Author: Lori Lucas

Early in 2009, a plan sponsor blurted out during an investment committee meeting, “I just need to make sure there are no ticking time bombs in my 401(k) plan!”

The plan sponsor was reacting at the time to the onslaught of unexpected 401(k) investment bombshells associated with the 2008-2009 market collapse. These included cratering market-to-book value ratios in stable-value funds, money market funds that were “breaking the buck,” and material cash collateral reinvestment losses in securities lending funds. In essence, plan sponsors were finding that even their most staid investment funds were imploding, and that seemingly benign aspects of their plan were in crisis.

With many of the fires of 2008-2009 extinguished or at least under control, plan sponsors are now asking: What are the next ticking time bombs to avoid? Or to put it another way: How can we disaster-proof our plans against the next financial upheaval—whatever that may be? Here are some approaches under consideration:

Breaking out the inflation hedges: According to a recent Callan survey, Real Return/Treasury Inflation-Protected Securities (TIPS) funds are the most likely fund to be added to 401(k) plans’ investment fund lineup in 2010. Moreover, the role of inflation-protection vehicles such as TIPS, real estate and commodities is increasing in many target-date funds as well. The reason is simple: Many plan sponsors fear the potential for severe inflation in the longer term, due to the twin Federal Reserve policies of low interest rates and a flood of liquidity, as well as massive federal spending to stimulate the economy. TIPS are particularly attractive to plan sponsors because they also offer additional fixed-income diversification opportunities. The majority of plans have only two fixed-ncome funds: a stable-value and a core bond fund. Some plan sponsors now believe it could be attractive to broaden the array of fixed-income offerings for risk-averse 401(k) investors.

Exploring a better target-date fund solution: Prior to the market crisis, target-date funds were viewed as the ultimate set-it-and-forget-it 401(k) investment vehicles. That perception has changed because of the wide variance in target-date fund performance during the market collapse—especially among funds geared to investors close to retirement—along with recent legislative and regulatory scrutiny. Plan sponsors are now debating whether their target-date funds should be managed with significant equity allocations through retirement to guard against longevity risk, or managed with a goal of being free of equity risk at retirement (assuming that plan participants will annuitize when they reach age 65). Plan sponsors are wondering if their target-date fund series should offer multiple risk levels (e.g., conservative, moderate, aggressive) in order to meet the varying needs of participants. They are even rethinking naming conventions, in some cases shifting to “birth-date funds” or “lifetime funds” and away from the concept of a target retirement date in the fund name.

Downside risk protection and guarantees: Just a couple of years ago, paying for downside protection—whether options strategies or annuities—was viewed as a waste of money. Now, plan sponsors are taking another look at downside-protection vehicles. These run the gamut from products that use options strategies in order to limit downside to products guaranteeing participants a certain stream of income during retirement. The buzz is particularly loud when it comes to in-plan annuities, such as deferred fixed annuities and guaranteed minimum withdrawal benefit products. Indeed, in Callan’s survey, while only 7 percent of plan sponsors said they are very likely to add a guaranteed-income-for-life solution to their DC plans in 2010, 15 percent said they were “somewhat likely.” The idea of attaching a guarantee to the near- or in-retirement portion of the target-date glide path has particularly caught the interest of some plan sponsors.

Rethinking capital preservation vehicles: In 2008-2009, plan sponsors felt particularly vulnerable when it came to their capital-preservation vehicles. Stable-value funds and money market funds were touted as a “safe haven.” Yet many of these funds were not immune to the recent credit crisis. Now plan sponsors wonder if it is more prudent to strip away the appearance of stability when it comes to stable-value funds and simply provide a high-quality short-duration bond fund instead. Others are contemplating introducing a government money market fund as their capital preservation bedrock, despite the very low yields such funds offer. At a minimum, there is more care shown today than ever before about the way such funds are communicated to plan participants. For example, there may be more emphasis on stable-value funds’ inner workings and less emphasis on their guarantees.

Are such initiatives by plan sponsors reactionary or prudent? Probably a little of both. The reality is that stable-value funds generally made good on their promises, and there certainly was little evidence of participant concern regarding these vehicles. According to the Callan DC Index, 65 percent of all money flowing into the funds of DC plans during the fourth quarter of 2008 was directed to stable-value funds. On the other hand, market-to-book value ratios on many stable-value funds dipped precariously low in late 2008 and early 2009. (The ratio represents the value of the underlying fixed-income portfolio relative to the guaranteed redemption value to participants.) Currently, and probably for some time to come, stable-value yields are coming under increasing pressure due to more stringent credit-quality requirements within the portfolios and higher costs for insurance wrappers. For this reason, it does make sense for plan sponsors to at least examine the efficacy of their capital-preservation and fixed-income alternatives.

Similarly, target-date funds have historically been viewed as somewhat generic investments, when in fact they are highly complex. It is wise for plan sponsors to step back and re-evaluate their goals in offering target-date funds, re-examine whether their current funds fit the demographics of the plan, ask whether their performance has met expectations and determine whether they have been communicated properly.

As for inflation-protection funds and downside-protection or guaranteed funds, plans sponsors should ask themselves whether these are truly a fit for the plan, or merely a case of good marketing by investment providers. TIPS could offer good diversification potential, but the market is relatively thin, and there’s little U.S. experience with these funds during times other than those of low inflation. Guaranteed income-for-life funds hold considerable promise conceptually, but are marred by significant issues of counterparty risk, portability and cost.

There is one exciting finding brought to light by the recent Callan survey. Unlike last year, DC plan sponsors are prioritizing strategic initiatives, such as re-evaluating their fund lineup, ahead of tactical initiatives, such as monitoring manager performance. This means that sponsors believe their DC plans are on steady enough ground that they can begin to position them for the future. The concern, however, is that any initiative might be disproportionately affected by recent market events and concerns. Plan sponsors, consultants and other providers to the 401(k) market will all have to be on guard against reacting to events in the past, and instead implement approaches that look to the future.

