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The (K)oncept Plan - Model 2003A number of years ago an automobile manufacturer promoted the idea of a "concept" car. The perfect vehicle. The ultimate melding of industry technology and customer demands. A dream come true for a country in love with the automobile! America may still be enamored with cars, but it's infatuation with 401k and 403(b) plans is fading. Though there is no reason to reinvent a new model, many indicators suggest defined contribution plans need a major tune up. They need to be managed differently if they are to serve both the sponsors who want to use them to recruit, reward, retain and retire their employees and the participants who are increasingly relying on them as their primary source of retirement security. An "overhaul and a new paint job" will keep defined contribution plans running just fine without any need of introducing a new solution. The Problem Defined In a practical sense, most defined contribution plans aren't working the way many people envision. By three important measures, the majority of programs would not pass a reasonable inspection.
We will examine a number of practical solutions in the context of three of the major elements that make up a plan's operation: design, participant services and investments. Design This part of a program's operation has to do with selecting various features and provisions in the document that define how a plan operates. Outcomes can be significantly shaped by how the framework of a plan is structured. A. Automatic Enrollment: For an objective that is so desirable, plan participation, why do so many sponsors assume the more detrimental of two possible scenarios? People follow the path of least resistance. Companies can take advantage of innate human behavior and favorable government rules to increase participation. It works! However, this technique is not without drawbacks. The good news is that a concept called SMT (Save More Tomorrow) offers a ready solution. In simple terms, build in an escalation provision that raises the level of deferral a nominal amount each year until a person is saving at least 8-10% of their income. Few people will be bothered by the adjustment, particularly if it coincides with a pay raise. They can always say no. Has any person ever complained about getting too much money from a retirement plan? B. Matching Contributions: A sponsor can convincingly show employees it is serious about partnering with them by matching dollar for dollar the money a person saves. The match should be 100% vested. This strategy is not as painful as it appears. The match can be instituted gradually in conjunction with (and in lieu of) a pay raise. Payroll taxes are avoided with retirement plan contributions and most plans would gain "safe harbor" status. C. Loans: Loans create more problems than they solve. They drive up direct and indirect costs of servicing the plan. More importantly, they are detrimental to sound retirement planning. In the long run participants should be able to earn more on their investments than they get from paying interest to themselves. Too many people don't pay off the loans when they terminate, triggering phantom income tax liability. Doing away with loans will likely be viewed as a "take away." However, the loan policy can be amended to limit the detrimental aspect of loans while preserving them as a way to encourage participation. Allow only one loan available at a time. Let participants borrow for any reason but limit the amount to only what the employee has deferred. This approach will help set the stage for paperless loans that will lower both the direct and indirect expenses of maintaining a plan. D. IRAs: Far too many employees spend the money in their accounts before they actually retire. This "leakage" out of the plan is most noticeable when distributions are made to terminated employees. Recent availability of Sec. 408 (q) is a great opportunity to fix the problem. If IRAs are part of the plan and aggressively promoted, the odds are far greater that ex employees will preserve their retirement savings. To a great extent, this planning idea is consistent with the concept of automatic enrollment. Presumption of an activity causes inertia towards its actual occurrence. At every opportunity a sponsor should take advantage of behavioral psychology. Participant Services The sad truth is most employees cannot be satisfactorily educated about retirement planning and investing. This doesn't mean sponsors should not make an effort. There are reasons to take advantage of Department of Labor's Bulletin 96-1. But it is time to face the inadequacy of participant education and manage the plan accordingly. An interesting explanation of this problem has been submitted in the paper Defined Contribution Plans: Plan Rules, Participant Decisions, and the Path of Least Resistance (see the Bibliography). There is a serious disconnect between what people say they will do and what they actually accomplish. The understanding of people's behavior, not their intentions, is what should govern plan management. For sometime economists have been formulating theories defining what is now generally called behavioral economics. The current derivation of this academic work is called Prescriptive Economics. Broadly speaking, this latest model uses what we understand about human nature and devises tools to help participants achieve a more normal, useful solution to their retirement planning goals. Default Election The first option to shape investment behavior is defaulting new enrollees into a broadly diversified, well-balanced portfolio. This could mean the use of a "life-style" fund. However, an alternative solution is a custom designed portfolio made from the core investment choices. One advantage of this approach is the menu would not be cluttered with superfluous options. For the people who do not stay in the default allocation, the portfolio serves as an example of how the core funds can be properly blended together. More importantly, the extra expenses associative with life cycle options would be avoided. The custom portfolio need not be unitized. Contemporary record keeping systems permit liberal and easy rebalancing. The portfolio could be adjusted as often as monthly to maintain the desired allocation. This technique should not be used without the guidance of investment professionals serving as formal advisors to the plan. The customary allocation for the default election would generally be a 60/40 split between equities and fixed income funds. Year in and year out the majority of large pension funds deviate little from this traditional allocation. If this target is used by so many institutional