Eliminating the Phone-A-Friend Retirement Plan

I read an article earlier this morning informing me that employees don't really understand 401(k) plans. News Flash: that's not news. In fact, looking at behavior of employees and overhearing casual conversations between otherwise intelligent 401(k) participants about the value of their 401 plans, their 201k (when they are underperforming expectations), their 501k (when they are overperforming expectations), and the ways that they choose investment options, this sounds like a statement from Captain Obvious.

How did 401(k) plans get this way? In their earlier incarnations, typical 401(k) plans gave employees an option to defer. In most plans, employees that did choose to defer got a match from their employers. Employees could then invest those assets within the plan in usually about five to eight options.

I recall a conversation back in the early 1990s with an individual who is now on every list of the great minds of the 401(k) world and the great innovators in the 401(k) world. This individual told me that no defined contribution plan needs more than six investment options ... ever .. and that any plan sponsor with more than six should be lined up with their adviser before a firing squad (the words are not precise, so no quotation marks, but they are pretty darned close). The same individual later became one of the leading proponents of a 'full menu' of options with at least one and often more than one from each asset class and each investment style within that asset class.

How exactly do employees benefit from such choices? They don't.

Suppose I choose three highly rated large cap funds from US News's report:

• T Rowe Price Institutional Large Cap Core Growth Fund
• Fidelity Blue Chip Growth Fund
• JP Morgan Intrepid Growth Fund

Let's imagine that they are all in my fund's lineup. How do I choose?

Intrepid sounds like a cool name. Maybe I should pick that. Blue Chip? My grandfather told me to invest in blue chips. I wonder if that's still true today. And, that long name? If it does all those things, it must be really good, too.

I could read the prospectuses. I could do research on performance history. I could look at investment styles and drift whatever all that means. I could phone a friend.

The simple fact is that for most of us, it's a crap shoot ... plain and simple. 

Because of that, despite all the forecasts in the world from 401(k) lovers, this should not ever be a primary plan for employees. As it was intended back in the late 70s and early 80s, this should be a supplemental savings plan -- an addition to what you get in your primary plan.

Your primary plan should be just that. It should be employer-provided. It should not be confusing. There should be no need for a phone a friend option. 

I don't care what kind it is although I have my biases. My bias is that the plan should provide for the ability for participants to take distributions in lump sums or wholesale-priced annuities (my term for annuities on a fair actuarial basis without middle men making profits at your expense). My bias is that the determination of your benefits in the plan should be simple. My bias is that assets should be professionally managed. 

I don't care what label you give to such a plan. I don't even care what label ERISA or the Internal Revenue Code gives to such a plan. What I do care about is that you not lose sleep over whether Intrepid is better than Blue Chip or conversely. What I do care about is that if you choose to annuitize your account balance that you get an annuity that is 100% of what you deserve not some number closer to 80%. 

And, for your supplemental savings, you can have your Phone-A-Friend ... oops, I meant 401(k) plan.

Winning the Race to Retirement

You can see it on TV all the time. This investment management firm or that one will help you to get to a prosperous retirement. There is nothing wrong with that. In a 401(k)-only world, you may need all the help you can get. So, with regard to those firms, while I am not Mark Antony and they are not Caesar -- friends, readers and others, I come to praise those firms, not to bury them.

Suppose you are a participant in a 401(k) plan. You probably are if you are reading this. Then, it wouldn't be surprising if your plan's recordkeeper (by the way, they may also hold the majority of the funds in the plan) gives you online access to some sort of retirement modeling tool. This is a good thing.

OK, so why is this idiot blogger wasting your time? There is a little problem here. On any of these sites, either the site makes assumptions for you, or, sometimes within a set of constraints, you get to choose assumptions for yourself. This can be dangerous.

Why?

Consider your best friend. Is he or she a smart person, financially savvy? Let's assume the answer is yes. And, you, of course, are financially savvy? Would you trust that best friend of yours to be able to pick your annual return on your 401(k) balance? Would your best friend trust you with guessing a return on their balance. Probably, the answer is no, so why would you think you can guess your own rate of return. And, even if you can, is that an average return, or a constant return. And, if it's an average return, what does that mean?

Oh, come on, idiot blogger, everyone knows what an average is.

Not so fast, there may be more than meets the eye.