Who should pay, and how? This is a debate Americans are having on many fronts—from health care to taxes. It is also a question that more and more 401(k) plan sponsors are asking about plan fees.

There are numerous ways that 401(k) fees can be paid: Plan sponsors can pay them; participants can; or fees can be shared between the two.

When participants pay for plan administration expenses, it is most commonly done through revenue sharing and other fund allocations. Under revenue-sharing arrangements, a portion of the expense ratio is allotted to the plan’s record keeper in order to offset administrative expenses. Not all revenue-sharing arrangements are created equal, though. And while some funds may offer revenue sharing, others may not. Indeed, according to a recent Callan Associates survey, nearly two-thirds of plan sponsors with revenue-sharing funds in their plan say that not all of the funds offered revenue sharing. Nearly 30 percent say that revenue sharing was offered by half of the funds or less.

Why does this matter? Take the case of a participant in hypothetical 401(k) Plan A. The administrative fees for Plan A are paid primarily through revenue-sharing agreements with the plan’s mutual funds. For example, Plan A’s International Equity Fund generates 35 basis points of revenue sharing, while the Stable Value Fund in Plan A generates 15 basis points. If a participant were to invest $50,000 in the International Equity Fund, he or she would contribute $175 annually to pay plan administrative expenses. However, if that same participant elected to invest in the Stable Value Fund, he or she would only contribute $75 annually to offset administrative expenses.

Like many plans, Plan A also could have funds with no revenue sharing at all. In this case, the participant could potentially invest in the 401(k) plan without contributing anything to plan expenses (although, of course, he or she would still pay the investment expenses of the fund). In short, because of variability in revenue-sharing arrangements across funds within a single plan structure, the payment of plan administration fees in Plan A isn’t likely to be equitable among participants. Depending on investment choices, in fact, some participants are undoubtedly subsidizing others within the plan.

Increased fee disclosure to plan participants that may result from pending regulatory and legislative initiatives has the potential to bring the issue of fair fee payment to the forefront. Uneven administrative fees can leave plan sponsors open to uncomfortable questions by participants, or may even bias participants against funds that carry the lion’s share of the administrative burden.

However, creating an investment menu with equitable administrative fees can be challenging. As we just saw, revenue-sharing arrangements—which are negotiated between the record keeper and the investment managers—are usually not consistent, and plan sponsors may have no control over share classes that are available to them.

For example, it may be that the international equity mutual fund in the example above has only one share class—the one that pays 35 basis points. That means that if the plan sponsor wishes to reduce or eliminate the fund’s revenue sharing in order to align it with that of the plan’s other funds, the plan sponsor’s only option is to replace the fund with a different international equity fund.

However, replacing a fund simply because of higher-than-average revenue sharing is hardly sensible if the fund’s overall expense ratio is reasonable relative to other funds in its category—and/or if the fund is meeting its performance objective. The various 401(k) fee disclosure bills that are making their way through Congress acknowledge that performance, not just fees, is important when it comes to 401(k) investments.

Another approach to reducing or eliminating revenue sharing is to replace funds with collective trusts or separate accounts. Indeed, fully unbundling the plan and eliminating all revenue sharing through the use of institutionally priced (non-revenue-sharing) mutual funds, collective trusts and separate accounts effectively eliminates the problem of uneven fee payment altogether. Administrative fees in the unbundled situation are then paid through a dollar-based per participant fee (e.g., $100 annually per participant); a percentage-based add-on administrative fee (e.g., a 10 basis point fee is assessed against every fund in the plan); or some combination of both.

The rationale for the dollar-based fee is that 401(k) administrative costs are largely fixed costs, so all participants should pay the same amount, regardless of account size. The rationale for the basis-point fee is that it would be unreasonably burdensome for an individual with a $1,000 account balance to pay the same $100 annual fee as someone with a $100,000 account balance.

According to Callan’s survey, 21 percent of plans are in a fully unbundled structure. Plan sponsors that unbundle their plans often find other benefits. Beyond making the plan’s administrative fee payment more equitable, unbundling can reduce overall plan cost. It can allow the plan sponsor to incorporate a broader array of institutional investment managers (including those within the defined-benefit plan). In general, unbundling the 401(k) plan can result in much greater fee and investment flexibility.

Of course, just as not all mutual funds are available in non-revenue-sharing share classes, not all have collective trust or separate account versions available. Also, the plan might be too small to qualify for the collective trust or separate account version of the fund. Even if the plan did have the economies of scale necessary, the plan sponsor might find the effort required to coordinate among the investment managers, record keeper and custodian daunting. In addition, the plan sponsor will need to be aware of potential additional costs associated with unbundling that are not factors in bundled solutions (such as separate account setup charges or fees for custom fund fact sheets).

If creating level administrative fees through the implementation of a fully unbundled approach is not possible, plan sponsors can still consider creating a more even playing field by selectively reducing or eliminating revenue sharing, and introducing a small per participant fee to offset administrative expenses. At a minimum, plan sponsors may wish to evaluate their comfort level with how revenue-sharing levels vary by fund within the plan. They may also wish to look into the possibility of greater participant disclosure around this topic.

Of course, communicating anything about fees and revenue sharing to plan participants can require a great deal of finesse—the last thing the plan sponsor wants to do is create confusion about or distrust of the plan. For that reason, the simpler and more concise the communication, the better.

General Motors, Goodyear, Frontier Airlines. As in past recessions, the list of companies that are suspending their 401(k) contribution grows longer every day.

