(k)Plans | Published in July 2001

The Empowerment Myth

Giving participants carte blanche to direct the investment of their 401(k) assets is blatantly irresponsible, some experts say. However, there is an alternative

By Elayne Demby | July 2001

Giving participants carte blanche to direct the investment of their 401(k) assets is blatantly irresponsible, some experts say. However, there is an alternative

»  Giving More Independence 
» How Plan Design Can Help  
»  Sophistication Is Scarce  
» There's No Turning Back

In the early 1980s, fewer than 40% of all corporate-sponsored defined contribution programs enabled participants to decide how the employer contribution component of their plan should be invested. The typical 401(k) offered few investment choices and limited opportunity to make changes.

By 1999, the percentage of corporate plans providing for participant-direction of employer contributions had nearly doubled. Moreover, almost all of these plans-94.4%-allowed participants to "self-direct" their employee contributions, up from 57% in 1983.

Similarly, the latest statistics from the Profit Sharing/401(k) Council of America found corporate plans averaging more than 11 investment choices as of 1999. And Hewitt Associates' survey results suggest that, by next year, as many as 54% of employers intend to put a self-directed brokerage account or mutual fund window in place. It is enough to make even a well-informed participant's head spin.


Giving More Independence

The question sponsors must ask themselves is whether their plan populations as a whole are any better off because of such changes. Considering that one-fifth of defined contribution plan participants do not know they can lose money in stocks, for example, does it really make sense to give employees ever-increasing levels of independence when it comes to their (k) plan investments?

401(k) pioneer Ted Benna, president of the 401(k) Association, says that, in many cases, the answer is no. "Most participants, given the choice, would opt to hand their money over to someone and forget about it," says Benna, whose company consults to 401(k) plans. "There's a lot of expertise involved in investing, and there's no way we can expect 40 million participants to master it," he says.

Wayne Gates, general director for the investment and pension unit at John Hancock Life Insurance Company in Boston, is even more adamant in his criticism of the newly autonomous plan participant. "The do-it-yourself retirement model is a bad idea," he says. "People don't do the calculations to see how much they need, they barely spend any time planning for retirement and, if they have enough money, it's almost by accident," he says.

There is no shortage of Taft-Hartley plan sponsors willing to support that argument. Although today's participant-choice movement has rocked the multiemployer community as well, multiemployer plans' collectivist vision has meant that, traditionally, where a Taft-Hartley has offered a defined contribution strategy, the investments were trustee-directed.

"It feeds into our philosophy that, from an investment standpoint, it's better to have professionals invest it, and we're also better off from a cost standpoint," says David Blitzstein, director of the negotiated benefits department of the United Food and Commercial Workers International Union in Washington.

Interestingly, statistics from Aon Consulting, released last month, found that 72% of the mostly large plan sponsors it surveyed recently said their participant-directed defined contribution plans performed below or well below expectations in 2000. When Aon asked sponsors of fiduciary-directed defined contribution plans, 60% said that their plans performed below or well below expectations last year.


How Plan Design Can Help

Is it time to return to the paternalistic defined contribution plans of the past, where the employer hired an investment manager to invest all the assets and distribute the gains?

Few believe that employers will ever turn the clocks back that far, largely because of the fiduciary risks associated with investing participant assets. But, plan design could certainly be used more effectively to help employees, says Gates.

Employers could have automatic enrollment with an automatic 3% deferral and an additional 1% increase annually. This would encourage employees to build up adequate savings for retirement.

The default option for these funds should be appropriate lifestyle funds where everything is done for the employee-including all the rebalancing of assets to more conservative investments as the employee ages, says Gates. While employees who are so inclined could elect out of the default lifestyle options into other investments, they should be prevented from doing so while invested in the lifestyle funds to prevent dilution of the strategy, he says. So far, turnkey investment solutions such as lifestyle funds have not lived up to their promise because employees generally are not restricted to these funds alone, and tend to use them as just another investment option. For instance, a recent Hewitt Associates study of 4,000 401(k) plan participants who invested in lifestyle funds found that 88% combined lifestyle funds with other plan funds.

