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An Update of the US Retirement Market – and its Potential Impacts

(July 26, 2007)

Dear Subscribers and Readers,

Before we begin this commentary, I would like our readers to take in the following chart – showing the credit default swap spread for the five-year CDX.NA.HY index (representing 100 high yield components traded in North America), courtesy of

Credit default swap spread for the five-year CDX.NA.HY index

When we last discussed the above chart two weeks ago, credit default swap spreads for this index was trading at approximately 360 basis points.  Two weeks later, it has risen another 100 basis points.  Coupled with the difficulty of the recent Chrysler and Boots buyout deals, and there is no doubt that the leveraged buyout market has – at the very least – shut down, for now.

As for the stock market – even though energy bounced strongly yesterday and even as crude oil broke the $76 a barrel barrier, there is no doubt that liquidity (or the lack thereof) is now having a detrimental effect on the U.S. stock market. However, the stock market is, in the short-run, very oversold right now, and so we will most probably wait for another bounce in the stock market before initiating a short position in our DJIA Timing System.  Subscribers please stay tuned.  Let us now go on to the main subject of today's commentary.

Introduction of the US Retirement Market

In our May 6, 2007 and May 28, 2007 commentaries, we had discussed the various aspects of the U.S. private retirement system as it stands today – focusing on 1) why the U.S. private retirement savings system is broken and what stakeholders are doing to solve these problems, and 2) the tumultuous changes that the U.S. defined benefits system is currently experiencing and what this may mean for the stock market going forward.

While it is always good to keep track on the general U.S. private retirement system going forward (note that a lot of ink has already been spilled on Social Security so we will definitely not visit that issue) – many changes that are currently being discussed will not have a significant impact on our subscribers – either as an individual or as an investor.  However, there is no doubt that profound changes are now occurring in the U.S. defined benefits system (which collectively accounts for $2.3 trillion out of the total $16.4 trillion in U.S. retirement assets) – and the scary thing is: A significant chuck of these projected changes (i.e. as much as a $1 trillion shift from equities into fixed income long duration strategies, hedge funds, infrastructure, and so forth) is only just starting to occur.  For folks who want a refresher on this topic, I urge you to go back and read our May 28, 2007 commentary entitled “A Worrying Headwind for the U.S. Stock Market.

Our focus for this commentary will be slightly different, as we are for the most part going to focus on the defined contribution (i.e. 401k, 403b, etc) and the individual retirement accounts (i.e. IRAs, etc.) of the U.S private retirement system.  Unlike Social Security or defined benefit plans, participants in these plans decide how much to contribute and also decide their asset and risk allocation going forward.  Hence the name “defined contribution,” as only the amount of the contribution is known in advance, as opposed to “defined benefit” plans where the benefit has already been predetermined based on a formula (i.e. the government or the corporation bears the investment risks instead of the individual).


Let us first give you an update of the amount of assets held in the U.S. retirement system (outside of Social Security, which is really a pay-as-you-go system anyway).  Following is a chart courtesy of the Investment Company Institute (ICI) showing total U.S. retirement assets from year-end 1994 to year-end 2006.  Note that this study was just completed earlier this month:

Total U.S. retirement assets from year-end 1994 to year-end 2006

During 2006, the total amount of U.S. retirement assets increased $1.7 trillion to $16.4 trillion, an increase of 11% during the year and a 55% increase from the end of 2002 – close to the bottom of the last bear market, buoyed by a net contribution of $98 billion to “long-term” mutual funds (i.e. funds excluding money market assets) during the year from retirement accounts (DC plans and IRAs). 

Marking a continuation of a 30-year trend, the amount of assets held in DC plans and IRA accounts grew faster than overall assets – increasing by 15%, compared to 8% asset growth for other retirement plans.  At the end of 2006, assets in DC plans and IRA accounts represented 51% of all retirement assets, up from only 39% in 1990.  Moreover, approximately half of all DC and IRA assets are held in mutual funds.  As a percentage of all U.S. retirement assets, mutual funds now make up about 25% - rising from 23% at the end of 2005 and as little as 5% in 1990 (following chart again courtesy of ICI):

Mutual Funds' Share of U.S. Retiremetn Assets (1990 to 2006)

During 2006, the net contribution to equity funds from DC plans and IRA accounts were only $44 billion, the lowest level since 2002, when these accounts only contributed $22 billion to equity funds.  On an industry-wide level, however, net inflows into equity funds were more robust, totaling $159 billion vs. $136 billion in 2005 and an outflow of $28 billion in 2002.  Both sets of statistics can be found in the following chart, courtesy of ICI:

Estimated Net New Cash Flow to Mutual Funds from Retirement Accounts by Type of Fund (1997 to 2006)

Unfortunately, the category of “equity funds” was not further broken down into foreign or domestic funds.  On an asset-held basis, however, the ICI study does show a breakdown, although those are only shown for DC plans and IRA accounts.  Nonetheless, this captures what need.

