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.

Of Course It's Time for a Better QDIA

The Pension Protection Act of 2006 (PPA) brought us lots of new terms and concepts. One of the more controversial has been the qualified default investment alternative or QDIA. Essentially, what it did was to require participants who did not make affirmative elections otherwise in defined contribution (DC) plans to be defaulted into a QDIA. On an ongoing basis, and oversimplifying somewhat, the Department of Labor (DOL) regulations give plan sponsors three broad alternatives in selecting their QDIAs:

1. Age-based funds
2. Risk-based funds
3. Managed accounts

Our observations suggest that the most prevalent have been age-based funds, largely in the label of Target Date Funds or TDFs. In a nutshell, a participant picks a year in which they expect to retire, rounds to the nearest multiple of five, and voila, they have a fund. Or, in the situation where a participant is defaulted into a TDF, the plan document uses the same algorithm and without the active consent of the participant, his or her money is in a fund.

The companies that serve as both DC recordkeepers and asset managers love this. To my knowledge, they all have TDFs that they actively market as part of their recordkeeping bundles, and each of these families of TDFs are proprietary funds of funds. In other words, a Fidelity TDF is composed of Fidelity funds and a Vanguard TDF is composed of Vanguard funds. The same could be said about the other asset management firms who are also DC recordkeepers. Perhaps there are one or two out there that do not fit the mold, but I am not aware of them.

This is not to denigrate the current state of TDFs, but I think we can do better. And, so, in fact, do plan sponsors. In a November 2010 study commissioned by PlanSponsor and Janus Capital, only 34% of plan sponsors (down from 57% in November 2009) thought a TDF was the best QDIA available for their DC plan. Or, stated differently, nearly two-thirds of plans (clients) don't like the product that is being pushed upon them. If you were a car manufacturer and two-thirds of potential consumers didn't like your product, you would likely need a bailout. If you made computers and two-thirds of the users thought your machines had the wrong features, you would need to re-think what you were producing.

Well, the large players in the market don't appear to see the motivation to re-invent the TDF, so as I am wont to do, I am going to consider the re-invention for them.

Today, when a participant is defaulted into a TDF, the sponsor (and recordkeeper) uses one data item to make that decision -- age. You would think that was the only data point they had. Well, if Bill Gates and I were both in the same DC plan, we would probably both be defaulted into the 2020 Fund. And, trust me, Bill Gates and I are not in the same financial circumstances. I know you find this shocking, but it just isn't so. The fact is that we do not have the same net worth as each other (I'll leave it up to my readers to work out who is worth more).

But, assuming that we were active participants in the same plan, here is some other data that our plan sponsor would have on us:

• Compensation
• Years of service with the company
• Account balance
• Rollover balance
• Savings rate
• Gender
• Whether our jobs are white-collar or blue-collar
• Accrued benefit in a defined benefit (DB) plan, if our employer sponsors one
• Whether we are eligible for company-provided equity

Each of these is likely to have an effect on our readiness for retirement at any point in time. Let's go through them quickly to see how.

Compensation. That's an easy one, but in general, the more money that an individual makes, the more likely it is that they will be able to retire earlier as compared to later.

Years of service. Continuity with the same company tends to result in larger DC account balances and larger DB accrued benefits making it more likely that a participant will be able to retire at a younger age.

Account balance and rollover balance. The bigger your balance, the closer you are to your retirement goal.

Savings rate. The more you are saving, the less time it will take you to get from where you are to your retirement goal.

Gender. Without regard to other factors such as health and family history, women will, on average, outlive similarly situated men, and therefore need a larger account balance to fund their retirements.

White-collar or blue-collar jobs. Studies done by the Society of Actuaries have shown that white-collar workers outlive blue-collar workers. This suggests that white-collar workers need larger account balances at the same retirement ages.

And, the other two elements may do more to affect the appropriate asset mix for a participant.

Accrued benefit in a DB plan. Accrued benefits in a DB plan can be thought of as a fixed income investment. That is, their value grows (largely) at a discount rate. Having a large DB accrued benefit means that the remainder of a participant's account balance could, and perhaps should, be invested more aggressively.

Access to company provided equity. If a meaningful portion of your compensation is in the form of equity, then you tend to possess a significant undiversified asset. This would suggest that your TDF should have significant diversification.

Again, who has this data? Your employer, the plan sponsor does. Combined with age, this list of parameters could give your employer ten data points with which to appropriately place you in a TDF instead of one. In the coming world of TDFs, this is what should happen.

Perhaps the TDFs of the future will not have years attached to their names, but instead will have letters, numbers, or some combination of the two. And, perhaps, these ten data items (or others like them) can be used as part of an algorithm to place participants into their proper TDFs. 

Finally, while we are redesigning, do we really think that any one asset management firm has a monopoly on all the best funds? I don't think so. Without naming names, I have an opinion on some of the best fixed income funds available in the marketplace. Surprisingly enough (not really), none of the firms that manages those fixed income funds also has, in my opinion, the best large cap equity funds, international equity funds, and real estate funds. So, wouldn't our new age TDFs be better if composed of funds from a variety of providers? I think so. And, if we suddenly had reason to believe that the great-performing real estate fund that we were using in our TDFs might no longer be as great (the main portfolio manager decided to retire), wouldn't we like to have the ability to change real estate funds? I think so.

It's time. Who is going to start the trend?

If Not Target Date, Then What?

Last week, I wrote about a major problem with Target Date Funds (TDFs). I suggested that for many people, the targeting, and therefore the asset allocation, is incorrect. So, what would make it better?

The short answer, in my opinion, is that workers need to defer more income. And, the government needs to abet this process. Under current law, many individuals are limited in the amounts they can defer to a 401(k) plan. This occurs for one of a number of reasons:

• An individual bumps up against the statutory deferral limit of $16,500 ($22,000 including catch-up for those who will attain age 50 or older in that year)
• An individual bumps upon against a plan limit (usually put in place to assist in passing ADP and ACP testing (nondiscrimination testing for 401(k) plans))
• An individual defers as much money as the plan allows (or some other significant amount) and the plan is not able to pass ADP testing, so amounts are refunded

Those three reasons usually relate to higher paid people. For the lower-paid, they often cannot afford to defer enough.

I suggest that unless Congress (and the President) do something to both promote and provide an incentive for employers to sponsor more and more generous retirement plans, then employees need to better understand the plight that they face. Perhaps the government shouldn't build the model (suggesting outsourcing it here), but workers need to better understand how much they really need to save. Individuals need to be able to model their scenarios based on reasonable assumptions. They need to be able to input one-time and limited-time expenses. There should be suggestions as to assumptions with education as to why those assumptions (or range of assumptions) may be appropriate.

Then, perhaps, workers will understand when they will be able to retire. And, then and only then, might TDFs become appropriate as default investments (QDIAs) in 401(k) plans. 

Since ERISA was signed into law in 1974, the federal government, in my opinion, has done everything in its powers to gut the retirement income security system it claimed to be protecting. It's time for them to step up and tell the people how bad they've made it.