Many plan sponsors recognize the drawbacks of eliminating their contribution to the 401(k), including reduced plan participation, potential nondiscrimination testing issues and weakened employee morale. A cut in the plan sponsor’s 401(k) contribution may even be interpreted by employees as a much broader intent by the company to permanently disengage from sponsorship of retirement income. After all, many companies have already reduced or eliminated pension benefits. Retiree medical benefits have also often undergone haircuts. Employees may very well wonder if the 401(k) plan is next to go. Behavioral research demonstrates that such a line of reasoning by employees may affect their on-the-job productivity.

Proponents of behavioral finance argue that benefits such as 401(k) plans enhance employees’ productivity by creating an interaction with the company that is more “social” in nature, and not just transactional or pay-related. Behavioral experiments indicate that the implied long-term commitment to the employee of such benefits may not only improve output, but may make people more willing to help others, act less selfishly, and be more team- and teamwork-oriented. Conversely, a movement away from such benefits can weaken the social fiber, reducing productivity.

In his book Predictably Irrational, MIT professor Dan Ariely cited one such experiment in social relationships, where people were asked to perform a simple task on a computer. Some of the participants were paid for the task (either 10 to 50 cents or $5); others were asked to perform the task as a favor to the experimenters. The experimenters found that those who did the task as a favor, regarding it is a part of a social relationship and not merely as a transaction, tended to work much harder than those earning 10 or 50 cents, and slightly harder than those earning $5 for the task. In other words, when the task was framed in a social way—as a favor to experimenters—it elicited greater commitment from the participants than when people were simply paid for their work.

Plan sponsors that need to cut their 401(k) contribution would be wise to consider the implications to the broader employer/employee social relationship, and take steps to counter this negative perception as much as possible. In particular, those who are committed to their 401(k) plan over the long term will wish to signal this commitment loudly and clearly. This can be done not only through explicit communication, but also by revisiting plan features. Steps to take include:

Communicate long-term intentions. Many plan sponsors who have cut the company contribution have already explained that the reduction is temporary. This telegraphs a longer-term dedication to the 401(k) plan by the sponsor. Continued, persistent communication in 2009 about the DC plan and the merits of saving will demonstrate concern about participants’ retirement well-being. Indeed, according to a recent Callan Associates survey, many plan sponsors are intending to increase communication/education to participants in 2009. According to the survey, 63 percent were going to increase communication in such areas as investing, plan participation and retirement income adequacy. With the use of e-mail, webinars and Internet postings, such communication can be a low-cost way of broadcasting continued support of the DC benefit.

Keep a residual commitment to the matching contribution. Studies have shown that even a tiny match can improve plan participation. If a cut to the match is required, plan sponsors may wish to consider keeping a residual match, or reinstating a residual match as quickly as possible. Even 10 cents on the dollar is better than no company contribution at all, and the small contribution can demonstrate that the company is doing what it can to help employees.

Break out the bells and whistles. Enhancing the 401(k) plan with features such as Roth contributions, investment advice and automatic rebalancing can provide a positive message and much-needed support. Unfortunately, according to a recent Callan survey, very few plan sponsors are considering adding such features this year. Just over a quarter (28 percent) have Roth IRA contributions, and only 1.6 percent are considering adding the feature in 2009. Just over a third (37 percent) offer investment advice, and less than 2 percent say they are very likely to offer it in 2009. Instead, plan sponsors say they are focused on other priorities, such as increased investment manager due diligence and compliance. This is understandable and important, but many plan enhancements can be relatively painless and low-cost to implement, and they can have a significant impact on the perception of the plan by employees.

Move ahead with automation. Likewise, the survey showed that few plan sponsors are adding automatic enrollment or automatic contribution escalation. Half of plans offer automatic enrollment, but only an additional 2 percent say they will add it in 2009. Just over a third (36 percent) offer automatic contribution escalation, with less than 5 percent planning to add it in 2009. For plans with a company match, the cost of adding automatic enrollment or automatic escalation may be prohibitive in today’s environment. But for plans without a company match, the reality is that automatic enrollment and contribution escalation will be the most effective ways of bolstering plan participation.

Ariely points out that once a social relationship is undermined, it is very difficult to regain it. Plan sponsors who see their 401(k) plan as a long-term investment in their employees will want to take this into account as they position any temporary reductions to their 401(k) plan or to any other employee benefits.

We can all agree that it feels good to close the books on 2008. But the new year will certainly hold its own challenges in terms of market volatility, economic change, regulation and legislation. Defined-contribution plan sponsors would be wise to take this opportunity to clean house and make sure their plans are best positioned in terms of design, delivery and communication. Here are 10 New Year’s resolutions we recommend:

    1. Stay on top of plan fees. New and pending regulation heightens the need to rigorously monitor, evaluate and benchmark plan fees on a regular basis. At the same time, market volatility has been a game-changer. With fund returns as poor as they have been recently, excessive fees become a glaring plan weakness. An annual, formal, documented fee review is essential.

    2. Take aim at the employer stock fund. According to the Callan DC Index, the company stock fund in the average DC plan has underperformed its diversified benchmark by 4.39 percent annually since the beginning of 2006. While it is not easy to eliminate a company stock fund from a plan—ironically, many participants tend to object—it is important to consider all options, including freezing the fund to new contributions, limiting contributions to the company stock fund or outsourcing fund management. At a minimum, education and advice around company stock should be a top priority in 2009.

    3. Clean up the fund lineup. Plan sponsors may argue that today’s market volatility makes it difficult to eliminate unwanted “legacy” funds, streamline the fund lineup, or even replace poor performers. In fact, current market conditions can be viewed as providing a unique opportunity to take a clean-sweep approach. After all, a lot has been learned about the markets in 2008, and it is highly prudent to implement those lessons by repositioning the investment fund lineup as needed.

