To Choose or Not to Choose; That Is the Question

October 14, 2014 (PLANSPONSOR.com) - The transition from defined benefit retirement plans to a retirement plan landscape in which employees are responsible for their own investment decisions has not been without stress for both employers and employees.
By PS

One part of this stress is the choice of investments made available to employees. The Employee Retirement Income Security Act (ERISA) governs certain retirement plans such as 401(k)s and 403(b)s, and it sets forth the prudent-man rules that regulate how plan sponsors should manage such plans.

Plan sponsors select the investment options available to retirement plan participants. Since this is an ERISA fiduciary duty of plan sponsors, the individual investment decisions that employees make can lead to additional legal risk for sponsors. To relieve some of this fiduciary liability, ERISA provided a measure of safety for sponsors in Section 404(c).

As part of the basic investment requirements of 404(c), employees should have a chance to determine the degree of potential risk and return they are willing to assume in their portfolios. As part of this choice, the plan must offer at least three investment alternatives with materially different risk and return characteristics.

The Pension Protection Act of 2006 also provides guidance about how plan sponsors can avoid many of the fiduciary risks associated with investment guidance by requiring that investment options fall within well-defined investment strategies, detailed in the regulation as “qualified default investment alternatives.” These options include choices such as lifestyle funds that gradually shift from a growth to a capital conservation strategy, and professionally managed portfolios that are diversified to match an employee’s risk tolerance. To the extent that plan sponsors choose to offer target-date funds within this safe harbor, they should beware of the higher expense ratios of such funds relative to lower-cost index funds.

The problem that many employees face, especially as they approach retirement, is that a conservative investment strategy may not produce an outcome that will reach their investment objectives. Plan sponsors who err on the side of capital conservation may find that employees must work longer, save more, or take more investment risk later in life to achieve their retirement goals. According to Fortune magazine, 8,000 people will reach the age of 65 every day for the next 15 years, putting great pressure on a retirement system that is structured to avoid investment risk and, in the process, mute the potential rewards that such a system could provide.

On the other hand, if choices provided to employees are too broad, then the chances for an error in judgment increase—even if the plan sponsor was simply trying to satisfy employee groups that demanded greater flexibility in their investment options.

Take, for example, one personal experience I had with a 401(k) plan sponsor’s investment options back in the stock market bubble of the late ’90s. A number of employees were inquiring why the company was not offering mutual funds that allegedly earned an 800% annual return. The problem was that these funds contained many high-tech stocks that subsequently collapsed in the early 2000s. Following such a collapse, there surely would have been an increase in the number of employee complaints and accusations that, by adding these funds, the plan sponsor had not acted in a fiduciary (or best interest of the participant) capacity.

Another example might be the knee-jerk response to TV commercials that urge participants to invest their entire retirement plans in precious metals—either the physical metal itself or a fund that invests in these hard assets. With no regulatory oversight of these influential advertisements, less knowledgeable employees can easily fall for this speculative strategy and lose the advantage of portfolio diversification.

At the other end of this spectrum is the company that offers so much choice that the sheer number of investment options becomes bewildering. One company I talked with offered more than 140 mutual funds; another offered only 23 funds, but they were all classified as value funds—no growth funds included.

The challenge to plan sponsors acting as fiduciaries should not be to ensure that they are insulated from virtually any possible regulatory penalty or employee complaint by simply opting for “safe” choices. Instead, acting in the best interest of their employees means providing guidance that allows for a reasonable determination of where they want to be financially at retirement. This determination should be based on the amount of money they currently have saved for retirement, how much they plan to save, and how much they will need in retirement to satisfy their income expectations.

The independent variable in this equation is the rate of return necessary to achieve the end goal. If a reasonable rate of return is not going to get the retirement portfolio to that point, then the employer can offer help for employees to review other options each year and change course as necessary. To me, that is the most important choice that both the plan sponsor and the employee can make.

 

Tom Nugent is executive vice president and chief investment officer for PlanMember Securities Corp. Nugent, who has worked in investment and portfolio management since 1968, provides investment framework and market strategy for all PlanMember Services investment programs. 

 

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.

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