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One year ago, 401(k) plans were in crisis: account balances had plunged by double digits, employers were suspending matching contributions, and the volatility of the Dow made it uncertain as to whether the bottom had been reached.
The situation improved markedly in 2009. Fidelity Investments reports that participants in the millions of
401(k) accounts it administers enjoyed a 28% pop in 2009, a rate that beats the S&P 500 by 2%. (On the downside, the positive performance of 2009 simply put balances back at 2007 levels.)
But while plan participants managed to make up some lost ground last year, that bit of good news obscures a darker truth: the gains could be traced mostly to employees ignoring their accounts, as they have for the entire 30-year history of 401(k) plans.
Employers have long struggled to educate employees about how to actively manage their accounts for maximum gains. But research has shown that employees rarely do so, and have to be coaxed mightily into joining plans and choosing how to invest their money.
Ironically, their reluctance to manage their accounts seems to have served them well in the recent crisis. Fidelity reports that among the 11 million 401(k) plan participants in the plans it administrates, only 6.1% made any kind of asset exchange in the hairy last quarter of 2008, up a mere percentage point from the previous quarter, and only 11.3% took any action in all of 2009.
"What we're finding out about these plans is that they're ruled by inertia," says Bill McClain, a principal with Mercer's U.S. retirement, risk, and finance business. While that inertia likely saved many people who otherwise would have made bad moves, such as selling at the bottom of the market and buying back in as it climbed, it is hardly what most would consider a wise investment strategy.
This fresh reminder of how reluctant (or unable) most employees are to take charge of their financial futures is spurring many employers to reconsider the pension-fund model — if not in the actual funding of the benefit, at least in terms of making it dummyproof. Employer-sponsored
401(k) plans "are definitely moving toward a more paternalistic, 'we're going to do it for you' approach," says McClain. "We saw that with the movement to automatic deferral, and I think we'll continue to see that with automatic increases, and even automatic rebalances," with some companies going so far as to unilaterally move existing employees out of their own inappropriate investment choices into target-date funds (and letting them opt out, if they choose).
The new paternalism revisits steps that companies have taken in the past, but this time with valuable lessons learned about what type of help works for various populations — and what doesn't.
Tell Them What to Do?
While there have been plenty of efforts to educate employees with general aphorisms about long-term investing (nuggets like: Adjust your mix of equities and fixed income to your age, and diversify, but not too much!), it's clear that many employees need more than a group information session to actually become galvanized.
The range of advice products designed to give people specific recommendations about portfolios is broader than ever, covering everything from interactive computer programs to independent financial consultants who meet with employees in person. Fifty-one percent of employers now offer online investment guidance, 39% provide online advice, and 30% offer phone access to advisory services, according to a recent Hewitt survey. Another 34% plan to add some form of advice this year. (At most companies, the retirement plan or the company itself will pay for a third party to provide this advice, in order to avoid the legal burdens that befall company executives who give it.)
While this sort of help sounds good in theory, there are several obstacles. For one, the perpetual debate about what kinds of advice can be offered, and by whom, has yet to be resolved. Pending regulations at the Department of Labor are likely to redefine what is and isn't acceptable, and a bill in the House of Representatives (HR 2989) also seeks to put new boundaries around it. "Until the Department of Labor advice regulations are finalized — there's some justifiable angst about what is conflicted advice and what is not" — many employers are sitting tight, says Lori Lucas, defined contribution practice leader at Callan Associates, an investment consulting firm.
The low interest level shown by employees would, some experts suggest, make an already high cost (an independent adviser could cost even a small company $60,000 to $70,000 a year) seem that much more burdensome. The problem, again, is inertia. Lower-cost approaches may not fare much better. With interactive online services, for example, "it can take 20 or 30 minutes to go through all the questions, and you need all sorts of financial information to fill them out, so most people don't bother," says Robyn Credico, senior retirement consultant at Towers Watson. "And even if you do go through the questionnaire, few people actually act on the advice, and even fewer go back and do it again next year."
A recent study by Hewitt and Financial Engines shows that the people who are most likely to want advice, in any form, are those who are younger and who have relatively large account balances. The average participant using online investment advice in the study, for example, is 41 years old and has a plan balance of $69,057. The average participant overall has a balance of $41,072.
Or Do It for Them?
One way to overcome the legal questions surrounding advice, and employees' apparent indifference toward such help, is to go a step further and offer managed-account services. A number of firms, including ProManage, Financial Engines, and GuidedChoice, will manage 401(k) accounts for fees far below those that wealth-management firms charge high-net-worth individuals.
Some 26% of employers now offer this option. Among them is Allergan, a $4.4 billion maker of pharmaceutical products. "A lot of people have come to me over the years and said, 'I'd rather have someone do this for me,'" says Gary Prem, assistant treasurer at the company. Several years ago he enlisted Financial Engines (which offers both advice and management options) to do just that.
Employees fill out forms identifying their retirement goals, various risk parameters, and other relevant information such as stock holdings or a spouse's retirement portfolio. Then Financial Engines takes over, for fees (paid by the employee) that start at 60 basis points for the first $100,000 in assets. "This has been a great success, way beyond my wildest expectations," Prem says; 17% of employees had signed up for the service as of the end of 2009, nearly double the usual uptake, and 90% have stuck with it.
For the most part, the work is accomplished through online and phone interactions rather than the face-to-face meeting a high-net-worth client might get, and the portfolio shaping relies heavily on computer models.
