401(k) Automatic Rebalancing


By Damian Davila

Employer-sponsored retirement accounts like the 401(k) are the most common way that American workers are saving up for retirement. To encourage employees to sign up and contribute to those plans, employers take several steps, such as including low-cost index funds and matching employee contributions. However, there is one feature that is often included in employer-sponsored plans, particularly in 401(k)s, and ignored by many account holders: the automatic rebalancing of funds. Human Interest offers this feature and it’s one of our clients’ favorites — let’s review exactly what automatic rebalancing is, its advantages and disadvantages, and whether or not it’s worth deciding to use.

Here is how automatic 401(k) rebalancing works

Let’s imagine that you have a $30,000 portfolio split into three funds:

Initial Value% of Total Assets
Total Portfolio Value$30,000
Vanguard 500 Index Fund - Investor Class (VFINX)$21,00070%
Vanguard Total Bond Market Index Fund Investor Shares (VBMFX)$6,00020%
Vanguard REIT Index Fund Investor Shares (VGSIX)$3,00010%

Here’s a review of how to decide how to allocate your funds, if you were doing it manually: How and Why to Change Your 401(k) Setup Percentages. This will help explain some of the assumptions in the paragraph below if you’re unfamiliar with the concept of asset allocation.

Given that you’re seeking to minimize your investment fees, you have selected three low-cost index funds. Since you’re about 30 years away from retirement age you have allocated the majority (70%) to an index fund tracking the S&P 500 (VFINX). Assuming that you have a moderate tolerance to risk, you have allocated 20% of your portfolio to an index fund providing broad exposure to U.S. investment-grade bonds, including corporate bonds and U.S. government bonds of all maturities (VBMFX). Then, seeking to hedge against inflation, you allocated the remaining 10% of your portfolio to an index fund with holdings in real estate investment trusts (VGSIX).

Using data from Vanguard as of June 30, 2016, this is what that same portfolio would look like one year later:

InitialInitial %One year laterOne year later %
Total portfolio value$30,000$31,880
Vanguard 500 Index Fund - Investor Class (VFINX)$21,00070%$21,80668%
Vanguard Total Bond Market Index Fund Investor Shares (VBMFX)$6,00020%$6,36120%
Vanguard REIT Index Fund Investor Shares (VGSIX)$3,00010%$3,71312%

(Notes: Values rounded up or down to the nearest dollar. Percentages rounded up or down to the nearest digit. Actual values and percentages may differ due to rounding. The effects of taxes and costs of investing have not been reflected.)

Assuming that your 401(k) has automatic rebalancing set once every twelve months, here’s what your rebalanced portfolio would look like in the end:

Initial%1 year later(no rebalancing)%1 year later (rebalanced)%
Total portfolio value$30,000-$31,880-$31,880-
Vanguard 500 Index Fund - Investor Class (VFINX)$21,00070%$21,80668%$22,31670%
Vanguard Total Bond Market Index Fund Investor Shares (VBMFX)$6,00020%$6,36120%$6,37620%
Vanguard REIT Index Fund Investor Shares (VGSIX)$3,00010%$3,71312%$3,18810%

(Notes: Values rounded up or down to the nearest dollar. Percentages rounded up or down to the nearest digit. Actual values and percentages may differ due to rounding. The effects of taxes and costs of investing have not been reflected.)

The automatic rebalancing would reallocate the extra 2% of your portfolio in the real estate index fund into the bond and equity index funds.

Let’s take a closer look at the advantages of automatic rebalancing.

Advantage #1: Keep your target allocations in check, correct for outliers

In the last twelve trailing months, the Vanguard REIT Index Fund Investor Shares (VGSIX) had an outstanding performance at a whopping 23.75%. In comparison, the Vanguard 500 Index Fund – Investor Class (VFINX) only returned 3.84% during the same period. While you must have loved the performance of your real estate fund during the past year, you should be aware that its average annual performance for the last three years was 13.25%.