For his part, Benna feels that defined contribution plan participant investing should be restricted to two alternatives. One should be a structured portfolio: an option where employees could invest their money but in only one fund that is rebalanced regularly so that the equity allocations automatically decrease as the employee ages. These funds should also be geared to participants' investment risk tolerance, says Benna. "This should be the choice for most participants."

The second alternative, he says, should be a wide-open investment window where employees can invest in anything they want. This would accommodate those employees who wish to do their own investing.

Costs for the vast majority of plan participants restricted to a structured portfolio would be approximately $30 a year per participant, he says, whereas the typical cost of an open-window account would be approximately $150 a year per employee.

Apparently, some plan sponsors are thinking along similar lines. In May, the investment advisory committee for the $584 million Colorado Public Employees' Retirement Association 401(k) decided to take a close look at adding "life strategy" funds for members not actively involved in managing their accounts, says Lana Calhoun, Colorado PERS' deputy executive director.

"A lot of employees are calling us asking 'What should I do with my money?'" she says, and plan officials provide no investment advice service. "There's a need and desire among members for something that's more auto-pilot, that's based on their risk tolerance and their retirement dates."

Will Colorado PERA restrict the use of other investments by members investing in lifecycle funds? Calhoun says that it is likely. Otherwise, she predicts "employees [will] tend to use it as another investment option and defeat its auto-pilot purpose."


Sophistication Is Scarce

While the number and diversity of investment options have grown, and day trading 401(k) accounts is not uncommon, participants are not sophisticated investors for the most part. In fact, the time, money, and effort spent on trying to educate employees to be wise investors still has left many employees ill-prepared to invest for themselves. Most employees decide where to invest based solely on prior year returns, says Randy De Frehn, executive director for the National Coordinating Committee for Multiemployer Plans, an association representing trade unions and Taft-Hartley plans. And, according to a survey of 800 defined contribution plan participants conducted by Mathew Greenwald Associates, the knowledge that participants have regarding investing is patchy at best.

Meanwhile, the prolonged bull market has masked participants' investment mistakes, says Gates. Benna agrees. "It's been more of an accident that they've done well than that they are making the right choices."

Nor has providing actual investment advice as opposed to just investment education proved to be a full-blown solution. Employees who are offered investment advice by their plan sponsors either do not seek out the advice or follow it once they have gotten it, if you ask Robert Liberto, a vice president at Segal Advisors, Inc., in New York. At least 50% of those who use investment advice products do not follow the advice they receive, he says (also see "Filling The Seats" ).

There is no question but that many employees would be better off in a plan where a fiduciary made all the investment decisions for them, say Liberto, Benna, and Gates. "Employers who have workforces with large groups of employees who are not likely to be financially sophisticated might be doing their employees a favor by giving them the option of having their accounts professionally managed," adds Richard Shea, a partner in the Washington law firm of Covington & Burling.

Clearly, they say, it would be beneficial to many employees to have financial professionals do the investing for them. "Everyone owns a house, but we don't expect everyone to be their own plumber and fix their own pipes. There are advantages to specialization and many people would be better off with a specialist to do their investing," says Shea.


There's No Turning Back

Sponsors probably will never go back to the old-style defined contribution plans where investment managers invested a single pot of money, experts agree. For one thing, they say, it is too difficult for one investment strategy to work for all participants' needs.

Another issue is the additional fiduciary liability involved. "Employers don't want to go back to investing money for participants because they don't want to take back that risk of fiduciary liability," says Liberto.

Under the plan design solutions recommended by Gates and Benna, employers should be shielded from this level of liability since employees would retain the option of electing out of the restrictive investment schemes in question.

On the other hand, employers can provide a plan structure that allows those who can invest for themselves to do so, and those who choose not to to have the investing burden lifted.

"There's been a lot of talk about empowerment," says Shea. But, "while you could be giving some employees the power to succeed, others will fall flat on their faces."