    4. Reconsider mutual funds. In a recent survey, Callan found that plan sponsors ranked shifting to collective trusts and separate accounts as their third-least likely activity for 2009. Yet, because they have so much less overhead than mutual funds, collective trusts and separate accounts can be a cheaper way of accessing investment managers—sometimes by as much as 30 to 40 percent. Plans don’t need billions in assets to benefit from these vehicles, and many of the perceived weaknesses of separate accounts and collective trusts are more myth than fact. For example, plan sponsors often worry that participants will complain that collective trust and separate account performance is not listed in newspapers. However, a survey by AllianceBernstein found that the majority of participants seek fund performance information from their quarterly statements and plan Web sites.

    5. Think outside the investment provider box. Two-thirds of plan sponsors report using the proprietary asset allocation funds (risk-based or target-date) of their record keeper. And yet target-date funds are far from commodities. Their equity allocations can vary dramatically. Some restrict themselves to the most basic asset classes, while others diversify with highly esoteric asset classes. The list of significant differences goes on and on. Given all of this—and especially in light of the current market volatility—plan sponsors would be wise to evaluate whether their target-date funds are the right fit for their plan’s needs. Some larger plan sponsors have even taken the opportunity to customize their own target-date funds based on their existing fund lineup. This is truly thinking outside the investment box, and may make sense for many larger plans.

    6. Embrace automation. One thing is certain today: DC participants are going to need to be better investors than ever in order to reach their retirement goals. They’ll need to save more, diversify better and stay the course with their equity allocations, despite market volatility. Creating a workforce of super-investors is unlikely. But plan sponsors can make it far easier for employees to succeed by automatically enrolling them into their plans and tying in automatic step-up features. The twin efforts of using asset allocation funds as a default, and offering automatic rebalancing for those who do choose to create their own portfolio, can bolster investment outcomes.

    7. Audit your compliance. Three-quarters of 401(k) plan sponsors consider their plans ERISA Section 404(c) plans, meaning the plan sponsor is responsible for selecting what investments are in the plan but participants are responsible for their own fund choices. Many industry observers believe, however, that the actual number is considerably lower due to lack of compliance. Likewise, if your plan is a 401(k) plan, it probably has a qualified default investment alternative (QDIA), which also receives the 404(c) safe harbor. However, if the QDIA is not properly vetted, communicated and implemented, the safe harbor may be providing plan sponsors with a false sense of security. Companies need to thoroughly review the plan’s compliance with 404(c)—particularly around the QDIA.

    8. Step up monitoring procedures. After the events of 2008, due diligence must surely be the new buzzword. Many plan sponsors report increasing the frequency of investment committee meetings and improving their documentation of meeting minutes. When the markets are changing as rapidly as they have been, such actions may be prudent. At a minimum, though, plan sponsors will certainly wish to review their investment policy statement, making sure that it is complete and thorough—and also making sure that the investment committee is adhering to its principles. It is important to remember that an investment policy statement can be a double-edged sword. It can be a fiduciary’s best friend in ensuring a rigorous investment selection and monitoring process. Or, it can be a fiduciary’s worst enemy if it is not being followed.

    9. Increase educational support. If DC participants felt ill-equipped to make investment decisions going into 2008, then going into 2009, they are undoubtedly even less confident. Stepping up communication and education is another important item on the resolutions list. This should include communication that explains market volatility, discusses the stability of the plan’s record keeper, and underscores sound investment principals. Now is also a good time to take advantage of the Pension Protection Act’s support of advice, and add an online advisory service. With loans and withdrawals on the rise, proactive communication on those topics is also likely warranted.

    10. Stop plan leakage. As layoffs mount, plan sponsors should embrace an active policy when it comes to terminated participants. It’s possible that the best course of action is to encourage participants to remain in the plan, keeping costs down for everyone. Rollovers should be made as flexible as possible. Commonly, the record-keeping platform makes it easy to roll into the record keeper’s IRAs, but very difficult to roll into other, potentially more attractive IRAs. Plan sponsors might also want to consider allowing loan payments to continue after termination, as another way to keep retirement monies in the retirement system.

    If much of these recommendations sound familiar, it’s because a number of them were outlined in the House Education and Labor Committee’s plan to preserve and strengthen 401(k) plans. That’s a reason to not only make these resolutions, but to keep them.

For 401(k) plan sponsors, these times may seem like the ultimate test. Just as many employers have put in place automatic enrollment programs for their 401(k) plans and added target-date funds as defaults, markets across the board have cratered, leaving benefits-center phones blaring. So now what?

    Right now, the best action for plan sponsors is to keep a cool head. That, for the most part, means business as usual. Are the plan’s funds behaving as expected on a relative basis? Are the service providers sound? Are participants getting the right messages?

    Still, the current market turmoil does create a few wrinkles.

    For example, many plan sponsors will find that this is the first major market decline ever experienced by their target-date funds. Even target-date funds that have been around for a full market cycle have, in many instances, experienced dramatic changes to their investment approach over the past several years, effectively making this their first bear- market test. What expectations were laid out in terms of how the target-date fund would navigate such an environment? Is this claim playing out in terms of actual performance? Is the target-date fund’s exposure to certain markets and certain sectors in line with expectations relative to their stated glide path? And if not, what rationale does the fund manager have for the change in strategy?

    Stable-value funds are another unique animal, and particularly challenging in the current environment. Like other short- duration bond funds, the underlying investments in many stable-value funds have not performed well. Now more than ever, it is important for plan sponsors to require extreme transparency and to closely monitor the performance of the underlying investments within the stable-value fund. Other crucial steps include evaluating the type of insurance wraps (which provide the stability of the stable-value fund) used by the investment manager and understanding the scenarios under which the wrap providers supply protection to the fund.

    If the plan has a money market fund, the plan sponsor will want to understand whether the fund is participating in the U.S. Treasury temporary guarantee program for money markets, and just how important that participation is. For example, are the underlying securities of the money market fund impaired? Or is the guarantee important to participants just from a psychological perspective?

