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Crossing the Line

More 401(k) plan sponsors are taking investment education a big step further by offering employees advice.

1Dec

Adam Kelly's retirement plan is in surprisingly good shape for a worker who's only 24 years old. He diverts 5 percent of his salary to his company's 401(k) plan, dividing his contribution equally between two stock funds, one that invests in small, fast-growing companies and another that focuses on larger companies that also have good growth rates. Kelly, a digital color specialist for BFS Business Printing, a commercial printer in Boston, knows if he keeps it up he could have 150 percent of replacement income when he retires in 41 years, assuming, of course, that equities reproduce the average annual return of 15.4 percent that they have achieved during the past 20 years.


What makes Kelly act more like a 44-year-old than someone 20 years younger? His employer spends $20 annually to provide Kelly with a personalized report that suggests an optimum savings rate and asset allocation model. Then, Roxanne Fleszar, a certified financial planner with Peabody, Massachusetts-based Financial Resources Management Corp., visits BFS twice a year to help Kelly and the company's 94 other employees choose appropriate plan funds to achieve their goals. "Without the report, I wouldn't be saving as much or knowing where to invest," he says.


Adds John Merrill, CFO and treasurer of BFS: "We have to provide enough information to explain to employees that unless they save, they are going to have to work all their lives. And most of our employees take it seriously."


Like BFS, a growing number of plan sponsors feel compelled to provide investment advice, not just generic education, to 401(k) participants. "Employees seem to need this," says Lisa Crosby, benefits manager of Fujitsu America Inc., in San Jose, California. "We try to give as much education as possible, but employees come back and say, 'I've read through everything, and I still don't know enough to diversify the way I should.'"


Last year, Fujitsu bit the bullet and brought in 401k Forum Inc., an online third-party advisory service based in San Francisco. Crosby rolled out the service to most of Fujitsu's 17 American subsidiaries in January. "With 17 different companies in different locations, there is always the chance that an employer representative might answer the question, 'How would you do [it] if you were me?'" she says. With 401k Forum, the representative can respond, "I can't answer that for you, but here is a site where you can find the answer."


Today, 14 percent of plans offer access to advisory services, according to technology research firm Forrester Research Inc., in Cambridge, Massachusetts. An additional 62 percent of human-resource executives say they would consider providing unambiguous, direct- investment advice. "You can't pick up a newsletter or magazine without reading about advice," says Kathy Guthormsen, benefits and risk manager for Autodesk Inc., a $617 million software company based in San Rafael, California. "We, as plan sponsors, feel that ultimately we face more liability if we don't give people advice than if we do."


Many sponsors aren't so sure. In 1996, the Department of Labor (DOL) clearly warned that anything beyond generalized education could turn the plan sponsor into a fiduciary for plan performance--a potential legal liability most sponsors are loathe to assume. Sponsors and their plan providers and educational firms can illustrate generalized asset-allocation models for different investor types, such as investors close to retirement and investors with years to spare. But they can never recommend individualized asset-allocation plans or endorse specific funds to buy.


Unfortunately, education often doesn't work. "Every piece of research we've done shows education is a waste of time," says Lou Harvey, president of Dalbar Inc., a financial services research firm in Boston. "Corporations have spent billions of dollars for nothing."


A determined sponsor can safely provide advice by hiring a financial adviser with no links to either the sponsor or the plan provider. But that kind of personal advice is costly, usually starting at $250 per employee. "Advice has been a cost-benefit problem," says Harold Fethe, senior vice president of human resources for Alza Corp., a $464 million Palo Alto, California-based pharmaceuticals company now piloting an online program for Financial Engines Inc., also in Palo Alto. "To get good advice that's more than a nice seminar has been prohibitively expensive."


Several developments now make it more affordable:





  • Online 401(k) information has evolved from a record-keeping and transaction vehicle to a computerized modeling tool that can provide individualized investment advice at a fraction of the cost of a personal financial planner. Most online investment advice can be economically distributed by a telephone representative, so that all employees have access to the service.

