There is no question that the pension reform measure
passed in August 2006 solved a lot of the issues that 401(k)
plan sponsors have wrestled with in recent years.
Specifically, those employers had
been debating whether to automatically enroll employees into
their plans, and if they did, which investments to use as the
default. Their concern was that if they automatically enrolled
employees into an option, employees could come back years
later and sue them if the investments performed poorly.
But the Pension Protection Act of
2006 eased a lot of concerns by offering plan sponsors
protection from fiduciary lawsuits if they automatically
enrolled employees into certain investment options deemed
appropriate by the Department of Labor. The DOL proposal
provides safe harbors for three default options: balanced
funds, lifecycle funds (also known as target-date funds) and
managed accounts. Safe harbors exempt employers from fiduciary
liability and nondiscrimination testing, which can be a
time-consuming process for plans.
Now, 12 months later, it seems
that the Pension Protection Act has employers wrestling with a
whole new set of questions as they try to figure out which
default investment option to use with their 401(k) plans.
The stakes are high, since
employees tend to stay in whichever investment employers
choose, experts say. Eighty percent of plan participants never
trade investments in their 401(k) plans, according to the
Vanguard Group.
Even though the new rules donft
take effect until January 2008, a number of plan sponsors are
having these discussions now, says Don Stone, president of
Plan Sponsor Advisors, a Chicago-based 401(k) consultant.
Many employers were surprised to
see that stable-value funds, which a large number of companies
had traditionally chosen for automatic enrollment, were not on
the Department of Laborfs list of qualified default investment
alternatives. These funds have been a preferred default
investment option for many plan sponsors because they are
conservative, experts say.
In a March 30 letter, the American
Council of Life Insurers urged the White Housefs Office of
Management and Budget to address the Department of Laborfs
proposed list of default investment options and add
stable-value funds to it.
In June, the Investment Company
Institute, a Washington-based organization that represents the
mutual fund industry, fired off its own letter to the Office
of Management and Budget, saying that adding stable-value
funds as a default option "would be inconsistent with the
purpose of measures enacted in the Pension Protection Act"
because they are too conservative for the majority of
investors.
While the insurance industry and
mutual fund industry both have a vested interest in their
arguments (insurers make money from the sale of stable-value
funds, just as mutual fund companies make money from the sale
of target-date funds), observers say they donft know which
party will win.
At press time, the Department of
Labor had not issued a final ruling on the matter.
Each of the default investment
options approved by the Department of Labor comes with its own
set of pros and cons, and itfs up to each employer to decide
what makes sense for its own employee population, says Lori
Lucas, senior vice president and defined-contribution practice
leader at Callan Associates, a San Francisco-based consultant
to institutional investors.
"Each company needs to clearly
think about what makes sense for their employee demographics
and whatfs going to appeal to their employees," she says.
Workforce Management spoke
to 401(k) plan consultants around the country about the pros
and cons of the default investment options approved by the
Department of Labor, as well as stable-value funds.
Balanced funds
What they
are: Balanced funds generally have a mix of stocks and
bonds that reflect a specific risk profile. Typically, these
funds have a 60-40 ratio of stocks to bonds—an asset
allocation that consultants agree should suit a wide array of
investors. These funds will periodically reallocate to
maintain their stated asset allocation.
While praising the simplicity of balanced funds,
analysts also note that their one-size-fits-all approach
doesnft work for all investors.
"Balanced funds may be appropriate
for a lot of people, but if you have employees in their 20s
and people in their 60s, itfs hard to argue that itfs
appropriate for all of them," Lucas says, noting that younger
investors tend to have a greater risk tolerance than older
ones. Only 18 percent of plan sponsors surveyed by Callan say
that they plan to use balanced funds as the default option in
their 401(k) plans.
Also, balanced funds tend to be
limited in which asset classes they represent, Stone says.
"Typically in a balanced fund, you are not going to get as
much diversification as you can," he says.
These funds usually invest in
bonds, cash and domestic equity. "Not a lot of them have
international exposure, and thatfs an asset class many
investors would want right now," Stone says.
Lifecycle funds
What they
are: These products, also known as target-date funds,
automatically reallocate according to the year investors plan
to retire. A target-date fund for 2040, for instance, is aimed
at employees who plan to retire that year. The fundfs asset
allocation moves from aggressive to more conservative to help
investors reach their goal.
PROS: Lifecycle funds are the 800-pound gorilla
when it comes to default options in the 401(k) industry.
Seventy-one percent of plan sponsors want to use a lifecycle
fund as a default, according to Callan.
"These funds are generally
easy to understand—participants just pick a date and thatfs
it," Stone says. Essentially, many companies like this type of
fund because it doesnft require plan participants to do
anything, which is good since most of them wouldnft do
anything anyway, consultants say.
