How to Assemble Better 401(k) Plan Options
Say sayonara to the carefree days of your parents’ pension plans, when employers assumed the risk of a tanking stock market. In this sputtering economy, employees are on the hook for making wise investment decisions, but it’s the employer’s job to exercise fiduciary responsibility and common sense. That means encouraging employees to sock away as much money as possible, and offering them the tools to select the proper asset allocation and manage a diversified portfolio that will post solid long-term returns without incurring significant risk.
The average 401(k) balance fell by nearly 30 percent in 2008, according to some studies. That is particularly frightening for many employees whose 401(k) accounts represent their single largest asset outside of their homes, and potentially their only source of retirement income.
Even in this volatile climate, many employer-sponsored plans choose funds based on recent performance while dismissing risk, provide limited investment options that overlook many asset classes, and agree to excessive fees that are often hidden from the employee.
“A 401(k) plan is a means to an end for the employer,” says Robert Auditore, founding principal of Bay Colony Partners, an independent retirement planning firm that manages more than a half-billion dollars in individual and corporate assets. “To recruit and retain talented employees, you need a top-notch retirement plan.”
In ranking the top 30 401(k) plans of 2010, financial information firm BrightScope considered such factors as generous company contributions, immediate plan enrollment, company match eligibility and vesting schedules, low fees, high employee participation rates and high salary deferrals. The top five companies were: the Saudi Arabian Oil Company, Kaiser Permanente, Southwest Airlines, Amgen, and United Airlines.
Smaller employers may not be able to afford an independent investment advisor, who can charge $5,000 or more a year. Instead, they tend to choose a bundled plan structure, where a single company handles all the investment, recordkeeping, administration, and education services.
Often, a T. Rowe Price or Fidelity will have a relationship with a third-party vendor, such as Morningstar. For an added fee, the vendor will help an employer assemble a defensive-minded investment lineup. Ask about these services when selecting an investment house.
Follow these other tips to help your employees achieve their retirement goals.
Offer Enough Asset Classes
Experts recommend offering from 17 to 20 different investment choices, covering the major asset classes that are needed to construct a diversified portfolio. Core asset classes include stocks, bonds, and cash equivalents such as money markets. Further breakdowns within classes include growth stocks, value stocks, small, mid and large cap stocks, emerging market stocks, government bonds, and short-term and long-term bonds. To hedge against inflation, more plan managers are including Treasury Inflation Protected Securities (TIPS). Offer index fund alternatives to more expensive actively managed funds.
To whittle down the list, Auditore of Bay Colony may rely on three to six different screening mechanisms, including upside/downside capture ratios, which evaluate a fund’s historical performance during rallies and down markets.
Fund performance can be reviewed over a one-, three-, five- and ten-year time horizon. Along with studying quantitative measures, do some qualitative sniffing around by interviewing the portfolio management team, inquiring about extra services (on-site visits typically cost $1,000 each), and determining if the investment house caters mainly to smaller or larger employers. Experts also recommend steering clear of funds with over 1 percent expense ratios. Ongoing monitoring of the fund lineup is essential, either on a quarterly, semi-annual or annual basis.
Recently, personal finance columnist John Waggoner suggested assembling a “cowardly portfolio,” comprised of 50 percent equity income stock funds, 30 percent bond funds and 20 percent money market, to post minimal gains rather than suffer huge losses. Auditore disputes that one-size-fits-all model, explaining that other factors such as an individual’s current salary, outside assets, and cost of living should play a role in any investment strategy.
Choose Defaults Carefully
Default 401(k) plan options are designed to simplify investing, and studies show that individuals with limited financial background tend to choose them 20 percent of the time. Popular options are balanced funds and target-date funds, also known as lifecycle funds, which automatically adjust the weightings of asset classes within a portfolio to become more conservative over time. Yet employees need to understand that these funds are not risk-free. Many experienced steep losses during the 2007-2008 market decline.
Studies show that one out of four eligible workers fails to sign up for a 401(k). To counteract this trend, consider implementing automatic enrollment and auto-escalation, which automatically increases 401(k) contributions with salary increases unless an employee opts out. Auditore recommends that HR professionals provide frequent communication emphasizing the value of the company’s 401(k) plan, particularly when the market is tumbling. Don’t assume that employees have an extensive investment background. Consider offering financial engines that automatically rebalance a portfolio’s asset allocation to reduce risk.
One bright spot is that plan participants can expect to receive a steady stream of information under new disclosure rules set forth by the U.S. Department of Labor, effective May 2012. Under the new regulations, 401(k) plans must outline all associated fees and expenses each quarter. Additionally, they will provide charts to employees comparing the investment options’ fees, past performance, benchmark comparisons and risk levels.