How to Make Employees Take Their 401(k) Medicine
Source: New York Times
Author: Carla Fried
WITH more than $2 trillion invested in 401(k) retirement plans, it is hard to argue with their popularity. But a check under the hood of the 401(k), the primary retirement savings vehicle for Americans, shows a rash of problems that can send many plans back to the shop for overhauls.
A sizable minority of eligible workers - 30 percent - do not participate in company plans, 401(k) specialists note. That fact, they say, combined with meager savings rates of those who do participate, poor allocation choices and misguided corporate policy decisions are evidence that 401(k)'s are not operating on all cylinders.
"That may not be surprising, but it is concerning," said Lori Lucas, director of participant research at Hewitt Associates, a benefits consulting firm in Lincolnshire, Ill., "especially when you consider the increasing role that the 401(k) plays in Americans' retirement."
According to Hewitt research, 64 percent of plan sponsors who responded to a recent survey said that the 401(k) was now their company's primary retirement vehicle, up from 35 percent a decade ago. "Yet we have not seen a corresponding trend in the utilization of the plans," Ms. Lucas said.
The failure of many employees even to participate in their 401(k)'s - or to save enough in them for retirement when they do sign up - now has the attention of corporate boards. "A decade ago there was a laissez-faire attitude on the part of the corporate sponsor," said Russell K. Ivinjack, a principal at Ennis Knupp, a Chicago firm that provides consulting services to more than 50 defined-contribution plans. "Now we try to avoid the word 'paternalism,' but that's what is going on. Corporations are taking action to make sure the participant does what is needed to succeed."
It involves more than tinkering. "The paradigm has been fractured," said Stephen P. Utkus, director of the Vanguard Center for Retirement Research. "It used to be that we viewed the participant as the motivated manager, and the sponsor and plan provider would just supply the education. Now the participant is asking for help, not education."
It is easy to see why. "In the beginning it took me less than a minute to explain to someone how their plan worked," said Ted Benna, chief operating officer at the Malvern Benefits Corporation in Williamsport, Pa. Mr. Benna designed the first 401(k) plan in 1981. "Today if I tried, it would take forever to explain and I would still not get the job done well," said Mr. Benna. When 401(k)'s started, they offered one or two investment options, but many plans today carry 20 or more mutual funds, as well as company stock and self-directed brokerage options.
Starting in January, plans could have yet another option to explain: the new Roth 401(k), in which employees invest after-tax dollars but all withdrawals are tax-free. That can be an advantage over traditional 401(k)'s, in which contributions are made with pretax dollars but all withdrawals are taxed. The complexity of educating participants about this new twist, and the fact that the Roth option will expire in 2010 unless Congress extends current legislation, have dampened corporate enthusiasm for adding the Roth option to existing 401(k) plans.
Investors have also been less enthusiastic about managing their 401(k)'s since the bear market of 2000 to 2002. And overseeing a plan is also proving more difficult for companies. In the wake of the WorldCom and Enron meltdowns, which prompted huge 401(k) losses for employees who had company stock in their accounts, corporate boards are facing a steady stream of lawsuits challenging the suitability of having a company's own stock in a 401(k).
There is also a river of research showing how current plan policies fail to encourage participants' success. "All the behavioral finance research that documents the pull of inertia and inaction in our investing decisions perfectly applies to 401(k)'s," said Mr. Utkus at Vanguard. "In the past year or two, we are seeing sponsors and providers putting it all together and beginning to move toward 401(k) structures that address the shortcoming of human behavior." Companies are automatically enrolling workers in 401(k)'s, for example, and increasing their contribution rates over time.
Academic research also suggests that corporate boards have their own 401(k) shortcomings. Two finance professors at Emory University, Amit Goyal and Sunil Wahal, examined the hiring and firing of investment managers by about 3,700 plan sponsors from 1994 through 2003. (Professor Wahal has since moved to Arizona State University.) They found that companies tended to choose investment firms to manage plans based on the firms' recent returns, but that those managers tended not to beat their benchmarks after the hiring. And when companies dismissed firms after underperformance, the firm's returns tended to bounce back.
So far, the biggest shift is toward automatic enrollment of employees into 401(k)'s; in other words, the opt-in model is being supplanted by the opt-out. Hewitt says that 19 percent of corporate sponsors use an automatic enrollment system, and that an additional 47 percent say they plan to start using such a system soon.
Sponsors are also concluding that too much choice may not be good; while just 35 percent of plans surveyed by Hewitt in 2001 offered a lifestyle fund - a one-fund-does-all choice holding a mix of stocks and bonds - 63 percent offer this simplified solution today. "For the majority of participants this is the right choice," Mr. Benna said.
Another problem is that many employees who participate in 401(k)'s do not set aside enough money in them, specialists say. While the average amount saved is 7.9 percent of salary, some 22 percent of participants don't even save enough to get the maximum company match.
Corporate sponsors aren't much help. In plans with automatic enrollment, 58 percent set the participant's default savings rate at just 3 percent of salary, while 22 percent set it at 2 percent. An automated system pioneered by two leading behavioral finance economists, Shlomo Benartzi of the University of California, Los Angeles, and Richard H. Thaler of the University of Chicago, increases a participant's savings rate by one percentage point or so at each pay raise. According to the Profit Sharing/401(k) Council of America, a nonprofit group that represents the interests of plan participants and sponsors, about one-third of plans that offer automatic enrollment also now include an automated increase of the savings rate.
"Five years ago that was zero," said David Wray, president of the council.
Industry experts say corporate boards also need to change their approach to choosing their plans' default investment - the one used when participants don't indicate where they want their money invested. Many plans use a money market or stable-value fund as the default. That may appear to be prudent, but it is hard to meet one's retirement goals by earning just 3 percent annually in a money market fund. "Sponsors need to set the default to an age-appropriate mix of stocks and bonds," Mr. Ivinjack said. "It's the hardest decision a board has to make, but if you are adhering to long-term diversification principles, you can be comfortable with making that decision."
Company stock in 401(k)'s also remains an issue. In the past, many companies matched employees' contributions with company stock and restricted the workers' ability to sell it. After the Enron and WorldCom debacles, sponsors loosened the rules to allow employees to sell the stock and move the proceeds to other investments. Still, few people make the choice to opt out of what they are put into.
"There is still way too much company stock in 401(k)'s," said Rick Meigs, who runs 401khelpcenter.com, a clearinghouse of information for plan participants and sponsors. "It is inevitable we will see more Enrons."
THE growth in managed accounts is another controversial development. By signing up for a managed account, a participant cedes investing decisions to a third-party manager who charges an annual fee - typically 0.5 to 1 percent of assets. That fee is on top of the expenses of the plan's underlying funds, so the combined fees paid by participants can add up to a hefty 2 percent or more a year.
"I realize participants want help," said Matthew Gnabasik, a 401(k) consultant and the founder of the Blue Prairie Group in Chicago. "But my question for sponsors is, what's the best way to give them that help? An expensive managed account, or a lifestyle fund that is substantially less expensive and can achieve a lot of the same diversification?"
Mr. Ivinjack concurred, adding that only when the account manager charges 0.25 percent or less "does it become attractive."
Fees in general are the next big pressure point for corporate boards, many of which have not done much bargaining with plan providers. Mr. Wray of the Profit Sharing/401(k) Council says the emergence of consultants who focus solely on fees means that "more plans are going to get the haggle rate rather than the rack rate." That could be a boon for 401(k) participants.
"Sponsors are beginning to acknowledge that if you simply reduce plan expenses by half a percentage point a year," Mr. Meigs said, "it is going to have a sizable impact on participants' success."
