The 401(k), the beast that ate the traditional pension plan, has been the backbone of the retirement savings structure for tens of millions of workers since its inception in the early 80s. But the defined contribution concept has also left a lot of people behind.
The problem with the 401(k), however, lies in the very flexibility and freedom that initially attracted people to it: It creates grossly uneven and unreliable outcomes. It’s brutal on people who are relatively unsophisticated investors – which, unsurprisingly, describes the majority of plan participants who make investment decisions without any kind of professional help or guidance.
We find that hardworking Americans routinely underperform unmanaged indexes like the S&P 500 with their 401(k)s. And not just by the costs of investing. That would be expected and unavoidable. No, Americans are underperforming by huge margins. That’s a problem for employees – and their employers.
The underperformance problem is so pervasive and severe that it has sparked hundreds of lawsuits from disappointed employees, who noticed that their returns were well below those of management and senior staff (with presumably more financial education, access to financial planning, etc.). The argument goes, “you have a fiduciary responsibility to your employees to manage the plan solely for the exclusive benefit of beneficiaries, and yet you sat back and watched this problem for years and did nothing!”
But for many years, employers were afraid to do anything! What if they made financial planning help available to their employees, and the advice didn’t pan out, or the retirement planner made some reasonable recommendations that didn’t happen to pan out? Would plan sponsors be held liable? For years there was no good answer, and no real safe harbor. Workers were left on their own – and when major market meltdowns happened in 2000, at Enron, and in 2008-2009, plan participants just got slaughtered.
Workers Need Help
Underperformance comes from a number of factors.
Poor fund selection. (but the plan sponsor selects the funds on the menu)
High expenses. Fund companies and benefits brokers have to make their money somehow. But excessively high fees are a cancer on investor returns – especially with today’s low interest rates, where a 1 percent annual expense ratio can consume 20 percent of a 5 percent bond fund’s annual return! (That’s more than rock stars and pro athletes pay their agents!)
Bad market timing. People typically buy and sell at the wrong times. In fact, as the annual Dalbar Quantitative Analysis of Investor Behavior study verifies, people’s market timing decisions without help are absolutely atrocious.
Excessive risk averseness. People who self-select to read HR blogs like this one tend to be interested in 401(k)s and at least know enough about mutual funds to be dangerous. That’s not true for millions of hard-working Americans, who have little education or interest in learning all about the minutiae of tax efficiency ratios, R-squared indexes, correlation coefficients, ERISA and the Investment Company Act of 1940. So many of them, if they contribute to their 401(k) at all, simply keep their money in the risk-free money-market option. After all, they understand that!
That’s a great option for short-term money. But taken over a 30-year career or more, money market returns are not sufficient to beat inflation and provide for a secure retirement income.
Failing to Enroll at All. For whatever reason, many eligible workers never get around to enrolling in their workplace plan in the first place. This isn’t good for employers either: A good 401(k) plan can help build loyalty to the company, and help cement the bond between employee and employer. (Vesting, anyone?) If they aren’t invested in the plan, your talented employees will be that much easier for another employer to lure away.
“Overwhelmingly, participants look to their employers for information and access. They really depend on the employer to set a path to successfully save and invest for retirement,” says American Century’s Diane Gallagher, Vice President of Defined Contribution Investment Only (DCIO) Practice Management. “Twenty years ago, we spent so much time telling employees how valuable a 401(k) or defined contribution plan was to their compensation and benefits, but we didn’t tell them how to use the plan. Now, everyone understands that it’s a valuable benefit. The majority say, “I know I’m supposed to save, but I don’t know how. Please just set up a correct path for me, and I’ll stay on it.”
PIMP MY (K)!
So since the garden-variety, off-the-shelf, stock issue 401(k) plan isn’t working for workers, and it’s potentially exposing your company to risk, it’s time to make some changes. For years,
- Automatic enrollment. Don’t even give them the option of delaying. Delay is the mortal enemy of the retirement saver. It is also the mortal enemy of your employee. Automatic enrollment means just that: Unless the employee actually makes a move to opt out (by filling out an extra form, or going online), the employee is automatically signed up to contribute to the 401(k) plan.
A number of studies have shown that automatic enrollment has a dramatic positive effect on plan participation. The practice particularly benefits those groups of workers who are statistically at the most risk for chronic undersaving: Younger employees, women and minorities, as well as middle income Americans.
- Offer ‘Target date’ funds and model portfolios. Employees are usually atrocious at portfolio design. So don’t insist that they do it. Instead, give them some idiot-proof options. Target date funds are funds that are specifically managed with certain retirement date years in mind. For example, today, someone with an expected retirement date of around 20 years from now may choose a fund with a ‘target date’ of 2035. For now, there will be a pretty substantial investment in equities in search of long-term returns. The worker can afford to bear some risk. As the target date gets closer, the fund manager will dial back risk exposure. The employee doesn’t need to do anything other than keep contributing.
Model portfolios are similar, but are typically managed according to a given risk tolerance, rather than to a specific retirement date. Both practices, however, are on the rise. These aren’t perfect solutions, but having the option on the plan menu could be a godsend for some employees.
The use of target retirement date funds (also called ‘lifecycle’ funds has become quite prevalent, with over 40 percent of plan participants investing in them, according to the Employee Benefit Research Institute. That’s more than double the 19 percent figure in 2006. Meanwhile, the percentage of 401(k) assets held in lifecycle funds tripled between 2006 and 2013, to 15 percent of total assets held, according to EBRI.
Some sponsors are also moving to managed accounts (While it may be a terrific option to have on the menu for management/executive participants, I’m not convinced it makes much sense for the rank and file at most companies, due to the costs of separately managed accounts and the lack of opportunity for tax harvesting, which is one of the ways separately managed account managers can add value!).
Don’t Use Money Markets as the Default Option. Many 401(k) plans will automatically enroll employees, but use a money market as the default option. Employers may think this absolves them from liability. But the money market is not a suitable option for workers in their 20s, 30s and 40s who have many working years ahead of them before they reach retirement age. Consider using a more suitable default option, such as a target date fund. Look for funds with low fees, as well.