Following are two tables courtesy of ICI – with the first one showing IRA holdings of mutual funds by fund type and the second one showing DC plan holdings of mutual funds by fund type:

IRA Holdings of Mutual Funds by Type of Fund

Defined Contribution Plan Holdings of Mutual Funds by Type of Fund

Interestingly, while IRA investors were relatively conservative back in the early 1990s, this has since changed, as their domestic equity/foreign equity/bond allocation is now very similar to that of DC plans.  However, IRA cash holdings are still at a relatively high 10%, vs. 5% for DC plans.

Another interesting point – and one that has been discussed several times in our previous commentaries and on our discussion forum – is the fact that the foreign equity allocation of these accounts have risen dramatically over the last several years, as 1) domestic investors have been favored foreign as opposed to domestic mutual funds, 2) foreign equities have done significantly better than domestic equities, driven partially by the weakness of the U.S. dollar since 2002.  At a 53% allocation, IRA holdings of domestic equities are now at the lowest level since 1996, while for DC plans, the 58% allocation to domestic equities is now the lowest since records have been kept starting in 1992.

Besides foreign equities, a significant amount of assets held previously in domestic funds has also gone into hybrid funds over the last several years.  These funds invest in a mixture of equities and fixed income securities and include lifestyle and lifecycle funds.  The increased allocation to hybrid funds was mostly due to the growth in the popularity of lifestyle and lifecycle funds.  According to the ICI, assets in lifestyle and lifecycle funds grew 50% in 2006 to $303 billion, after rising 57% in 2005.

Potential Impact

So Henry, what do you see as potential impact for these latest trends in the U.S. retirement market, particularly in DC plans and IRA accounts?

In reading the latest findings of the ICI and in my experience with dealing in the investment aspects of DC plans and other long-term institutional investors, there are three main things that I see:

  1. While domestic equity funds as a percentage of total assets held by retirement accounts are relatively low on a historical basis, there is no reason to believe that this percentage cannot decline further, as U.S. domestic investors continue to “expand their efficient frontiers.”  That is, from a modern portfolio standpoint, it continues to make more sense to allocate more assets into foreign equities – as investors are still underweight non-US equities on a market cap basis and as more investment opportunities continue to appear in China, India, Brazil, Malaysia, and even Vietnam.  On an everyday basis, I also continue to see evidence of institutional investors allocating more of their assets towards foreign equities.  Unless 1) we experience a global recession, 2) the pace of financial liberalization slows dramatically in Europe (IMHO, Europe is still a big question mark) or Asia, 3) we experience a boom that has its roots in the technology and healthcare sectors, as opposed to the energy, materials, and industrials sectors, more institutional and retail investors alike should continue to “diversify” into non US equities.

  2. Now that most employees hired by US corporations have access to DC plans as opposed to DB plans – and with Social Security being called into question on a daily basis – the only alternative to the “press a button and forget” investment option is the lifestyle and the lifecycle fund offerings.  The asset allocations of these funds are mostly quantitatively-driven  and as a result, are devoid of emotions and will thus have a “smoothing effect” on the market, and at the very least, make the U.S. stock market more “efficient.”  However, this is unlikely to have any immediate impact, given the relatively small size of the lifestyle/lifecycle fund industry today.

  3. I had not mentioned this previously, but surprisingly, most of the equity, hybrid, and bond fund assets in DC plans and IRA are still invested in actively managed funds, as opposed to passively managed, or index funds.  At the end of 2006, $3.4 trillion of these assets were actively managed, versus only $336 billion in passively managed, or index funds.  Apparently, most investors still have not given up their dreams of “beating the market” and given the significant asset size increase we have witnessed in so many of the popular names – such as American Funds, Dodge & Cox, and PIMCO – it has become increasingly difficult to beat the market by investing in these funds.

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