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With so much riding on 401(k)s, more and more companies are reconsidering their plan offerings.
Kate O'Sullivan, CFO Magazine
December 1, 2007
Mark Anderson is in the middle of overhauling his company's 401(k) plan. Anderson is the finance chief of Granite City Electric Supply Co., a Quincy, Massachusetts-based distributor with about 180 employees. The project began because he and the company's investment committee wanted better service from Granite City's 401(k) provider. But as they started reviewing the plan, Anderson realized there was another reason to change. "We offer something like 25 or 35 funds," he says. "It's excessive. People get overwhelmed."
Gone are the days when designing a 401(k) plan meant little more than offering every kind of fund under the sun and letting employees choose among them. Today, companies realize that the investment behavior of many 401(k) participants ranges from the discouraging to the downright frightening. Moreover, research has shown that offering a slew of options can actually stymie employee choice and hinder plan participation.
As a result, more and more companies are taking their plans back to the drawing board. The task is becoming increasingly urgent, as the oldest members of the baby-boom generation approach retirement armed mostly with 401(k) savings. Companies like Granite City are redesigning their plans with an eye to providing a more manageable and appropriate menu of investment options. They are striving to make their plans as balanced as possible, adding healthy new choices such as lifecycle funds and collective trusts. And they are monitoring their plans to make sure that funds don't drift from their stated goals.
There is also another reason for CFOs to revisit the mix of fund choices and structure of their 401(k) offerings: the Department of Labor has just released its final ruling on the types of investments deemed appropriate for automatic enrollment. Money-market and other stable-value funds, which many companies offer as a default option for employees, didn't make the cut. The three types that did: lifecycle funds, balanced funds, and professionally managed accounts. (The DoL approved capital-preservation products as qualified default options for only the first 120 days of plan participation.)
Given the DoL's blessing, lifecycle funds should become markedly more popular. Also called target-maturity or target-date funds, lifecycle funds first appeared in 1995 but have just begun to catch on in the last five years. Still, just 33 percent of employers currently offer them in their 401(k) plans, according to the Profit Sharing/401(k) Council of America.
Like balanced funds, lifecycle funds comprise a balance of stocks and bonds. Unlike balanced funds, they are managed to automatically shift their investment mix to an appropriate level of risk as the employee ages. Their names — such as "Vanguard Target Retirement 2020 Fund" or "Putnam Retire Ready 2045" — usually feature retirement dates, making it easy for employees to choose the right fund. While some criticize the funds as too conservative or not diversified enough, they should provide better growth over the long term than stable-value vehicles.
"If you are on the hook as the fiduciary, you're thinking, 'Let's get folks into an investment structure that is appropriate for their age and their time horizon,'" says Sue Walton, senior investment consultant at Watson Wyatt Worldwide. "[Lifecycle] funds are appropriate and consistent." Forty-five percent of employees invest in lifecycle funds when they're available, according to data from Hewitt Associates.
Some lifecycle funds used to charge up to 0.75 percent of plan assets to manage asset allocation for employees, but fees have come down significantly as competition has intensified. Now, some companies don't add a fee for asset allocation at all, and those that do generally charge around 0.5 percent of plan assets for active management. Many lifecycle-fund managers now offer lower-cost alternatives for institutions like 401(k)s, and some are offering low-cost index-based options whose management fees are closer to 0.2 percent of plan assets. When comparing lifecycle funds, plan sponsors should look at the total package of fees — both those for the underlying funds and any additional management fee, says David Wray, president of the Profit Sharing/401(k) Council of America.
Large employers can reduce fees further by creating their own customized lifecycle options based on the funds in their plans, rather than simply offering prepackaged funds from a provider like Fidelity or Vanguard. "If you've done your job as a plan sponsor, the fees on the funds in your plan are pretty inexpensive, and they should be good investment options," says Grant Verhaeghe, investment consultant at Aon Consulting. "You can create a fund that is better than one that simply invests in a proprietary family of funds."