I'm going to consider four scenarios as follows:

• In the first, I am going to assume to assume that you have 10 years to save, that you are currently earning $50,000 per year, that 5% of that will go into a defined contribution (DC) plan every year (on the first day of the year), that you will get a 3% pay raise every year, and that those funds will earn a constant 5% rate of return.
• In the second, you still have 10 years to save and you are still currently earning $50,000 per year. You are still going to get a 3% pay raise every year and you are still going to put 5% of your pay into your DC plan. And, on average (arithmetic mean), you are still going to get a 5.5% annual rate of return on your money, but I am going to throw some volatility into the mix. I am going to give your annual investment return a normally distributed standard deviation of 11%. In simple terms, this means that about 69% of the time, your actual annual return will be between -5.5% and 16.5%. Further, about 95% of the time, your actual annual returns will be between -16.5% and 27.5%.
• In the third, I will keep all of these assumptions the same, except that your average annual return will be 6% and your standard deviation will be 18%.
• Finally, in the fourth scenario, your average annual return will be 6.5% and your standard deviation will be 26%, with all other assumptions kept the same.

Before I give you the results of this analysis, I need to explain a few more of the details here. In scenario 1, since there is no variability, I need not perform more than one simulation. In the other scenarios, however, I have normalized the annual returns so that the arithmetic mean return over the 10-year period is, in fact, the intended arithmetic mean. Additionally, I have done this simulation 10 times each and then taken the average (arithmetic mean) of the 10 account balances after 10 years.

What do you expect the relationship between the four ending account balances to be? What do you expect will be the range of results in each scenario after 10 years? 

Scenario 1:

      Average account balance after 10 years:  37,403

      Highest account balance after 10 years:   37,403

      Lowest account balance after 10 years:   36,403

Scenario 2:

      Average account balance after 10 years:  36,387

      Highest account balance after 10 years:   42,024

      Lowest account balance after 10 years:   29,106

Scenario 3:

      Average account balance after 10 years:  38,641

      Highest account balance after 10 years:   48,640

      Lowest account balance after 10 years:   28,022

Scenario 4:

      Average account balance after 10 years:  38,662

      Highest account balance after 10 years:   57,439

      Lowest account balance after 10 years:   26,411

Interesting?

The volatility is essentially offsetting the improved investment returns. So, when you go to your recordkeeper's website and use their modeling tool, what rate of return are you going to assume? Do they give you a place to input assumed volatility? I'll bet they don't.

I'm sure your recordkeeper means well. They don't want to confuse you. But, are they really helping you to win the race to retirement? Or, does slow and steady win the race?

It's your retirement. You make the call.

Another Sub-Par Year for Target Date Funds -- What to do Now

The S&P 500 gained about 2% during 2011. The Barclay's Aggregate Bond Index had an increase in the neighborhood of 8% for 2011. According to a Morningstar survey as reported by the Wall Street Journal, the average 2015 Target Date Fund (TDF) lost nearly 1/2 of one percent during 2011. To state the obvious, that's not good. At the end of this article, I'll give you one take on a solution. Until then, we look at the problem.

What's going on here? Shouldn't a plan participant within five years of retirement expect to do better? Or, are the funds in the 2015 TDFs allocated so as to avoid any significant losses at the risk of giving up the upside?

I am not in a position to analyze the contents of every 2015 TDF out there. I know about a few of them from having looked at prospectuses, in some cases because I had the opportunity to invest in them myself. But, I have also discussed the makeup of some of these funds with people who either sell them or manage the investments.

DISCLAIMER: What I am discussing below here are purely generalities about the TDF market. I am neither condemning nor endorsing any particular TDF. Further, my comments don't reflect information about any particular TDF. What you read into what I say is at your own peril.

Whew, it feels good to get rid of that disclaimer. I hate those things. On the other hand, I don't want to get sued for making an innocent statement that gets taken the wrong way.

First off, most of the large TDFs are proprietary funds of proprietary funds. What does this mean? Well, suppose you are invested in a TDF offered and managed by WSWAARGIC (that's We Say We Are A Really Good Investment Company for anybody who was wondering where the firm got its name that just rolls off the tongue). We will call them WSW for short. Take a look inside the WSW TDFs. Each one uses WSW equity funds and WSW fixed income funds. In fact, 100% of the assets in the TDFs are actually in WSW funds.

Now, we all know that WSW is a good money manager. We know this because our employer wouldn't have chosen them if they weren't really good. Just how good is WSW, though? In looking a little bit deeper, we see that the WSW 2015 Fund is invested in 7 distinct asset classes through 7 WSW funds. Of those 7 funds, 4 have been top quartile over the last 5 years. That's pretty good. Another 2 have been in the second quartile over that period. That's not bad. But, the seventh fund has been in the bottom quartile. It's the so-called Core Bond Fund and it makes up a good portion of the allocation for the 2015 Fund. The problem is that WSW doesn't really have a fund to replace it in the TDF and WSW insists that this is a short-term blip and the Core Bond Fund will improve.

