies over investing in stock from the company where the participant is employed. As a result, there were lawsuits, and Congress debated legislation that would alter the 401(k) system. Even so, not many employees made big changes to their accounts.

"On the surface, that's surprising," says Lori Lucas, a defined-contribution consultant at Hewitt, a human capital management-consulting firm. "It would seem that the participants would pay more attention."

According to the study, only 19.5% of active 401(k) participants did any trading to move their investments into different funds or rebalance their portfolios. This is down significantly from 2000, when 30% of participants made at least one trade.

Although 401(k) participants, investing for the long run, are generally more passive than investors putting money into taxable accounts, the size of the decline is striking.

One reason 401(k) participants do not change their accounts, experts say, is that they are in denial. "When the market performs poorly, investors put their head in baskets," says Jaime Punishill, analyst at Forrester Research, a technology research company. "There comes a point when the pain is too much [to face]."

But the pain is undeniable. According to Boston-based consultants Cerulli Associates, the average 401(k) account balance fell $4,528 to $36,390 in 2001. Overall, assets shrank by $101 billion to end 2001 at $1.64 trillion.

Some industry experts say, however, the retreat in 401(k) trading is more than just an escape from an unpleasant experience. Investors don't know what to do. They believe that September's terrorist attacks changed the business environment. "People are trying to get their hands around what the world is like today," says David Wray, president of Profit Sharing/401(k) Council of America. "When you are in that mind-set, you don't make changes."

Others say that 401(k) participants are not confident enough in their own knowledge of the market, along with rapidly changing company accounting revelations and government regulations, to alter their investment plans. Simply put, they don't know what kind of change would boost their returns.

"Small allocation changes aren't going to make much difference in the large percentage their account balances have fallen," says Punishill.

Still others say that the 401(k) inactivity is due to neither fear nor confusion, but endurance. Investors are simply riding this market out.

As a result of this inertia, the asset allocations in some 401(k)s might be out of whack. At the end of 2000, 81% of 401(k) plan assets were invested in equity investments. That proportion fell to 76% in 2001, according to the Hewitt report. Because stocks traditionally perform better than bonds over the long term, such a shift to a more conservative position could weigh down a portfolio's ultimate returns.

Company Stock

Despite calls for diversification from investment professionals last year, many 401(k) participants kept a significant portion of their investments in the stocks of the companies that employed them. Approximately 15% of participants had all of their balances in such stocks, while 29% had at least three quarters, according to the Hewitt survey.

Even though older participants typically diversify their 401(k) holdings, in the Hewitt study members of this age group were just as likely as younger participants to have sizable investments in their own companies' stock. One third of participants aged 60 or older had at least 75% of their total plan balances in such stocks, and nearly 20% had their entire balances.

"People haven't generalized from Enron to their own companies," says Wray. "Plus, many people are loyal to their companies. Generational studies have shown that those between the ages of 60 and 77 are the ultimate company people: They've worked all their lives at one firm."

Employee reluctance to change the holdings in their 401(k) plans did have a positive effect, according to Hewitt. Contribution levels remained the same year over year. Despite the volatile market, participants who were active in their plans both in 2000 and 2001 didn't reduce the amount of money they put into their 401(k)s. During both years, members of this employee group contributed an average of 7.5% of their pay.

"Keep in mind [though] that ideally, employees would increase their contributions in order to make up for market growth deficiencies when it comes to retirement wealth-building," Lucas said in a statement accompanying Hewitt's report.

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