The Fixing the 401(k) Approach in Action

I was pleasantly surprised to read a recent article in BusinessWeek praising IBM's 401(k) plan and calling it "the new gold standard."  Frankly, it has been quite some time since I've heard anyone find something praiseworthy to say about a 401(k) plan.  In fact, if many of the critics (and the media) are to be believed, the 401(k) plan should be put out to pasture for good. 

Despite my criticism of the retirement plan industry and most plans I come across (hey, I didn't come up with the title of my book by accident), I've always maintained that a 401(k) plan is an excellent vehicle for retirement saving.  Unfortunately, it's the implementation of these plans, especially in the under $50 million plan space, that leaves most of them lacking. 

The responsibility for poor 401(k) implementation, in my opinion, lies primarily with plan fiduciaries who have failed in their duty to make well-informed decisions, either by lack of knowledge or just plain indifference.  My book, in large part, was designed specifically to empower these key decision-makers,  who have an enormous legal (and I would argue societal) responsibility to properly oversee these plans.

As I read through the article, I was pleased to see how much of the Fixing the 401(k) SM approach IBM is currently using.  To revisit, there are four key components (or what I call "pillars") to the Fixing the 401(k) SM approach, including:

  1. Effective Plan Design - The plan should be designed in such a way that both plan participation  and participant contributions are increased progressively over time.  Automatic enrollment, automatic deferral increases, and default investments are key elements of a well-designed plan.

  2. Cost Containment - All plan service providers are required to fully disclose their compensation (in percentages and dollars) and fiduciaries focus on reducing and re-structuring as many costs as possible on a fixed basis in order to control these expenses as the plan grows over time.  The use of passive investments, such as index funds, and fixed, per participant charges for administration and recordkeeping should be maximized.

  3. Successful Investment Experiences - The plan should be designed in a way that helps participants utilize the plan effectively and make prudent investment decisions.  To limit poor decision-making, the vast majority of participants should utilize professionally managed, custom portfolios.

  4. Fiduciary Protection - The oversight of the plan should be organized and structured in such a way that fiduciaries are empowered to make well-informed, prudent decisions and have limited personal liability. 

Here are a few quotes from the article that clearly highlight elements of the Fixing the 401(k) SM approach:

"IBM takes a very paternalistic and serious attitude in terms of the quality and the cost to participants," says Ted Benna, chief operating officer of pension consultant Malvern Benefits and the man considered to be the father of the 401(k)."

"Advice is helpful, however, only if the plan is structured right. Studies show that many 401(k) participants make bad decisions, and that defined-contribution plans such as 401(k)s underperform compared with the defined-benefit variety. So IBM leveraged its money-management expertise to assemble the best investments at the best prices....We try to negotiate as well as we can to wring every penny out of costs," says Ray Kanner, chief investment officer of IBM's retirement funds."

"We try to negotiate as well as we can to wring every penny out of costs," says Ray Kanner, chief investment officer of IBM's retirement funds."

"The plan also nudges participants toward better choices than they may have made on their own. Behavioral finance research by academics Richard H. Thaler of the University of Chicago Booth School of Business and Shlomo Benartzi of UCLA Anderson School of Management demonstrated the merits of putting the 401(k) on automatic pilot. One feature, auto-enrollment, pulls workers into retirement plans unless they opt out. Another, auto-escalation, increases contributions along with raises in pay—again, unless they opt out. In studies, these tricks substantially increase 401(k) participation and savings. IBM also offers automatic rebalancing, meaning employees' portfolios are automatically reset to the asset allocation they want over time."

"Custom target-date funds are another feature IBM uses to serve employees who don't like to manage their own money. Target-date funds are portfolios that set asset allocation based on how close a participant is to retirement; the funds then ratchet down risk (by decreasing equity exposure, for example) as the retirement date draws nearer. Such funds got a lot of flak after some off-the-shelf products with target dates of 2010 plummeted in the market downturn. IBM, like some other companies with billion-dollar 401(k) plans, has created its own customized target-date funds. Those funds mix indexed portfolios, which are at the core of IBM's plan offerings, and active portfolios. To hedge against inflation, plan managers threw in Treasury Inflation-Protected Securities and alternative assets such as commodities and real estate."

I disagree with the author's contention that "IBM's creation isn't revolutionary in design or implementation" because very few companies have taken such a progressive and thought-leading approach.  Otherwise, the author would not be arguing that IBM has "reinvented" the 401(k).

And while not every plan has the enormous pricing power that IBM's wields, every plan (whether large or small), can implement the Fixing the 401(k) SM approach and have a "gold standard" plan just like IBM.

Congressman Says 401(k) Participants Need Independent Advice

According to this article in InvestmentNews, Rep. Robert Andrews, D-N.J. spoke earlier today at a Barclays Global Investors event in New York and said believes that 401(k) system would be strengthened by providing participants with with independent investment advice.  Andrews is the Chairman of the House Subcommittee on Health, Employment Labor and Pensions wants to pass legislation that encourages companies to hire independent investment advisers for their participants.

Andrews made some comments that I generally agree with, specifically about participants being "woefully equipped" to make their own investment decisions and the fact that the 401(k) system needs to improved rather than scrapped entirely. 