Anderson says the move to lifecycle funds is the biggest change that Granite City is making to its plan. "[Employees will] get some growth over a long time horizon, and [their investments] won't be just sitting in a money-market fund earning the bare minimum rate," says the CFO. Granite City is making lifecycle funds the default option for its plan.
For companies that do offer lifecycle funds, investor education is essential. While some plan participants like to allocate some of their investment dollars to such a fund and spread the rest around, the blended nature of a lifecycle fund may cause the employee to end up overexposed to certain parts of the market. Employers should therefore encourage participants to either put all of their 401(k) dollars into a lifecycle fund or avoid the category entirely, say experts. "They should be an all-or-nothing proposition," says Verhaeghe.
Some employees also choose multiple lifecycle funds — for example, a 2020 fund, a 2030 fund, and a 2040 fund — in the mistaken belief that doing so is similar to choosing a mix of stock and bond funds and will thus yield better diversification. "That's a good sign there needs to be some education," says Verhaeghe. Employers can also structure their plans so that employees may choose only one lifecycle fund.
For more-sophisticated investors who want to make their own fund choices, employers should offer a selection of active and passive funds that span the risk-return spectrum. With a couple of index funds, domestic and international equity funds, a fixed-income option, and a stable-value or capital-preservation fund, employers can cover the critical bases required for diversification.
Yet, while experts have long recommended paring back 401(k) offerings to just 10 or 12 fund choices — and although studies have shown that employees often find a wide array of choices so daunting that they opt to do nothing — the average number of funds offered by companies remains too high at 18, according to the Profit Sharing/401(k) Council. "It's hard to take things away, and anything you take off the investment menu is viewed as a takeaway by participants," comments Walton. "Even plan sponsors still have the perception that more is better, even though data shows that having too many options leads to poor participation."
Depending on the demographics of the employee base, employers may decide to add a few (and just a few) specialized choices to their core offerings. For example, at Method, a maker of eco-friendly cleaning products, employees were polled about what they wanted in a 401(k) when the company established its plan last year. Perhaps not surprising, "the loudest response was from people who were looking for a socially responsible choice," says CFO Andrea Freedman. The company now offers a socially responsible fund as well as index funds, which employees also requested. Method offers about 15 funds in all.
At Aruba Networks, a Silicon Valley, California-based technology firm with a fairly investment-savvy employee base, finance chief Steffan Tomlinson says staffers clamored for more choice. As a result, Aruba's plan has some 15 to 20 funds, including a series of lifecycle funds and an international bond fund.
But companies shouldn't offer too many eclectic or trendy choices, because they often fail to perform well in 401(k) plans, which can have time horizons of as long as 40 years. Pamela Hess, director of retirement research at Hewitt Associates, cites real estate investment trust (REIT) funds as a specialty sector that doesn't work well in a 401(k) plan, because people invest in them when they are hot and then forget about them. "In any niche subsector or specialty sector like REITs, you get people chasing those returns, and then they don't get out and rebalance their account," she says. In general, retirement investors who are intrigued by specialty vehicles don't do well over time, says Hess. "They tend to buy high and sell low."
Keeping in Style
After selecting a mix of 401(k) funds, employers must also track them to make sure they are what they say they are. Some investment committees, after making their initial fund selections, fail to monitor fund managers' performance and behavior afterwards. But so-called style drift, in which a fund manager moves away from a fund's stated objectives and invests in securities outside the targeted sphere, can throw off a plan's asset allocation and leave employees unwittingly overexposed to certain market sectors.
While the problem has diminished somewhat as investors' awareness of it has increased, style drift is still common, particularly in midcap funds, say experts. Small-cap fund managers are often guilty of drifting into the midcap part of the market as their funds grow and they struggle to diversify their holdings, while large-cap fund managers dabble in the stocks of a few smaller companies, looking for the next successful large-cap. For this reason, Walton says she doesn't recommend any dedicated midcap funds to clients, since the sector is often overlapped by other funds.