    Essentially, what plan sponsors are looking for here are red flags that indicate a fund change may be required. Either way, it will be prudent to formalize this due diligence so that a written record is maintained showing that a thorough review was undertaken. In a similar vein, now more than ever, it will be important to make sure that an up-to-date investment policy statement is in place. Among other things, it can help guide the investment committee, and keep decision-making rational.

Reacting without overreacting
   In some instances, reacting quickly and decisively to the current environment really is necessary. For example, is the plan’s record keeper exposed to or affiliated with a financial services company that has collapsed, been purchased, or is teetering on the brink? If so, it will be essential to promptly examine the potential impact on plan delivery. Plan assets, of course, won’t be at risk, given that they are held in trust for participants. However, serious service disruptions could be possible. At a minimum, a due diligence meeting should be conducted. It may even be necessary to undertake an actual record-keeper search.

    In a measured way, plan sponsors will also want to take the current market environment into account in the execution of any plan changes. This is not to say that plan sponsors should be reluctant to proceed with strategic plans to replace a fund, change the composition of the fund lineup, or even implement a new record keeper. It is impossible to predict when the market will be calmer—and for how long. However, it is still important to recognize that market volatility is likely to cause plan participants to be hypersensitive to changes, and this should be taken into account.

    For example, plan sponsors who are seeking to eliminate a company stock fund will wish to be especially cautious about allowing ample time between the announcement of the change and the actual event itself so that participants can understand that the move is strategic, and so that they can choose how and when to transfer the money on their own. This might also be a time to consider cutting-edge approaches such as the Shlomo Bernartzi’s “Sell More Tomorrow” program, which is effectively a mechanism to dollar-cost-average over time out of employer stock.

    Even when it comes to diversified funds, participants may be susceptible to concerns about “locking in their losses” within funds that are being replaced due to performance (or other) issues. This may tempt the plan sponsor to freeze the fund instead of replacing it. However, it is difficult to rationalize why a fund that is not suitable for ongoing contributions is a reasonable place for existing participant monies. Further, the 2006 Pension Protection Act did provide considerable guidance (and protection) around fund mapping, which should provide plan sponsors with some comfort. Again, communication will be key. Given the current circumstances, plan sponsors may wish to allow more time than usual to communicate fund changes, and to allow participants to move monies out of the fund prior to the mapping exercise, if they choose.

    Note that none of these recommendations involve changing plan features or investments in reaction to short-term market volatility. For example, it may be tempting to replace or augment the plan’s stable-value fund with a money market vehicle. But is the addition of such a vehicle really consistent with the long-term focus of the retirement plan? Is it even feasible, given 12-month put options and other limitations that tend to be in force? Likewise, it may seem appealing to add a low-correlation gold fund in hopes of improving diversification. However, plan sponsors will recall that it might also have seemed like a good idea to add a technology fund in 1999 and an REIT fund in 2005. Adding “hot” funds often simply leads to market timing by participants, not improved diversification. Also, plan sponsors could inadvertently send a message about the market to participants through such changes. In the example above, the addition of a money market fund could suggest to participants that the plan sponsor believes this is a good time to get out of equities.

Preventing participant panic
   Of greatest importance, perhaps, is the need for plan sponsors to allay the fears of participants by providing them with a context for what they are seeing in the markets. Record keepers have not been reporting an all-out panic by participants, but they do indicate that benefit-center call volume has risen significantly, Web site hits have soared, and transfer activity from equity to fixed-income funds is higher. Many record keepers have already posted content to their Web sites on topics ranging from historical market volatility (e.g., the 1973-1974 bear market and subsequent recovery) to how stable the record-keeping organization is. Participants also need to be reassured regarding the fact that they ultimately own their 401(k) account—not the company or the record keeper. Concepts such as how the plan’s funds work, the dangers of market timing and the concept of rebalancing will also need to be reinforced.

    Above all, it will be important for plan sponsors to lead by example, and keep a cool head in what is clearly a very challenging environment.

Very often, 401(k) plans are referred to as nest eggs. For some plan participants, however, they are more like sieves—money flows in, but then flows right out the other end.

    This issue was recently brought into the limelight with the controversy over 401(k) plan debit cards. These cards provide participants with easy access to 401(k) loans, and were dubbed a “gross distortion” of the intent of 401(k) plans at a July 2008 hearing by the Senate Special Committee on Aging.

    Although 401(k) plan debit cards are not widely used, they do symbolize a valid concern: What is the point of increasing participation in 401(k) plans through automatic enrollment, automatic escalation and the like if the monies simply leak out?

    As David John and Mark Iwry of the Retirement Security Project put it at the hearing, “It won’t matter how tightly we lock the front door of the barn if the horses are free to run out the back.”

    The reality is, though, when it comes to 401(k) plan leakage, loans may be a relative trickle. A Transamerica Retirement Services survey finds that loan utilization has increased in the past few years, but less than one in five participants have loans outstanding. Almost all participants who take out loans repay them. And according to Hewitt Associates, among those with loans, the average outstanding loan balance is $7,800.

    What causes that trickle to become more of a torrent is what happens after employees leave their companies. Often, when this occurs, nearly half of them simply take their 401(k) assets in the form of cash. The number is much higher—66 percent—for younger employees, according to Hewitt Associates.

    Now consider that figures from the Department of Labor put the median job tenure for workers ages 25 to 34 at less than three years. This creates the specter of many people reaching their 40s with little retirement savings—despite perhaps having actually participated in their defined-contribution plans for a number of years thanks to being automatically enrolled.

    Among those who do preserve their retirement savings, many participants roll their money into an individual retirement account versus leaving their money in the 401(k) plan or rolling it over into another 401(k) plan.