I also think steps need to be taken to ensure that any advice is truly "independent" and that it's not simply an entry point for an advisor/broker/consultant to get access to a bunch of participants for the purposes of "cross-selling" other products and services.  Having considered what the actual economics of delivering individual participant advice would look like, I think it is a difficult business model to make profitable at this point.  The main issue is who is going to pay for it.  Participants?  I find it unlikely that most participants (especially those with low account balances) are going to be willing to pay enough to make it worthwhile for a competent advisor to spend the time necessary to make it work.

I still argue the point that the way to get participants to make better investment decisions isn't to provide more "education" or even simply individual investment advice that the participant needs to then turn around and implement themselves.  The idea that complete self-direction is an effective approach is flawed at best.  I think the best approach is to design the plan effectively so that the only investment options available are managed portfolios (constructed and managed by an ERISA-defined "Investment Manager") rather than individual mutual funds.  I spell out the idea, here

However, only providing managed portfolios is still a tough sell to employers at this point because of the backlash they expect from most employees who believe self-direction is their inalienable right.  Interestingly, when we provide managed portfolios for our clients we find that anywhere from 75-100% of participants choose them.

Wise Words from David Swensen

Here's a recent NPR interview (print and audio) with David Swensen who manages Yale University's endowment.  Over the past twenty years he's averaged a 16 percent return for the endowment and is one's of the world's best investors.  He's generally an advocate of passive investing and has also written a couple of excellent books including Unconventional Success: A Fundamental Approach to Personal Investment which is on my "Recommended Reading" list.

The events of the past six months have created fear and panic not seen since the Great Depression. This fear, which in many ways is justifiable, has led most individuals to question the investment strategy they have chosen and whether it is still viable.  Swensen's got some excellent advice for anyone who is wrestling with such issues.

Buy High, Sell Low - Some Things Never Change

Here's a very interesting article from planadviser Magazine discussing how 401(k) assets in stable value reached an all-time high in November.  The article cites data from the Hewitt 401(k) Index.  Here's a few of the details:

  • "The Index for November shows stable value funds gained $342 million from participant transfers, and by the end of the month, the allocation to stable value was 33.4%, up from 20.5% just one year ago. Balanced and money market funds also received $61 million and $12 million in inflows, respectively, Hewitt said."
  • "Outflows mainly came from large U.S. equity, lifestyle, company stock, and international funds."
  • "On average, 401(k) participants transferred 0.06% of balances on a net daily basis in November (slightly above the trailing average of the past 12 months)"
  • "The direction of transfers was fixed income-oriented on 58% of the days in the month"
  • "The level of transfers was above normal four days of the month, with moneys moving toward fixed-income investments on all four days, each of which was immediately following large declines in the stock market."  (emphasis mine)

This is just more supporting evidence that the vast majority of participants do the wrong thing at the wrong time (usually because of emotion).  It's also the reason most participants earn sub par returns. You may be familiar with the study DALBAR releases each year that shows the 20-year return of the S&P 500 as compared to the average equity investor.  Every year it seems the average investor trails the index by roughly 7-8%!

There is no question that the past three months have been incredibly trying for every investor, whether novice or professional.  The velocity with which information flows in a globally connected world hasn't helped, especially when just about every newspaper, magazine, website or news station has contributed to doomsday scenarios.

I make no predictions about which direction the markets are going to go for the foreseeable future or whether we've already "hit the bottom" (and I wouldn't trust anyone who tells you they can predict the future).  However, consider this point:  November 20th represented the low point so far for the S&P 500 when it reached 752, having fallen 100 points in two days.  If you had invested in an an S&P 500 index fund on August 28th (when it closed at 1,300) you would have lost 42% of your money.

Presumably, one of the four days during the month where the level of transfers was above normal was on or around November 20th and those investors who transferred their money into stable value/fixed income locked in huge (and permanent) capital losses.  Many are likely to be nowhere near retirement and therefore had no immediate need to sell other than the emotional distress they were experiencing (pointing, in part, to a risk tolerance/time horizon problem). Assuming the market reverts to the mean and returns its historical average of approximately 10%, it would take those investors roughly 4 years to make their money back.  Interestingly, since November 20th the S&P has gained approximately 20%, despite a continued onslaught of bad news and significant volatility. How many of those people who went to cash do you think are still sitting there?  Probably most of them.

None of this is to say the market couldn't drop another 20% (or 30% or 40%) over the short-term - it could.  However, the market has corrected so severely that valuations are lower than they have been in many years and a growing number of experts expect returns to be very attractive moving forward.  I would fully expect that the successful investors of today will be the ones who, in the face of great concern and fear, moved money into "riskier" asset classes such as stocks rather than fixed income. 

I also fear most of those investors who are in "safe" investments like cash will remain there until the market has recovered substantially and will have missed the gains.  They will undoubtedly have an unsuccessful investment experience over time, earn sub par returns and probably have difficulty accumulating enough money to retire successfully.  As much as I hate to say it, the data continues to suggest that the closer participants get to making investment decisions the worse they will do.  Buy low, sell high might be the goal but the opposite seems to be the reality.