Last year’s performance was definitely an outlier year and it demonstrates the fund’s higher volatility when compared against a broadly diversified equity fund. Overexposure to a fund’s higher risk can really hurt your nest egg during market downswings. To keep in line with your tolerance to risk and selected retirement strategy, automatic rebalancing matches you again with your pre-selected portfolio allocations.

Advantage #2: Buy low, sell high

This is one of the oldest investment maxims. In our example, cashing in the profit from the real estate fund allows you to bump up holdings in your core fund, the S&P 500 index fund. Automatic rebalancing forces you to buy low and sell high, boosting the returns in your 401(k)


Advantage # 3: Minimize investment fees

In our example, we have not considered applicable fees. The real estate fund has an annual expense ratio of 0.26%, which is 0.10% higher than that of the index fund trailing the S&P 500. Remember that the >annual cost of a fund is the only dependable predictor of future performance, according to research from investment think tank Morningstar. When automatically reallocating monies to funds with lower investment fees, automatic rebalancing can help you minimize your investment expenses in the long run.

Advantage #4: Have access to entry-level wealth management

For young retirement savers, those with low account balances, and those without the need for more complex wealth management services, automatic rebalancing can be a useful and affordable alternative to having a full-fledged financial advisor. More and more retirement plans are offering 401(k) robo-advisors, which provide investment guidance and management based on specific details about you.

For example, they tend to use algorithms based on your age, pay, and/or risk preference, and sometimes include your answers to questionnaires about your investment and retirement goals. Some robo-advisors or automated investing services offer additional features, such as automatic rebalancing of your portfolio, which can help stay the course with your investment strategy if the market fluctuates.

However, automatic rebalancing isn’t without some drawbacks.

Disadvantage #1: Can be painful to watch

An undisciplined investor would be biting his nails watching funds being taken away from a “winner” into a “loser”. In our example, the real estate fund may look like a big-time winner. Based on this short-term performance, trying to time the market or adjust investment could cost an investor between 1.5% and 4.3% per year.

Remember that in our example, we assumed that you were 30 years away from retirement. This means that you still have a day job to focus on and won’t have enough time to make timely trades. Even if you were to have the time, only 20% to 35% of active portfolio managers beat their benchmarks over a five-year period. And these are the pros whose day job is to make trades!

Disadvantage #2: May not be necessary at all times

In our example, we had an allocation of 70/20/10. Is it really necessary to rebalance your portfolio if you have a 69/21/10 allocation? Depending on the rules of your portfolio, you could be better off waiting a bit longer to avoid applicable fees. It’s hard to predict future market movements, but it’s easier to predict that automatically rebalancing your portfolio every month is too much.

Disadvantage #3: Not always free

Before signing up for automatic rebalancing with your plan provider, review the schedule and set of rules for fees to make sure automatic balancing isn’t costing you extra trading fees. Pay particular attention to any front-end loads, back-end loads, and exchange fees. For example, you may hold a fund with a 60-day waiting period to prevent an offloading fee. In that case, it would make more sense to set the automatic rebalancing beyond 60 days.

The bottom line: Automatic rebalancing is worth it

If your plan doesn’t offer automatic rebalancing or you would like to compare the service provided by your current plan administrator, consider Human Interest, which provides automatic rebalancing that can be customized to your needs. With Human Interest, you can decide whether or not to opt in into automatic rebalancing as you wish and have access to Vanguard funds in the Admiral share class without any minimum account balance on your part (generally, you would need $100,000 for them).

In the end, the advantages of automatic rebalancing win over its disadvantages. The proof is that an investment strategy that reacts to market movements in a mathematical, emotionless manner has been shown to boost returns by 0.4% per year. By periodically adjusting your portfolio allocations, you can keep in line with your target allocations, buy low and sell high, reduce trading fees, and gain access to entry-level wealth management.

Damian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.

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