Wednesday, September 19, 2012

Building a 401(k) Plan that Prepares Employees for Retirement

It's one of the biggest concerns that I hear from people in 2012: "How will I ever be able to retire?" They tell me that their dad had a pension plan and Social Security, but they don't have a pension plan and they may not have Social Security. Whether these people will have Social Security benefits or not I can't tell you, but for most, their only employer-sponsored retirement plan will be a 401(k).

What does an employee whose only sources of retirement funds will be their 401(k) and Social Security need to do in order to ensure that he or she will someday have enough to retire? It's not rocket science, but it may not be easy either. Try this list on for size:

  • Start saving early in your career. Money that is saved at age 25, compounded at just 5% annually will have more than double by age 40. But, at age 25, most people have other things in mind for their paycheck than their 401(k).
  • Save continuously. Treat your 401(k) deferrals as if they will never be part of your paycheck. They are just money that is not there. In today's economy, that's not easy. When your expenses exceed your income, one way to cover that gap is to cut back on your 401(k). And, in these economy, more people than not seem to have an employment discontinuity. Just as employees don't have the loyalty to their employers that was once the norm, neither is the reverse true. Layoffs come frequently and re-employment is difficult.
  • Invest prudently. Especially with the communications that plan participants receive, most of them have no idea what it means to invest prudently. They receive more advice than they know what to do with while their personal filters are not good enough to know which advice they should follow. One rule of thumb that I see frequently is that the percentage of your account balance that should be in equities is 100 minus your age. But, equities are volatile, and that has an effect -- a dramatic effect.
  • Reduce volatility. Gee, John, didn't you just tell me to invest heavily in equities when I'm young, but that those investments are volatile? Actually, I didn't; I simply pointed out a common theme among the advice that plan participants receive. Consider this. Suppose I told you that in Investment A, the $1,000 that you deferred at age 25 would get an annual return of 5.00% every year until age 65, but in Investment B, your returns would alternate so that in the first year, you would get a return of -9.00%, in the second year, 20.00%, and that this would repeat itself until age 65. Simple math tells us that your average annual return would be 5.50%. So, which investment would you rather have (remember, these returns are guaranteed)? The answer is not even a close call. Despite the average return of 5.5% in Investment B, $1000 in Investment A after 40 years will accumulate to roughly $7,040 while $1000 in Investment B will accumulate to just $5,814. In fact, it would require the 20.00% return in the up years to increase to nearly 21.00% to make B as good an investment as A. Volatility is a killer.
So, the messages to the employees need to include 1) save early, 2) save continuously, 3) invest prudently, 4) reduce volatility. I would suggest that the first two items can be achieved for many people through auto-enrollment. But, most 401(k) plans that auto-enroll use a 3% deferral rate. 3% of pay is not enough. You'll never get there. Plans need to auto-enroll at rates closer to 10% of pay to ensure that employees will have enough to retire on. 10% is a lot. Many employees will opt out. It's going to be difficult.

The last two items relate to investments. The Pension Protection Act of 2006 (PPA) introduced a new concept to 401(k) plans, the Qualified Default Investment Alternative (QDIA). For employees who do not make an affirmative election otherwise, their investments are defaulted into the QDIA. Generally, QDIAs must be balanced funds or risk-based funds. Many plan sponsors use target date funds (TDFs) to satisfy the QDIA requirement. I went out to Morningstar's website to look at the performance of TDFs since the passage of PPA. All of them have had significant volatility. This is not surprising, of course, since equity markets have been extremely volatile over that period. But, we saw just a few lines up what volatility can do to you. Perhaps employees should be opting out, but into what? It's going to be difficult.

So, what are the characteristics of a 401(k) plan that guarantees employee preparedness for retirement? Many would argue that this 401(k) plan may not be a 401(k) plan at all. Perhaps what employees need is a plan that has some of the characteristics of a 401(k), but not all of them. Employees need to be able to save. Employees need portability as they move from one job to another. And, then, employees need protection against volatility and protection against outliving their wealth (longevity insurance). 

Consider that last term -- longevity insurance. The second word is insurance. Insurance generally is attained by a counterparty pooling risks. An individual cannot pool risks. An employer with enough employees can. An insurance company can.

Perhaps the law doesn't facilitate it yet, but a system in which employees can defer their own money to get a guaranteed rate of return (tied to low-risk or risk-free investments) and then have the amounts annuitized at retirement is the answer. Perhaps the law needs to facilitate it.

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