  • A 401(k) advisory industry has emerged, populated by both start-up enterprises, such as 401k Forum and Financial Engines, and established asset managers, such as TCW Group, The Vanguard Group, and Fidelity Investments.

  • The DOL has declared its willingness to promote participant advisory services, as long as advisers meet strict standards. The DOL has issued several prohibited-transaction exemptions to providers that can demonstrate that their recommendations do not involve self- dealing. In other words, providers aren't allowed to push participants into funds with fatter fees.


Even if sponsors are ready to plunge in, the choices aren't easy. Advisory products vary greatly. Financial Engines, for instance, simulates how mutual funds in the plan and those held separately are likely to perform in future years, and suggests investments accordingly. Fidelity's program simply takes Morningstar historical data and creates a model portfolio based on investment style, not projected future performance.



A Court Date in 30 Years

Unlike defined benefit pension plans, which are managed by investment professionals, 401 (k) plans are managed by their holders, who are more likely to get their investment advice from an uncle or a co-worker than from an expert. That can have dangerous consequences. From 1982 through 1997, defined benefit plans returned an average of 2 percentage points more than defined contribution plans, most of which are 401(k) plans, according to a study by consulting firm Watson Wyatt Worldwide. The reason: Individual investors make greenhorn mistakes. They move too slowly into promising investments and jump out too fast when the market shifts.


These blunders will have profound ramifications at retirement. For an employee who contributes 6 percent of an annual salary of $30,000 starting at age 35 and receives a 50 percent employer match, that 2 percentage point gap would result in a 28 percent difference in replacement income at age 65, according to Watson Wyatt.


Plan sponsors fear that if participants outlive their savings, they'll argue that employers should have warned them that they weren't investing correctly. That is a distinct possibility whether or not the recent turmoil in the stock market proves to be the start of a prolonged downturn, say industry experts. "Thirty years from now the liability will fall on the corporation," says Brian Roehl, a partner at investment-education firm Educational Technologies Inc., in Troy, Michigan. "Sooner or later, the attorneys will grab hold of this, and it will be just like the tobacco lawsuits."


Many sponsors provide some advisory services out of a sense of responsibility, not fear. Since 1994, IBM Corp., in Armonk, New York, has contracted with Merrill Lynch and American Express Financial Services to offer financial- planning advice to employees, at a cost of $200 to $1,000 per person, according to Don Sauvigne, director of retirement programs. IBM doesn't pay for the service outright, but permits employees to use a $250 annual Life Planning Account to help cover the cost. Some 25,000 out of 130,000 IBM employees in the United States have pursued that option over the past four years, he says.


"I'm satisfied with what we have, but I think it's appropriate to look at the next cycle [of advisory services] to encourage employees to improve their investment behavior," Sauvigne says. No adviser, however, would be hired without a prudent review of the adviser's capabilities and compliance with DOL regs, he says.


The bigger the employer, the less likely it is to participate in this first wave of advice. And some are less than impressed with what outside advice providers have to offer. Says one benefits manager at a Fortune 500 company: "The providers aren't there yet. I am not going to spend my political capital at this company to bring them in."


Pioneers, however, think they're already reaping ample benefits. Says Fujitsu's Crosby of 401k Forum: "What I like best is their quick response in a situation of volatility. They have been the voice of reason during the market's turbulence." The service sent E-mail to all participants, coaxing them to stick to their plan. "They described the situation in a way that employees could relate to," she says. "They said, if you start a long trip and find out that your car needs an hour's worth of service, you don't cancel the whole trip."



Who's the Fiduciary Here?

The thorniest question for plan sponsors is whether they are assuming fiduciary liability when they bring in an advice-giver. "Hiring an independent adviser is ideal," explains Roberta Casper Watson, an ERISA (Employee Retirement Income Security Act) attorney with Trenam, Kemker, Scharf, Barkin, Frye, O'Neill & Mullis, in Tampa. Using providers that have received the prohibited-transaction exemption from the DOL helps as well, she says.