The big question for managed accounts is whether they result in investment performance that is measurably superior to that provided by a semicustomized target-date fund. Managed accounts seem to work best for people in their mid-40s or beyond, because, as Hewitt's Pam Ness notes, "That's when target-date funds work a little less well, because people's situations become more dissimilar as they get older." The account balances of employees who avail themselves of managed-account services also tend to be lower than average — less than $49,000, typically, according to the analysis.
At Magnetek, a $100 million manufacturer of digital-power and motion-control systems, for example, the 70% of 401(k) plan participants that use ProManage represent only half the plan assets, says CFO Marty Schwenner, noting that "the ones with the bigger balances like to manage it themselves." The company has been using ProManage, which charges about 25 basis points on assets under management, for almost 10 years, he says, with a consistently high usage rate throughout that time.
Schwenner says the option has been better for his "reluctant investors" than target-date funds because they take factors like position, salary, and other retirement benefits into consideration, even absent employee input. And while it's hard to say exactly how much better those using the management service weathered the market meltdown last year, Schwenner says "we saw a lot of people who do not use the service move their money to fixed income after the market drop, and they're still there, so they missed out on some big gains."
Target Funds 2.0
Target-date funds continue to evolve. The professionally managed funds are customized for age or expected lifetime, and are automatically rebalanced as needed. Most surveys show that more than 75% of plans offer them, and more participants are beginning to choose them. "Asset-allocation funds, including target funds, now represent between 20% and 25% of total plan assets," says Alan Vorchheimer, a principal in Buck Consultants's New York office. "The whole industry thinks this is the future."
Many companies that have automatic enrollment programs use the funds as a default option to give new employees a shot at a balanced portfolio. According to the Hewitt/Financial Engines report, the average participant enrolled in a target-date fund was 38 years old with 3.8 years of tenure and a plan balance of $6,295.
Evidence indicates that such funds do better than the average employee on his or her own. Fidelity looked at people who have been in their plans for the past 10 years (1999–2009) and measured how those who assembled their own portfolios did compared with those who had Fidelity target-date funds that corresponded with their age. Of that group, a whopping 70% "showed a lower return than their age-based funds over the course of the decade."
But there is room for improvement. "Too many plan sponsors still view target-date funds as commodities, using the proprietary target-date funds of their recordkeeper without performing appropriate due diligence in the selection process," says Lucas of Callan Associates. Because there is tremendous variation in glide paths (that is, rebalancing as retirement approaches) and returns, she says employers should conduct in-depth research on the funds and expand such offerings if need be.
One key differentiator, which must be communicated adequately to employees, is between target-date funds that stop reallocating at the target retirement date and those that are continuously managed through an expected lifetime. In many cases, "people thought that when they picked the 2010 fund, that was the date at which they got a big pile of money," says Vorchheimer. "Meanwhile, the people who ran these funds were [factoring in] another 25 years for expected life span, so the equity concentration in the funds for people closest to retirement was probably much higher" than some people expected.
In February, Securities and Exchange Commission chair Mary Schapiro announced that she wanted SEC staff to look into this confusion. "In the year ahead, we are going to confront the issue of the potential for target-date fund names to confuse investors, or lull them into a false sense of security," she said, noting that rules on additional disclosure as well as on the marketing of such funds are in the works.
Having an investment professional build a customized target-date fund using the plan's existing investment options is one way to avoid such pitfalls, and may result in lower fees to boot. Some companies hire consultants to construct different target funds based on their plans' existing investment options. This approach makes a lot of sense for plans with more than $1 billion in assets. One drawback: if the funds use stable-value funds as part of their asset allocation, the "wrap provider" (that is, the firm that guarantees the principal of the stable-value funds) may raise a red flag regarding the looming liquidity implications.
Indeed, "as a plan sponsor, you need to be very careful that you don't run afoul of the contract with your stable- value fund wrap provider," says Lucas. "If you're considering this, the first thing you would want to do is talk to the stable-value fund manager and see if it can test the waters with the wrap providers [it partners with]."
Annuities may prove to be the missing link between current 401(k) plans and the pension plans of yore. President Obama has hinted at them being a required part of any plan, and the Labor Department is currently soliciting comments (due May 3) on what role these instruments, which pay a set amount of money over a fixed time period, could or should play. Proponents say they can mitigate longevity risk (the risk of outliving your assets) by allowing participants to buy an annuity that, for example, would kick in at age 85, allowing them to spend down in a more manageable way the remainder of their assets over the intervening years.
Today, however, annuities are most often used as an external (that is, outside the 401[k] offerings) rollover option for people hitting retirement, and even then by only 14% of the companies recently surveyed by Hewitt. As for allowing employees to invest in them during working years, only 2% of companies currently offer that option.
The main problem is one of liability. Annuities are generally run by a single insurance company, and in this post–AIG meltdown era experts say many people may not trust one company enough to bank a significant portion of savings with it. Lack of portability is also an issue. In short, says Vorchheimer, interest in annuities "is bubbling, but the government is going to have to mandate it, or it's going to take a very long time" for plan sponsors to add them.
Despite the strong gains of 2009, most employees still have plenty of catching up to do. Over the long term, the ignorance-is-bliss approach won't serve them well. Fortunately, companies have more tools at their disposal, and they know they need them — a spot poll on www.cfo.com found that three-quarters believe they need to do more to educate employees about 401(k) plans. Unfortunately, with no silver-bullet solution in sight, companies will also have to educate themselves about the pros and cons of each of these emerging options.
Alix Stuart is senior editor for human capital and careers at CFO.