The end of the year is open-enrollment time for many 401(k) plans, with employees carefully weighing their investment choices and deferral rates. These are no small decisions; poor choices made today can result in a less prosperous future, as 401(k)s have become the primary retirement vehicle for millions of workers. By recent estimate, investors have nearly $4 trillion in 401(k) plans.
Employers can help new and current participants make the best choices by giving their 401(k) plans a thorough checkup. To help them with this task, we asked experts on defined-contribution plans for their advice on plan goals, fund mix, automatic enrollment, fees and more.
A Pathway to Retirement
“Five or 10 years ago, the attitude among plan sponsors was, we provide a solid plan for our employees, and it’s up to them” to take advantage of it, says Bill McClain, principal and intellectual capital leader for defined contribution at Mercer. “A plan sponsor might say that they have an 85% participation rate, and their deferral rates are above average.
“But ultimately, the real measure of a plan’s success is this: Does it provide employees with a secure financial future? Does it provide a pathway for employees to retire?”
Making sure a 401(k) can deliver adequate retirement income has become the number-one goal of many plan sponsors, says McClain. “There’s a lot of anxiety among employees about their financial future,” he says. “Until you dig a little deeper, you may not realize this. There may be a pocket of employees who aren’t deferring, or who should have started earlier and should be contributing more, or are taking money out for loans.”
Beyond concern for the welfare of their workers, employers have their own bottom-line interests in ensuring that 401(k) plans are performing at the top level. “There are productivity issues and workforce management issues when employees can’t afford to retire,” says McClain. “They incur higher health care costs.” Employees who stay at a company simply because they don’t want to retire are employees who are not engaged in the business, he says.
An Inviting Menu
A balanced 401(k) menu offers a variety of funds: equity and index, fixed-income, balanced, target-date (or life-cycle) and more. But such menus can be quite long in practice, and just as in a restaurant, the sheer number of choices can be overwhelming. The continuing trend in plan design, therefore, has been: keep it simple.
“Study after study has challenged the notion that more choice is better,” says Josh Cohen, defined contribution practice leader at Russell Investments. “Keep it limited to a few of the major asset classes. Research indicates that participants appreciate having a more manageable number of choices to choose from.”
Increasingly, plan sponsors are consolidating fund options. “Does a company really need two large-cap value funds? Pick one,” says Rob Austin, director of retirement research at Aon Hewitt. On average, a company has 15 funds in its 401(k) plan, according to Austin; the average rises to 25 if target-date funds, which come in five-year vintages, are counted separately. (Vanguard pegs the average number at 18; see “401(k)s by the Numbers,” below.)
Cohen says one asset class that sponsors should consider adding to the menu is real assets, which include commodities, real estate, and infrastructure. “They provide pretty good diversification relative to stocks and bonds, and they have a relationship to inflationary pressures,” he says. On the downside, real assets can be volatile and hard for participants to understand. Cohen recommends either embedding real assets into a target-date fund or building a portfolio of real assets as a stand-alone option.
As for offering company stock, sponsors should tread with care in the post-Enron era, warns Austin. Company stock has been the focus of many participant lawsuits. In October, International Paper settled for $30 million a seven-year-old lawsuit that alleged, among other things, that the company had violated its fiduciary duty by offering its publicly traded stock as a main investment option in its 401(k) plans. To keep everything above board, some experts recommend that sponsors hire independent fiduciaries to evaluate and monitor company-stock performance.
When should a plan sponsor pull the plug on a fund? “Some companies will look at its performance over a three-year period, others over five years,” says Austin. Sponsors should take care in determining how they will put a fund on a watch list, he says. “Are you going to do it strictly on a return basis or a percentile ranking? It has to be a balance of those—nothing hard or fast.” Context is key: in 2008, a fund that had a negative 10% return might have been a top performer in its asset class, Austin points out.
Default Choices, Deferral Rates
One in three plans have automatic enrollment, according to Vanguard. The main issue with automatic enrollment is not whether to offer it but what the right deferral rate is, says Cohen. Three percent is standard, he says, “but lo and behold, plan sponsors see that participants are still at that rate a few years later,” he adds. To overcome investor inertia, he suggests either starting automatic enrollment at a higher rate (5% or 6%) or automatically escalating the rate each year to a higher threshold.
The three qualified default investment alternatives for automatic enrollment are target-date funds, balanced funds, and professionally managed accounts. Nine times out of 10, companies choose target-date funds. Sue Walton, a director in Towers Watson Retirement Services, says she’s seen greater interest recently in professionally managed accounts, although there has been “more discussion than implementation.” “What makes managed accounts effective is the ability to customize them relative to a participant’s needs and risk tolerance,” says Walton. But the challenge of using managed accounts as a default option, she adds, is that many participants tend to be passive investors: “They’ve already been defaulted into the program.”
Hitting the Target
The approval of target-date funds as a default investment spurred their growing popularity. Half a trillion dollars are now invested in these funds, which automatically rebalance their asset mix from riskier investments like stocks to safer investments like stock as the investor ages.
But target-date funds have been under scrutiny by the Securities and Exchange Commission since 2008, a year when they fell in value by more than 20% on average and by as much as 41%. The dismal performance prompted the SEC to propose a rule in 2010 requiring more disclosure about the funds’ asset mix and “glide path” to retirement; the rule is still on the drawing board.
“There is a perception that target-date funds are still not as well understood as they should be by the average investor,” says Walton. They can confuse plan sponsors, too, since they vary widely in their construction, methodology and philosophy, says Walton, as well as their expenses. “Some tend to be very aggressive at retirement, with some pretty heavy exposure to equities,” she says.
In February the Labor Department issued guidelines (available on the department’s website) on selecting and monitoring target-date funds, emphasizing the importance of establishing a process for their selection. Walton says the guidelines provide a good opportunity for sponsors to go back and review the target-date funds in their plans, particularly if they were early adopters in the fund space, when there was limited choice.
Are target-date funds performing well today? “More yes than no,” says Austin. Aon Hewitt collaborated with investment adviser Financial Engines to study how 401(k) participants who received “help” (either invested in target-date funds or managed accounts, or used online advice) fared from 2006 to 2010. The result: their annual returns were nearly 3% higher, net of fees, than those of people who did not receive help.
Currently, target-date funds only take age into consideration; the next step may be customization for an individual’s risk tolerance and goals. “It’s what we call adaptive allocations,” says Cohen. “We’re spending a lot of time working on that.”
Fees: A Wake-Up Call
2012 saw the start of mandatory disclosure of plan fees, by vendors to plan sponsors and by sponsors to participants. Such disclosure “has had very little impact on participants themselves,” says McClain. “But it has been a wake-up call for plan sponsors.” Industry watchers say plan fees have trended down since fee disclosure began, while Mercer has seen an uptick in interest from companies in benchmarking fees, says McClain.
There are a number of sources for benchmarking fee data, but McClain recommends that sponsors put their plans out to market every two or three years. Surveys or searches for similar plans aren’t good enough, he says, “because plans are so different in terms of demographics, service requirements, how they’re set up in terms of assets, and so on. Get current market data on your plan.”
Experts recommend benchmarking record-keeping and investment fees separately. Many 401(k) plans over the past 10 years or so have followed a bundled model, where the service provider furnishes both record-keeping and investment management and calculates the fees for both as a percentage of assets. “We’ve seen a lot of arrangements where you pick the investment lineup and revenue sharing is used to pay for record-keeping costs,” says McClain. “We’re trying to decouple that.” Plan sponsors should negotiate fixed administrative fees based on head count, he says, a transparent arrangement that enables them to change fund options without having to renegotiate the administrative fees.