Starting in 1993, the DOL has issued those exemptions for a number of 401(k) plan providers. The first to qualify were Prudential Mutual Fund Management, Shearson Smith Barney, and PaineWebber. Last year, the DOL issued exemptions for Wells Fargo Bank and TCW Group. The DOL's director of exemptions, Ivan Strasfeld, says the department is working on several exemption applications now, including those of Dreyfus, Bank of Oklahoma, and 401k Forum. He also makes clear that the department does not endorse any program or judge the quality of the advice given.


Watson warns against using providers that do not have the exemption. "If you have a service that might be construed as a prohibited transaction and everyone makes a lot of money, no one will challenge it," she says. "The challenge will come when someone is unhappy with the decisions that were made and starts looking around for someone to sue." The consequences can be severe, she says. If there is a loss, the fiduciary has to make it up, and there is a possible penalty tax as well.


With the exception of TCW's, the exemptions were granted based on the applicant's willingness to level the expense fees charged for different plan options. TCW's strategy was a little different, and it is one that other providers are expected to follow: Hire a third- party to issue the advice on TCW's funds. (Los Angeles­ based TCW is the parent of Trust Company of the West, which manages more than $50 billion in assets.) TCW chose Ibbotson Associates, a Chicago-based advisory firm that provides analytical and forecasting tools to the pension industry.


Two of the biggest names in the 401(k) advice business today--Fidelity and Vanguard--have not applied for a DOL exemption. Both outfits claim it isn't necessary. Fidelity says its product offers only suggestions, not specific recommendations, so it really isn't offering advice. Vanguard says that because it sets fund expenses at cost, not for profit, there's no self-dealing involved.


Fidelity is busy selling its online PortfolioPlanner product, even without a DOL exemption, saying its program provides education, not advice. The subtlety is lost on some PortfolioPlanner-using plan sponsors that use the terms "advice" and "education" interchangeably.


That's not the only confusion. "I know this program has been approved by the DOL," says Marvin Adler, assistant vice president, finance, of human resources at Turner Construction Co., a $3.2 billion general contracting firm in New York, which has only Fidelity funds in its 401(k). Told that Fidelity doesn't have a DOL exemption, Adler says nonetheless he didn't see any evidence of self-dealing during Turner's six-week beta test last spring. "Our analysis didn't reveal that most people had switched into the international funds, which charge the highest fees." Turner now is implementing PortfolioPlanner for all of its 3,000 employees.


Another PortfolioPlanner user, Amdahl Corp., a computer maker in Sunnyvale, California, with $460 million in 401(k) plan assets, has only two Fidelity mutual funds--Magellan and a money-market fund--among its eight available funds. Since the program started in April, both Fidelity funds have lost market share as PortfolioPlanner has encouraged participants to accept higher risk for higher returns. Pete Apor, savings manager for Amdahl, says, "There is no sales pitch to lure investors in."



Not a Lot of Protection

Autodesk's Guthormsen has no qualms about using Vanguard's online Navigator Plus software, because Vanguard remains a fiduciary even without a DOL exemption. "We wanted whoever provides the advice to become a fiduciary and indemnify us. In reality, it doesn't give us a lot of protection if we're named in a suit. But it shows we chose our provider prudently," she says.


Vanguard's product clearly is considered advice, notes Jim Norris, a principal with Vanguard, in Valley Forge, Pennsylvania. But he sees no reason to apply for a DOL exemption, because Vanguard isn't engaging in a prohibited transaction. "It comes down to our corporate structure," he says. Vanguard is mutually owned--that is, owned by the shareholders of the funds it manages. Therefore, it provides its services at cost and seeks no profits. "We don't have an incentive to recommend one fund over another, because we are an at-cost provider," Norris says. "Whether you are in Windsor or a money- market fund, each is operated at cost."


