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The much-maligned 401(k) plan is being beefed up. So are the penalties for failing to manage it well.
Randy Myers, CFO Magazine
December 1, 2009
Complain all you like about the 401(k) plan, but it is not going away.
True, 401(k)s have not proved to be the perfect substitute for pension plans. Workers tend not to use them to full advantage, and employers don't always follow best practices in designing them. Participants' account balances took a terrible beating in the market meltdown of 2008, jeopardizing the retirement ambitions of millions of aging baby boomers. When Time magazine recently devoted a cover story to "Why It's Time to Retire the 401(k)," it may have engaged in some journalistic hyperbole, but it also captured Middle America's growing angst over the fate of a critical long-term investment.
But there is good news: thanks to a raft of innovative new products, plan-design changes, and regulatory safe harbors, it is easier than ever to build a low-cost, high-performing 401(k) plan that gives your employees a fighting chance of achieving financial security in retirement, while simultaneously protecting you from missteps that could lead to messy and potentially expensive lawsuits. Automatic enrollment makes it easier to get people into the plans who might have neglected to join in the past. Target-date funds give them an easy way to invest in a professionally managed, diversified investment portfolio. And the Pension Protection Act of 2006, which led to the designation of certain approved types of funds as "qualified default investment alternatives" (QDIAs), offers a fiduciary safe harbor to plan sponsors, allowing them to make investment decisions on behalf of participants who don't make them on their own.
The bad news? Get any of this wrong, and you are more likely than ever to be held accountable for cleaning up the mess. Capitol Hill and the Department of Labor are in a race to drive down fees and drive up transparency in the 401(k) market, and however noble the intentions, any new rules they hand down will create new compliance challenges for plan sponsors.
Meanwhile, plaintiff's lawyers aren't waiting on legislators or regulators to drive change. Over the past several years they have filed dozens of lawsuits on behalf of plan participants alleging that plan sponsors failed their fiduciary duties. Among other things, they claim sponsors paid excessive fees to service providers and populated their plans with costly and underperforming investment options. Some of those lawsuits have been dismissed, but many others are still winding their way through the courts, and at least one ended in a settlement that cost the defendant tens of millions of dollars.
Whether you've got front-line responsibility for your organization's 401(k) plan or play an advisory role, here are four 401(k) trends to watch, and perhaps take advantage of, in 2010:
New Retirement Income Solutions
One of the biggest complaints about 401(k) plans is that they function purely as asset accumulation vehicles, with no mechanism for helping participants prudently draw down their savings in retirement. Over the past several years, a number of vendors have attacked this problem by introducing annuities that function as investment options within a plan.
Some work like variable annuities with guaranteed- minimum-withdrawal benefits: the participant is assured no loss of principal while saving for retirement, and can then take annual withdrawals equal to, say, 5% of their account value at retirement, even if their account balance subsequently falls to zero. Others are essentially deferred annuities that allow participants to purchase future chunks of guaranteed income. To date, these products have attracted limited interest from plan sponsors, but look for that to change as Congress, regulators, and vendors press for better solutions.
"Variable annuities have been quite successful in the individual market, but the ones applied to the retirement market to date have been retrofitted; they weren't originally designed to fit into a defined-contribution plan like a 401(k)," observes Charlie Nelson, president of plan provider Great-West Retirement Services. "Some say you have to be in the product for five years, or, if your plan sponsor changes providers, you lose your benefits. Or they might say we will refund your money if you leave. Well, I don't want a refund of my money; I want the guarantee."
Nelson says the next generation of products, including an offering from Great-West, will be designed to fit inside a defined-contribution plan and will take into account portability at the plan level. They will allow participants to invest in more than one company's investment option, lock in high points of the particular fund or target-date series in which they have invested, and then draw down that amount over their lifetime. Look for some of these second-generation products to debut this month or early in 2010, Nelson says.
Better Investment Options
In the wake of 2008's financial-market meltdown, many plan sponsors are reassessing their plan's investment lineup, beginning with the target-date funds that so many have installed as their default investment option. "It's the preeminent issue right now," says David Wray, president of the Profit Sharing/401(k) Council of America (PSCA), a nonprofit employer group. "Companies are definitely interested in seeing if they can do better with their target-date funds. It's not that they are unhappy with them, but they want to do better."
Much of the public criticism of target-date funds has focused on the "glide paths" they follow as they reduce their equity exposure over time (see "Are Target Funds on Target?" May). Some funds with a target date of 2010 lost 30% or more of their value in 2008, prompting complaints that they were overly invested in equities for participants nearing retirement age.
But a recent PSCA survey shows plan sponsors themselves are less concerned with glide paths than they are with the quality and cost of their target-date funds' underlying investments. Where target-date portfolios are invested exclusively in a vendor's own funds — and especially where those underlying funds are higher-cost, actively managed funds — some sponsors are wondering if they're getting the best possible investments or simply padding the vendor's revenue stream.