As someone who plans to retire in three or four years, how do you feel about this? I'd bet that you wish they had worked out the Core Bond Fund problems outside of the TDF and replaced it with some other company's core bond fund.

But, most TDFs don't work that way. The managers tend to look for what they think are the best available investment options WITHIN the proprietary group of funds. Some observers think that they may not even be looking for the best, but just the most expensive, but I'll leave that for the reader to decide.

I'm going to go under the assumption that if you as a plan sponsor are using a TDF as your qualified default investment alternative (QDIA) that you think it's the right choice as a QDIA. Even so, are you in the right TDF? Suppose that instead of a proprietary TDF, you had a custom TDF consisting of (we'll use 7 as the number again) seven funds in seven asset classes where all seven funds were relatively low-cost, yet historically high-performing funds that have not had recent manager changes or other disruptions. These funds exist. Morningstar might call them 5-star funds. With this TDF, you would need someone to help you set it up, manage it and rebalance it, but all that can be done. From a participant standpoint, they would get better funds for lower fees ... and isn't that what a 401(k) plan is supposed to provide?

I Wish I Had Such an Investing Mirror

Everyone seems to be coming out with new and groundbreaking research these days. Well, maybe not. Everyone is coming out with research, but perhaps it is neither new nor groundbreaking. I did read a different take on defined contribution (DC) investing at Wellington Management's website.

The summary of their piece suggests that an additional percentage point of investment return at age 55 is nearly 4 times more powerful than at age 30 because of the increased asset base. It further suggests that "[P]lan sponsors should be thinking about how to construct a robust menu of investment choices that will facilitate an improved investing experience and outcome."

Wow!

There are some great phrases in there. I hate to disparage this summary more than others, but take a look at those words: "facilitate an improved investing experience and outcome." Isn't that really the same as saying that plan sponsors should have a fund menu that produces better returns on investment?

Duh!

Back to the whole point of this blog post, though, and I may get fairly technical for a moment, generally, when a pool of assets is invested in such a way as to increase the likelihood of generating higher investment returns, this is done by taking on more risk. At older ages, this goes against conventional wisdom which says to take less risk. Let's take a more geeky look.

For years, much of portfolio analysis has been done, oversimplifying somewhat, using a normal distribution (bell curve) of occurrences, or if you prefer, a mean-variance model. By way of example, this suggests that if you have an investment with a mean rate of return of 7% per year with a standard deviation (square root of variance) of 9%, then your average (and most likely) rate of return is 7% and that roughly 70% of the time, your annual rates of return will fall between -2% and 16% (+/- 1 standard deviation). Suppose you take on more risk for more return so that your mean is now 8% and your standard deviation 11%, then roughly 70% of the time, your annual rates of return will fall between -3% and 19%.

I want to look at three concepts now that perhaps direct added risk to the higher return portfolio (beware, these may not be for the faint of math):

• Geometric versus arithmetic returns
• non-normal distributions
• fat left tails

Geometric versus arithmetic returns

Let's consider three sets of annual rates of return, all of which average out to 7% per year (add up the 10 years and divide by 10) on an account balance of $100 (no new money coming in):

1. .07, .07, .07, .07, .07, .07, .07, .07, .07, .07
2. .115, .105. 095, .085, .075, .065, .055, .045, .035, .025
3. .025, .035, .045, .055, .065, .075, .085, .095, .105, .115

In case 1, we wind up with an account balance of 196.72. In cases 2 and 3, we wind up with an account balance of 196.01. This is equivalent to an annual return of approximately 6.9614% which is less than 7.00%.

Suppose we add in annual contributions of $10 per year on the last day of that year. Let's see what happens then. Now, case 1 leaves us with an account balance of 265.80, case 2 with an account balance of 259.76, and case 3 with an account balance of 270.69. The average of cases 2 and 3 is an account balance of 265.23. From this, we can learn two things: 1) the additional risk decreases our expected final account balance; and 2) Wellington is correct that more leverage is attained from later investment returns, whether that leverage is positive or negative.

Non-normal distributions

So, you think I've been pretty geeky thus far. It's about to get more geeky. 

Perhaps there have been two reasons that we have historically assumed that investment returns have been distributed normally; that is, they follow a normal distribution. First, it's simple. Second, and far more technically, there is this wondrous concept in probability called the Central Limit Theorem. Oversimplifying a whole bunch, it says that a probability distribution of a number of random occurrences that is really, really big (apologies to Ed Sullivan) will revert to a normal distribution. Hold on, occurrences of investment returns are not random. They have outside influences. 