The all-in-one bundled approach that combines asset management, record-keeping, and a low- cost advisory service can be particularly appealing to smaller companies seeking to simplify plan administration and keep costs low. Vanguard assesses no fee for its program, and Fidelity's per-participant charge "is considerably lower" than the $20 typically charged by an outfit like 401k Forum, says Jane Jamieson, executive vice president of Fidelity.


The DOL's Strasfeld stresses he hasn't seen either the Fidelity or the Vanguard program, but says, "There are people who are doing similar things who do not have the same level of comfort and have come to the department for an exemption."


A June 1998 Forrester Research report found that two-thirds of sponsors surveyed would sign on for advice from a provider, while 17 percent would use an independent software firm. But Forrester predicts bundled advice won't ultimately dominate the market. "Providers that build in-house products will stumble," states the report. "Providers with proprietary advisory products like Fidelity won't be able to overcome concerns about bias, and they will frustrate users by offering souped-up education when users want unambiguous advice."


But whether a plan sponsor is exposing itself to undue risk won't be known until the first court case rolls along. "The difference between defined-benefit and defined- contribution liability is visibility," says Gregory Metzger, director of the defined contribution practice at Watson Wyatt in Los Angeles. "If there is a loss in a 401(k) plan, it is immediately visible." And plan sponsors won't have any place to hide.


----------------------------------------------- --------------------------------- How Advice (Supposedly) Works
While a number of 401(k) advisory products are now available, all seek to align participants' investment objectives and time horizons with an optimum mix of assets. Most services keep them aligned by rebalancing their portfolios at regular intervals to take into account changes or declines in value. Most are also available online and offer backup telephone support for employees without computer access. The cost is either a fixed fee ranging up to $50 annually per participant, or up to 95 basis points added to the annual charge levied against net assets. Despite their similarities, there are some distinctions in approach. Here's a rundown:


Funds of funds. The simplest advice is offered by so-called lifecycle funds, which allow participants to buy a single fund based on their time horizon and risk tolerance. To match those characteristics with the proper mix of assets, a fund of funds allocates a participant's money among other funds, eliminating any need for the participant to select asset classes. The participant simply gets help in choosing which fund of funds most closely matches his or her goals. "Every time you incur a decision or an action step for an employee, you lose him or her," says Sherrie Grabot, senior vice president of Los Angeles­ based TCW Group, which has formed seven such funds of funds and won an exemption from the Department of Labor's rules against offering both fund management and investment advice by using an outside pension advisory firm for advice.


Repeating history. TCW's service and that of some other advisers depend on historical, rather than projected, returns, which may appeal to sponsors that worry that projections might encourage participants to time the market in their fund choices. Historically based advice is also available from such firms as Vanguard Group, 401k Forum Inc., and Fidelity.


Crystal ball. Other 401(k) advisers use projected returns instead of historical ones. The typical approach here is known as Monte Carlo simulation, in which firms try to assess the most likely performance of various asset classes in every conceivable market condition. Financial Engines Inc., of Palo Alto, California, uses a Monte Carlo simulation in combination with asset allocation recommendations based on modern portfolio theory, which holds that returns can be maximized with minimum risk through proper diversification. "The question is, Which funds will get you to your goal with a degree of certainty?" explains Jeff Maggioncalda, Financial Engines president and CEO.


Of course, projections may be no better than history at predicting future performance, and there could be legal as well as financial consequences for getting it wrong. Yet advice that avoids sophisticated analysis of either kind may offer no protection, either. "There will be legal challenges," predicts Francois Gadenne, president and CEO of Rational Investors Inc., in Cambridge, Massachusetts, which markets its service to providers rather than sponsors and characterizes its advice as somewhere in between simple and complex. "If the analytics are too trivial, you will get slammed. If it is too theoretical, a black box that no one understands, what do you think the jury will do?"

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