    Internal Revenue Service data shows that rollovers to IRAs from employer-sponsored plans are the main source of new cash flowing into IRAs. Yet the fees associated with retail mutual funds typically used within IRAs can be significantly higher than that within 401(k) plans.

    Consider a participant who has access to an institutionally priced S&P 500 index fund within a 401(k) plan that costs as little as 2.5 basis points per year. The average retail S&P 500 index fund’s expense ratio exceeds 60 basis points. Compounded over time, such a wide differential in fees can have a tremendous impact on retirement accumulation.

    Why should plan sponsors care? After all, is it really their responsibility to ensure the retirement income security of people who are no longer in their employ? Further, do they really wish to have fiduciary oversight over former employees’ assets?

    Some plan sponsors will care because the defined-contribution plan is the only retirement-income vehicle that they provide to employees. The idea of former employees marching toward old age without any employer-provided retirement benefits may be very much at odds with employers’ goals in offering a defined-contribution plan in the first place.

    Other plan sponsors may recognize that it can be in the best interest of both current and former employees to encourage terminated and retired workers to stay in the plan. After all, increased plan assets mean greater economies of scale that could translate into reduced plan fees, better access to institutional money managers and even improved administrative services.

    What can plan sponsors do to keep people in the 401(k) plan once they are no longer with the company? One thing is to emphasize the benefits of the 401(k) plan throughout the tenure of an employee’s career.

    When employees leave or retire, plan sponsors may wish to reinforce these messages, with a view to countering the barrage of propaganda from IRA providers. Plan sponsors may even want to consider features that may make the 401(k) plan more attractive to former employees (and current employees as well).

    For example, some online tools can simplify participants’ financial lives by providing an aggregate view of all of their investment accounts (including outside brokerage accounts) through the defined-contribution plan’s Web site.

    Other tools include drawdown technology, which provides a way for retirees to receive a “paycheck” from their defined-contribution account. Periodic payments are made from the participants’ account to the participant on a regular basis, based on employees’ needs in retirement, and the balance available in their account—all of which the drawdown tool calculates.

    Finally, if the plan simply allows partial distributions, this in itself may broaden the plan’s appeal.

    Even if plan sponsors do not wish to actively retain former employees in the 401(k) plan, they can do much to help them avoid cashing out at termination. This might include providing them with statements showing how much they would have at retirement, even for the smallest of balances.

    Plan sponsors could provide employees with calculations that show the impact of taxes and penalties on withdrawn amounts. Further, more and more record keepers support “one-click” rollovers by having the record-keeping system connect directly with the systems of rollover providers. This can greatly streamline the often onerous rollover process, which itself can be an obstacle to rolling over plan balances. Again, any communication should start early, and should be reinforced when an employee leaves the organization.

    The weakened economy, higher oil prices and increasing foreclosures mean that 401(k) plan assets are more vulnerable than ever to leakage. Although there’s no widespread evidence that a run on 401(k) plan assets is occurring, certainly there are pockets of real concern. This has clearly caught the attention of regulators, who are already taking steps to plug up the holes.

    When it comes to helping employees maintain assets for retirement, what sounds like employer paternalism today may well turn out to be a requirement in the future.

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It is the rare plan sponsor who believes that defined-contribution plan participants have done a good job of investing. Indeed, the statistics remain grim: According to Hewitt Associates, at the end of last year, nearly two of every five 401(k) participants had 20 percent or more of their money in employer stock. Younger employees tend to be overly concentrated in stable value. Participants have been known to diversify by investing equally (and naively) in all funds in the plan. Others simply chase investment performance to their own detriment.

    Plan sponsors have recognized all of this and reacted by aggressively adding and promoting professionally managed asset allocation funds within their defined-contribution plans. The Callan DC Index finds that 89 percent of plans offer an asset allocation fund, with more than 60 percent of those being target-date funds. A good number of plan sponsors have gone even further and defaulted new participant money into such funds through automatic enrollment.

    Plan sponsors typically do so with the understanding that participant assets are likely to remain in these funds because of inertia and other factors. In fact, many would consider this a desirable outcome—or at least preferable to the outcome of participants making poor investment choices on their own.

    A logical next step for plan sponsors is to re-enroll existing participant balances into these asset allocation funds. After all, if such funds are a reasonable approach for new participants, wouldn’t they also be suitable for existing balances? Yet in a recent survey, Callan found that only 5 percent of plan sponsors planned to engage in a re-enrollment of their plan in 2008.

    Re-enrollment is essentially the same as “rebooting” the plan. It is a way of unwinding all of the poor investment decisions that plan participants have made in years past. It is also a way of seeing to it that existing participants more fully benefit from a plan that may look very different—and much more investor-friendly—from the plan in which they initially participated.

    The virtues of a reboot range from potentially dramatically reducing exposure to company stock to increasing the economies of scale (and possibly reducing fees) in the plan’s asset allocation funds.

    There are several reasons why reboots are still rare. One concern frequently raised by plan sponsors is that rebooting involves unwinding the active investment choices that participants have made, as well as shifting defaulted monies.

    This may be uncomfortable from a fiduciary perspective. Plan sponsors, of course, will have to rely on their own legal counsel for the ultimate answer regarding any possible fiduciary risk attached to re-enrollment. However, it is worth noting that the Pension Protection Act contains a number of provisions that provide ERISA Section 404(c) safe harbor protection for fund mapping and investment defaults.

    The provisions provide guidelines on notification requirements, specify what constitutes a qualified default investment alternative, and provide a framework for appropriate fund-to-fund mapping. In other words, the Pension Protection Act appears in many ways to support re-enrollment.

    And what about those active participant elections? Is it fair to change them? Studies have shown that even when defined-contribution plan participants make proactive choices, their investment preferences are weak at best.