Fat left tails

So, if these returns are not normally distributed, how are they distributed? Well, we don't have an infinite number of occurrences to look at just yet, but real data suggests that the mode is somewhat right of center (the most common occurrence is a return higher than the mean), but that there are fat left tails (there are a significant number of occurrences (way more than 5%) that fall in the range that we would have expected under a normal distribution to be in the worst 5% of all annual returns.

So, if we return to our cases 1, 2, and 3 from above, there is probably more downside risk than our earlier calculations had demonstrated (I'm not going to re-do the math, just trust me on this one if you can't envision it). This implies that chasing higher returns later in life will give you a greater chance of retiring with a really big account balance, but on average, that same account balance will be lower. In fact, on average, it will be much lower.

Back to common sense

At the end of the day, you need to make your own investment decisions. If you think that you can increase your returns by taking on only tolerable additional amounts of risk, then this may be a good strategy. But, unless you really understand the risks that you are taking, don't go chasing after these additional returns late in your career just because you think you have a robust menu of investment choices that will facilitate an improved investing experience and outcome ... whatever that means.

Customizing Target Date Funds

A recent study conducted by PlanSponsor and Janus Capital informed me that only about 1/3 of 401(k) plan sponsors (I think the actual number cited was 34%) think that Target Date Funds (TDFs) are the best Qualified Default Investment Alternative (QDIA) available. A year earlier, 57% were so enamored. That means that during a year that TDFs did not perform badly, approximately two-fifths of those who were on the TDF bandwagon fell off.

Why is that? Frankly, I'm not sure. The survey didn't ask them. Could it be that participant reactions to poor account performance come about a year in arrears? In other words, is there a natural time lag that occurs before the plan sponsor gets beaten up that goes something like this?

• Account balances decrease meaningfully
• Participant sees quarterly statement
• Participant finds last quarterly statement and compares
• Participant figures out which investment option he is in
• Participant asks 10 best buddies who to complain to
• Between them, they narrow down to the right person
• Complaints start pouring in 
• Plan sponsor sours on TDF as QDIA

Even in the best of years, however, one could question whether TDFs are an appropriate default investment vehicle. In the Pension Protection Act of 2006 (PPA), Congress came to a four-step conclusion:

1. 401(k) plan Participants who don't make an affirmative election regarding their in-plan investments should be defaulted into an appropriate fund
2. That fund should not be the same for all participants
3. Instead, it generally should be appropriate and the same for all participants of the same age who think they will retire roughly at the same time
4. It should be constructed in a way that is appropriate for a participant of that age

It left a few options out there. The investment manager who develops the TDF gets to decide what is an appropriate asset mix. A firm who is both a recordkeeper and an investment manager can nearly force a lot of money into their TDFs (some do this far more than others). A TDF can be 100% proprietary; that is, the TDF created by Really Powerful Investment Manager (RPIM) can be nothing but a mix of RPIM funds that already exist. TDFs need not take any parameters other than expected retirement year into account.

This cannot be the best answer. I repeat, this cannot be the best answer.

When I become President of the United States, a majority of both houses of Congress, and Secretary of Labor, it won't be the answer. Don't hold your breath waiting for any of that to happen. Even if I were an otherwise likely candidate for any of those positions, that I speak my mind freely in a forum like this would disqualify me.

So, consider this, the hint of the century (bonus points if you know who I stole that from, I'll tell you later). Not all 37 year olds who think they will retire in 2040 are similarly situated. Some have savings. Some don't. Some participate in defined benefit plans. Some don't. Some are homeowners. Some aren't. Some have kids. Some don't.

Let's just assume that the tie between recordkeepers and investment managers is not going to be broken. If that's the case, then proprietary TDFs will remain widespread. It may not be perfect, but I just can't see the whole industry losing its religion (that's a big hint, by the way). But, suppose that RBIM is the recordkeeper for the 401(k) plan that I participate in. And, suppose that the TDF family run by RBIM was the plan's QDIA.

But, let's throw in a few changes. Let's throw in a modeler. Now, each 37 year old who thinks they are going to retire in 2040 is going to tell a computer model something about himself. And, the model is going to take all this information and build a more appropriate TDF for that participant. And RBIM will change the name of its company to Really Excellent Manager (REM). 

Oh, and if you are looking for the answer to the trivia question that popped up earlier, you already have it.