pensions it should be a good enough starting point for employees. Several other portfolios (2-4) can be presented as companions to the default choice. That way other reasonable choices, with conservative and aggressive bents, can frame the default election. Investment Advice A balanced default allocation is an improvement over letting naive investors build their own portfolio. However, it doesn't fully meet the desires of the majority of people who want a tailored approach to their investment planning. There is no substitute for making available and promoting investment advice. Until quite recently, this approach has largely taken the form of Internet only providers. Experience has shown that few participants avail themselves of this resource for purposes of forming definitive investment strategies. The new and appealing derivation of advice includes a human element that is necessary for this service to be effective for the vast majority of people who want outright help. When the exquisite technology available on the Internet is married with human support, advice can be effectively implemented. Most people either want a knowledgeable professional to take control of the account or desire reliable parties to answer questions and generally render an intelligent second opinion. From a practical standpoint, advice also can be used to control the risk of using self-directed accounts. A sponsor may limit the use of these wide-open accounts to those participants who utilize the advice provider. The cost of investment advice can be paid from the plan account of the participant. Remember that the endorsement of a provider is a fiduciary act that should be done prudently. Investments Investments are the engine that runs retirement plans. If the assets don't perform then all the "fancy options and driving lessons" are wasted. Based on the lessons learned over many years of running defined benefit plans, it is disappointing how little attention is paid to investments in defined contribution plans. The good news is that there are three major steps fiduciaries can take to improve the investment component of their plans Proper menu design The menu must have enough of the major asset classes represented so participants can adequately diversify their accounts. This requirement is at the foundation of utilizing the fiduciary protection afforded from 404(c). While this is an issue investment professionals may quibble over, a well-rounded menu of asset classes should, to the extent practical, replicate the world's major capital markets. With this approach to constructing a menu, several fixed income options would be included. Numerous equity choices would also populate the menu. Certain non-financial assets could be deemed appropriate as well. In practical terms, the idea is to facilitate exposure to a broad spectrum of options that are demonstrably different in the pattern of their investment returns (negatively correlated). By some measures there are over sixty distinguishable asset classes. However, if six to eight of the major categories are on the menu sufficient diversification can be offered. Intelligent implementation Once the asset classes are selected, investment options need to be selected to fill each category. For a variety of reasons, the first, and perhaps the only, core choices should be passively managed index funds. The empirical research proving the efficacy of passive investing could fill a wing of a small library. In academic circles there is little dispute over the likelihood of indexing beating the median active manager over several market cycles. However, hope springs eternal so there is never a shortage of advisors and consultants who proclaim their ability to find a manager who will consistently and materially beat their benchmarked index. Can these money management firms really be identified prospectively? If so, will they work for your plan? Investment professionals will always debate this subject. However, there is one overriding reason for including indexed funds. There is a real danger that sponsors of self-directed defined contribution plans have become de facto guarantors of market level returns. If the actively managed options don't surpass the performance of passive choices a sponsor may be held liable for the difference in investment returns. Is this a bet you want to make? Indeed, index returns are typically used in litigation to calculate damages when a breach of fiduciary duty has been alleged. The only way to avoid this lottery is to put passively managed options on the menu. Practical presentation It is common knowledge that most participants are poor (make that bad) asset allocators. No matter eight or eighteen choices, the typical person uses no more than four funds. To add insult to injury, the initial election is seldom rebalanced. The logical way to fix this problem is to emphasize (or even make mandatory) carefully constructed portfolios representing mixtures of all the funds on the menu. Participants should understand that using one of the portfolios is the intelligent way to invest over the long haul. This technique helps assure most unnecessary risk is diversified away. With automatic rebalancing the only issue employees need to be concerned with is if the current portfolio still fits their long-term objective. Also, it is important to make a portfolio the only investment choice a person can select. Blending individual funds with a portfolio dilutes the benefits of intelligently designed allocations. The optimum way of capitalizing on the merits of portfolios is to integrate them into the investment advice solution. Summary Hopefully this article will stimulate thought by many sponsors. Most of these ideas will not fit every employer. However, heed the admonition from a twelve-step support group and "take what you can use and leave the rest." These concepts lead to desirable outcomes if the participants do little to affirmatively control their own destiny. With 401k plans, the path of least resistance can be the best route! The reality is that, consciously or not, a plan sponsor is the mechanic that employees rely on for help in keeping their accounts running successfully. Bibliography: Documentation to fully support the content of this article would be as long as the paper itself. However, the following resources contain the majority of proof sources that sustain the core positions. All are worth reading in their entirety.
### 401khelpcenter.com is not affiliated with the author of this article nor responsible for its content. The opinions expressed here are those of the author and do not necessarily reflect the positions of 401khelpcenter.com. | ||||
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