Earlier this year, Stanford University got rid of actively managed target-date funds it had been offering participants in its retirement-savings plan — along with more than 200 other actively managed mutual funds — in favor of target-date funds from Vanguard Group that invest exclusively in low-cost index funds. The plan's investment committee, says the school's vice president of human resources, Diane Peck, "collectively didn't feel it was appropriate" to continue offering the higher-cost, actively managed funds, although plan participants who want them can still access them through a self-directed brokerage window.
Meanwhile, some plan sponsors are leery of steering plan participants of the same age into the same target-date fund regardless of extenuating financial circumstances. For example, employees working for a company that offers both a 401(k) plan and a defined-benefit plan might want to take more risk in their target-date funds than employees working for a company that offers only
a 401(k) plan.
To address this issue, Great-West recently introduced a family of target-date funds that features a choice of three different glide paths and risk profiles for sponsors to choose from — conservative, moderate, and aggressive. To allay concerns about getting stuck with a vendor's proprietary funds, this new family of target-date funds also invests in 28 different underlying funds from 20 different investment managers, and offers a mix of both passive and active investment strategies.
"Managed accounts" are another investment option attracting the attention of plan sponsors. With managed accounts, an investment adviser slots plan participants into preassembled portfolios based on their age, expected retirement date, risk tolerance, and other personal financial factors. Like target-date funds, managed accounts are recognized by the Labor Department as QDIAs, and as such offer the same fiduciary safe harbor. Bank of America Merrill Lynch says that 24 of its 40 largest plan-sponsor clients — and more than 300 of the roughly 1,500 plans it manages — offer its managed-account service. And plan provider Standard Retirement Services reports that about 40% of the plans it is signing up as new customers this year are using its managed-account service.
Fees and Expenses
Washington's push to get more information to 401(k) plan participants about plan expenses will have repercussions for plan sponsors. The proposed 401(k) Fair Disclosure for Retirement Security Act would require that sponsors provide fee disclosures on investment options to plan participants, and while it has been pushed to the back burner by more-pressing legislative concerns, it is unlikely to go away for good, especially given the Obama Administration's enthusiasm for greater transparency in the financial markets.
In the meantime, the Department of Labor is still expected to finalize proposed new regulations that would, under Section 408(b)(2) of the Employee Retirement Income Security Act, require plan-service providers to make additional disclosures about the compensation they receive and any conflicts of interest that may exist among them and other involved parties.
For plan sponsors, one of the biggest challenges of these proposed disclosure requirements will be figuring out how to account for revenue-sharing and soft-dollar arrangements that are common among 401(k) vendors and present them to plan participants in a way that can be easily understood. Some plan sponsors may decide that the simplest way to do that is to eschew the types of investment options that enable those arrangements, such as mutual funds with lush expense ratios and 12b-1 marketing fees.
That might mean stocking your plan's investment lineup with low-cost index funds or even exchange-traded funds (ETFs). In fact, this disclosure issue was another reason Stanford opted to emphasize index funds in its investment lineup. "We wanted to be able to educate our employees about the importance of fees and how that played into your ability to accumulate money for your retirement," says Diane Peck, "and the fees for the actively managed funds were not as transparent as they needed to be."
ETFs are similar to mutual funds, but trade intraday on stock exchanges and are sold on a commission basis. They haven't captured a big share of the 401(k) market yet, in part because many recordkeeping systems aren't equipped to handle them, but they are making inroads.
"They're beautifully designed for the post-2008 world where perfect clarity on fees and costs, and where money is going, are important," says Michael Case Smith of Avatar Associates, a New York–based firm that manages about $250 million in defined-contribution assets. "When you buy an ETF, it's just like buying a stock — here's the cost, here's the commission. There are not a lot of opaque or hidden fees." His firm invests exclusively in ETFs, bundling them into collective trusts to ease administration and minimize trading costs.
Anyone inclined to dismiss the fiduciary liability associated with offering a 401(k) plan should think back to a case settled by First Union Corp. in 2001. The bank, acquired that same year by Wachovia, agreed to pay $26 million to compensate participants in its own 401(k) plan. They had argued that First Union had harmed them by considering only its own investment funds for the plan and by charging excessive recordkeeping fees.
There has been a wave of similar class-action lawsuits filed since 2006. Initially focused on revenue-sharing abuses, some have since been amended to include complaints that plans acted improperly by offering actively managed mutual funds rather than index funds as investment options, or by offering mutual funds instead of generally less expensive separate accounts.
To be sure, there is no law against offering actively managed mutual funds, which still capture more investment dollars than index funds. But now more than ever, plan sponsors that do offer them must be prepared to defend their decision.
It really isn't time to retire the 401(k). But it is time to retire any lingering notion that plan design can be treated lightly. It is vital not only to the future retirement security of your employees, but also to your own goal of offering a good plan without putting you or your organization in fiduciary jeopardy.
Randy Myers is a contributing editor to CFO.