    Professors Shlomo Benartzi of UCLA and Richard Thaler of the University of Chicago found in an experiment that participants unknowingly rated the average portfolio of their fellow employees equal to their own portfolio, and judged the median portfolio of their fellow employees to be significantly more attractive than their own.

    Indeed, only 20 percent of the participants in the experiment preferred their own portfolio to the median portfolio. In other words, even participants who make active choices don’t appear to do so with much conviction. Few participants tend to rate their own investment knowledge very highly, and many will admit that their investment choices were a guess. Often these choices were made at a time when the fund selection was vastly different from the way it is today. They were made, for example, before asset allocation funds were even available.

    Why does this matter? A Hewitt Associates study found significant delays in the use of new funds by existing participants. According to the study, it took more than three years for more than half of existing participants to use newly added funds. It took less than three months for more than half of new hires to use the new funds.

    Plan sponsors also worry about angry calls to their service center in response to shifting participant monies—especially in volatile market conditions. It is probably true that call volume will increase during a re-enrollment. However, consider the experience of one plan sponsor who recently re-enrolled participants from a balanced fund to a series of target-date funds. As a result of the change, the record keeper’s service center did experience a 30 percent increase in calls compared with the same time period a year earlier.

    Still, the plan sponsor reported that overall participant reaction was positive and supportive of the new program. Most important, the vast majority of participants allowed their assets to be defaulted into the target-date funds.

    Plans that are the best candidates for some form of re-enrollment are those whose participants would not generally be characterized as investment savvy. In other words, re-enrollment is generally likely to be better suited to a retailer than to a financial services firm.

    Plans that are engaging in a reshuffling of their fund lineup may also wish to take the opportunity to re-enroll or reboot, rather than to simply map assets from old to new funds. The rebooting solution may also make sense for plans with clear diversification issues, such as plans with an overweighting in company stock, stable-value funds or sector funds.

    It wasn’t so many years ago that features such as automatic enrollment, advice and target-date funds were considered aggressive and cutting edge. Plan sponsors harbored all the same worries about such features as they do today when it comes to re-enrollment and rebooting.

    However, today nearly half of plans offer automatic enrollment, and more plans offer target-date funds than risk-based asset allocation funds. Rebooting is just another such tool for plan sponsors to consider in their ongoing effort to improve the potential outcomes for defined-contribution participants.

At a global pension conference in Tokyo in fall 2007, Japanese plan sponsors—who are just beginning to grapple with defined-contribution plan issues—were seeking to learn from U.S. plan sponsors’ decades of experience.

One question attendees asked: How much plan-related communication and education is enough? As we know in the U.S., the answer is not simple. Indeed, after examining the 2006 Pension Protection Act, it is possible to conclude that the Japanese plan sponsors may not have been asking the right question: Perhaps it’s not how much communication and education is enough, but whether communication and education is useful when it comes to helping participants in defined-contribution plans reach their retirement income goals.

It’s true that the Pension Protection Act is filled with disclosure and notification requirements and supports plan-sponsor provided advice for DC plan participants. However, the bulk of the act’s regulation does not focus on communication and education. Instead, it is focused on automating plan features so participants in defined-contribution plans who do not take the time to plan for their own financial future can still benefit from the plan.

The act’s support of automatic enrollment, contribution escalation and diversified default investment alternatives implies that it might be better for the plan sponsor to simply place participants onto the appropriate financial path, rather than attempting to educate them in the hope that they will find the right path on their own.

There is no doubt that DC communication and education have shown their limitations:

• According to the 2007 EBRI Retirement Confidence Survey, while 73 percent of workers saving for retirement used written educational material they received from their employer or employer’s retirement plan provider, only 15 percent found it the most helpful material in saving for retirement.

  
  

• Meanwhile, 42 percent of DC participants in a John Hancock survey indicated they have little or no investment knowledge. About 50 percent believe they possess the skills required to manage their portfolios, but would rather spend time doing other things.

  
  

Still, to conclude that automation in defined-contribution plans can or should supplant communication and education would be unfortunate. After all, getting workers into a 401(k) plan, increasing their savings rate, and improving their diversification through default mechanisms is not necessarily synonymous with financial security.

A recent study by Annamaria Lusardia of Dartmouth College and Olivia S. Mitchell of the University of Pennsylvania examined baby boomer retirement security and the roles of planning, financial literacy and housing wealth.

The researchers found that those who report they undertook any planning—even “a little”—are much better off than those who said they planned “hardly at all,” according to the study.

In fact, the study found that people who engaged in even a small amount of planning were more prone to have sizable wealth holdings compared with those who had engaged in no planning.

What is “a little” financial planning? Psychological research shows that simply having subjects write down the specific steps they will take to implement a task can greatly increase follow-through. In other words, even engaging individuals at the most basic level when it comes to planning for retirement could improve the outcome.

Perhaps when it comes down to it, the right question to ask about defined-contribution communication and education is just this: What does the plan sponsor want to accomplish? If it is simply to increase plan participation, then automatic enrollment may be the right course of action.

But if the goal is to increase plan participation, and have participants value and appreciate the 401(k) plan, then communication and education can play an important role.

If the answer is to improve diversification, then diversified investment defaults may be sufficient.

But if the answer is to increase the potential for retirement income adequacy, then financial communication and education—at least according to the Lusardia and Mitchell study—may help.

The reality is that we have learned a lot about 401(k) communication and education in the past several decades. At least we’ve come far from the days when communication and education meant a 15-page color brochure that few took the time to read. So, in response to the basic question posed by the Japanese plan sponsors—what we do know about defined-contribution plan communication and education is the following:

Less is more. Simple one-page fliers have emerged as one of the most effective communication formats. This is especially true if they are focused on a single concept, are simple to understand and are easy to respond to. Plan sponsors have documented that one-page fliers asking employees to tear off and return a postage-paid response card so they can participate in the DC plan typically yield a 15 percent to 20 percent response rate.