To guard against style drift, companies' investment committees should regularly evaluate the funds in their plans and compare their performance with a style-specific benchmark — for example, a small-cap fund should roughly track the Russell 2000 index. "If your fund is significantly outperforming or underperforming that benchmark in a given year, that's a good indication that it may not be in the style you expected," says Verhaeghe. While a fund could outperform or lag its peers for any number of reasons, "you should be asking the reason why," he says.
One approach some companies are taking to both rein in costs and avoid style drift is to offer investment options through collective trusts instead of mutual funds. Collective trusts, which are ERISA-qualified vehicles that are only available to institutional investors like 401(k) plans, have long been used by defined-benefit plans. Because they are meant for an institutional audience that is highly attuned to the issue of style drift, collective trusts tend to be more style-pure than mutual funds.
Collective trusts have not been widely used in the defined-contribution market, because employers were concerned about the lack of public information about their performance, but the growing availability of fund data on company Websites and from financial-information providers like Morningstar has eliminated that obstacle. As a result, collective trusts are now starting to cross over into defined-contribution plans as employers focus more on lower-cost options, with 41 percent of plans using them in 2006, up from 32 percent in 2003, according to research from Morningstar and Greenwich Associates.
"In many cases, collective trusts have the exact same manager as a mutual fund, but they are a different type of vehicle," says Hewitt's Hess. Because they are not publicly traded, there are fewer regulatory and administrative costs associated with collective trusts, which results in lower fees. They also have more-flexible fee structures, with lower costs for plans with more assets.
For the Savviest
For the most sophisticated plan participants, some employers are now offering self-directed brokerage accounts within their 401(k) plans. While only about 18 percent of employers currently offer such an option, the number is growing, says Hess. Just 2 percent of employees use the brokerage option when it is available, but it is a good way to appease the savviest investors, who also tend to be the most vocal, she says.
"If you're making a big change in your plan and reducing the number of funds, there are going to be people in the plan who are downright upset, and it tends to be the people with the bigger balances," says Hess. The average user of self-directed brokerages has $100,000 in plan assets, compared with about $80,000 for the average 401(k) participant, according to Hewitt.
Users of the self-directed brokerage option typically pay a fee, and they may sign an agreement that acknowledges that the responsibility to research investments lies with them, not the plan sponsor. By providing the vocal minority with the option to invest in a wide array of funds or securities that have not been screened by the company, employers can then comfortably pare down their core plan offerings to the 10 or 12 funds that will meet the needs of most employees. Those employers who are concerned about the risk that comes with a self-directed brokerage account can set limits: employees may be restricted to investing only in mutual funds, or there may be a cap on the percentage of their contributions they can devote to the brokerage account.
For most companies, however, the greatest challenge of providing an effective 401(k) plan lies not with the savvy few, but with the unsophisticated many. The Labor Department notes that fully a third of eligible workers do not even participate in their companies' 401(k)-type plans. Revisiting a plan to make sure it has a reasonable mix of funds, and an approachable structure that will encourage savings and participation, is a good way to get those workers on board.
Kate O'Sullivan is a senior writer at CFO.
With guaranteed pensions rapidly becoming a thing of the past, 401(k) savings will be all many workers have when they reach retirement, aside from a Social Security benefit. But utilization and savings rates continue to lag far behind where they need to be to replace employees' incomes. Fidelity Investments, the 401(k) behemoth, provides the following statistics about the 10.1 million participants in its plans in 2006:
Source: Fidelity Building Futures VIII
The Best Mix
Retirement-plan advisers urge employers to keep their fund offerings simple so as not to scare off participants. For a streamlined but effectively diversified 401(k) offering, experts suggest choosing one or two funds from each of the following categories:
Four for Default
A new regulation issued in October under the Pension Protection Act specifies four qualified default investment alternatives for 401(k) plans:
Source: U.S. Department of Labor