Communication must pave the way to action. Through research and experience, we have also learned that it is not enough to hold a financial seminar for employees in the hope that they will take action. The success of the financial seminar will greatly increase if workers can respond immediately— at the site of the seminar—to sign up for the plan, for example.

The employee may be a reluctant consumer. Frequently, it isn’t that employees cannot understand the plan, but that they do not want to take the time to understand it. That’s where lessons from marketing and advertising can come in handy. Targeted and personalized messages can grab the attention of reluctant consumers of the plan and create interest where none previously existed.

There is more than one type of employee. Given that the typical employee base consists of a spectrum of workers who are diverse in such areas as age, gender and education levels, plan sponsors may wish to attack communication and education challenges from multiple angles, using a variety of communication channels. For example, some workers might respond well to a Web-based tool, whereas other workers may prefer more “high-touch” or paper-based communication approaches.

U.S. plan sponsors are fortunate to have the benefit of not only the Pension Protection Act’s support of plan automation, but several decades of experience in communicating with and educating defined-contribution plan participants. The lessons learned during those decades haven’t come easily, and they certainly should not be forgotten.

New research from Harvard and Yale universities provides defined-contribution plan sponsors with more food for thought.

    A paper titled “The Impact of Employer Matching on Savings Plan Participation Under Automatic Enrollment” contends that the success of automatic enrollment in increasing employee participation in defined-contribution plans is only marginally dependent upon whether the company makes a matching contribution.

    In the paper, researchers John Beshears, David Laibson and Brigitte Madrian, all from Harvard, and James J. Choi from Yale conclude that “participation rates under automatic enrollment decline only modestly when the employer match is eliminated or reduced.”

    The report finds 401(k) plans with automatic enrollment that move from offering employees the typical match of 50 percent on the first 6 percent of pay to offering no match at all reduces savings-plan participation by 5 percent to 11 percent.

    Plan sponsors may argue over whether that percentage-point decline is indeed modest. This type of reduction in participation could mean the difference between passing and failing nondiscrimination testing.

    Nonetheless, the findings should give plan sponsors pause: If defined-contribution plans can obtain significant participation rates under automatic enrollment without a company match, is it really necessary?

    The possibilities extend much further than saving companies the cost of the matching contributions. After all, there are a number of other productive ways that funds currently dedicated to the company match could be employed:

    ● Create an employer-sponsored retirement “floor” for all employees. Instead of a matching contribution, 401(k) plans with automatic enrollment could switch to non-contingent company contributions—as did one of the plans in the study. Under such a structure, even employees who don’t participate in the defined-contribution plan would still receive some defined-contribution-related retirement benefit from the employer.

    Instead of matching 50 percent of participants’ contributions up to 6 percent of pay, the company could simply provide a contribution equal to 3 percent of pay, whether or not participants contribute to the plan.

    This could be a very important goal for companies whose only retirement benefit is the defined-contribution plan. It would assure that all employees, including those who have opted out of the plan that had a match, would have some level of employer-sponsored retirement benefit.

    Plan sponsors might wonder whether non-contingent contributions would further exacerbate automatic enrollment opt-outs. The concern would be that employees might feel so “wealthy” in retirement funding as a result of receiving the company’s contribution that they would believe there was no need to contribute to the defined-contribution plan. That reaction is known as an “income effect”.

    In the analysis, a plan that switched from a match to a non-contingent company contribution was estimated to experience a 6 percent to 6.7 percent decrease in participation because of an uptick in opt-outs under automatic enrollment as well as the income effect of the company’s contribution.

    ● Reduce or eliminate participant-paid defined-contribution fees. A somewhat more controversial alternative for plan sponsors with automatic enrollment plans is to redirect some or all of the funds that would normally go to matching contributions to the payment of plan expenses. Unlike the first solution, participants in defined-contribution plans might view the decrease in matching contribution as something being taken away from them—even if the effect is economically neutral. Nonetheless, in an environment where the burden of monitoring and disclosing fees appears to be increasing, as are the number of fee-related lawsuits, this approach is still worth considering.

    ● Enhance other benefits. From a total benefits perspective, plan sponsors may also view a move away from matching contributions as a way to enhance other benefits—such as health care. Again, the message to employees would have to be carefully crafted. However, in situations where health care subsidies are more greatly valued than defined-contribution matching contributions, this may be a winning strategy for employers.

    Of course, the reality is that the existing matching structure will probably remain the logical approach for most plan sponsors. The majority of companies offer defined-contribution plans not only to create an effective benefit, but to compete in an environment where talent is difficult to attract and retain.

    For most plans in most industries, that means offering a match. Further, many plan sponsors will likely remain more comfortable with the collaborative approach to saving that results from matching contributions, rather than the gift-giving approach represented by non-contingent company contributions.

    Plan sponsors will also likely find the challenge of communicating a change to the matching program more onerous than it might be worth. Even if the change has no true negative economic impact (such as using the funds to pay for plan expenses), it may be too difficult to offset the negative perception by participants.

    Finally, even a small increase in opt-out rates that would likely come from decreasing or eliminating the company match may be too much of a sacrifice for plan sponsors.

    The point is this: As plan sponsors consider the options presented by the 2006 Pension Protection Act, such as adding automatic enrollment, they can choose to act tactically or strategically. The tactical approach is to address specific plan issues, such as participation. The strategic opportunity is to rethink the goals of the defined-contribution plan in particular and benefits overall.

    Even if the outcome is embracing the status quo, it can be an important exercise for plan sponsors to consider all of the strategic possibilities and re-evaluate why they are offering their defined-contribution plans, what they hope to achieve and whether they can reach their goals more effectively in the current environment.

    By thinking differently, plan sponsors may even come to question legacy decision-making and realign their retirement programs with new business realities and workforce needs.