"If they never look at their
investments again, at least they are in the proper asset
allocation," Walton says.
Also, since these funds are
popular now, competition is driving providers to come out with
better and more diversified versions of these products, Lucas
says.
CONS:
Just because these funds are the most popular among
plan sponsors doesnft mean these funds are a shoo-in as the
default option for 401(k) plans, consultants say.
First, since many of these funds
are new, there are few with three- or five-year track records,
making it difficult for plan sponsors to gauge their
performance, Lucas says.
These funds often contain only the
provider's proprietary funds, Walton says. "Thatfs not
necessarily bad, but not every company does every fund well,"
she says. "And as the fiduciary, plan sponsors need to be
comfortable with the underlying funds within the
portfolio."
Lifecycle funds also have higher
fees than their balanced-fund counterparts. Fees for the
underlying funds within an actively managed lifecycle fund
usually are around 80 basis points, and sometimes there is an
overlying fee, bringing it up to 100 basis points, analysts
say.
Some 401(k) plan sponsors might
object to the assumption that lifecycle funds make, which is
that investorsf asset allocation should become more
conservative as they approach retirement, Meigs says.
Today, people are living longer,
and plan sponsors shouldnft assume that they will cash out
when they turn 65 or that they only need the money for a few
years, he says.
"A 60-40 mix of stocks to bonds
still makes sense when an investor is 65 years old," he says.
"Too many lifecycle funds are too conservative for older
investors."
Some employers are just
philosophically opposed to lifecycle funds because they do
everything for employees. "A lot of companies want employees
to take an active role in saving for retirement," Stone says.
"They are worried that if they encourage employees not to have
to think about anything, then they are creating a liability
for themselves."
Managed accounts
What they
are: Managed accounts let providers ask participants about
themselves and their assets to create a customized portfolio.
Many of these programs allow participants to plug in their
information online.
PROS: Managed accounts are considered to be the
ultimate in customization because they try to take into
account various factors beyond the age and income of the
employee. "Managed accounts can take other assets into
account—such as outside 401(k)s or spousesf income and
retirement savings," Stone says. "Itfs a more holistic view of
an individualfs overall investment portfolio."
For plan sponsors, the advantage
of offering managed accounts over lifecycle funds is that a
company can offer a managed account program that creates
portfolios based on the funds already in the plan, Walton
says. "That means there are less funds for the plan sponsor to
conduct due diligence on," she says.
CONS:
The main disadvantage of managed accounts is the
fees. Managed accounts can charge anywhere from 25 to 100
basis points on top of the expenses of a fund, which means an
employee could end up paying up to 150 basis points, says Pam
Hess, director of retirement research at Hewitt Associates.
While paying such high fees might
make sense for those 401(k) participants with a lot of outside
assets who are willing to take the time to provide personal
information, few employees fall into that category, observers
say.
"Most participants donft have
other assets, so it doesnft help them much," Stone says. "Who
it helps are those employees with fairly high average balances
who are inclined to take the time to provide their
information."
But managed accounts are evolving
and fees will come down, so plan sponsors should keep abreast
of these offerings, Lucas says.
"Managed-accounts providers are
discussing creating a tiered pricing structure by which people
who are defaulted into managed accounts and donft use all the
features could pay a lower cost than those who do," she says.
Stable-value funds
What
they are: Stable-value funds invest in bonds bound by
insurance "wrappers." If the rate of return of these funds
falls below the rate of return set by the insurance wrapper,
the insurer pays the difference.
PROS: If the portfolio gains beyond the wrapperfs
set return, the fund pays the insurer the difference. These
funds tend to generate higher returns than money market funds
at slightly more risk.
In the past, a number of 401(k)
plan sponsors opted to make stable-value funds their default
options because itfs pretty much assured that investors wonft
lose money and wonft come back to sue the company for
investment losses. Now that the Department of Labor has given
the nod to lifecycle funds, balanced funds and managed
accounts, thatfs no longer a benefit of stable-value funds,
experts say.
However, many plan sponsors see
benefits to stable-value funds as default options,
particularly for short-term investors. Under current law,
employees who have been defaulted into a 401(k) plan have 90
days to get their money back. If their contributions are
defaulted into a stable-value fund, getting them the money
back is easier than if it was invested in a more active
portfolio that could have realized investment losses, says Joe
Hessenthaler, a principal at Towers Perrin.
Also, if an employer has high
turnover, many plan sponsors opt for stable-value funds
because itfs easy for employees to cash out, Lucas says. "But
it seems a little shortsighted to focus on those individuals,"
she says.
And then there are those companies
that have done their homework and have found that their
employees would prefer to be defaulted into stable-value
funds—and as long as they can prove they did their homework,
there is nothing wrong with that, Walton says. "I have plenty
of clients who will stick with stable-value funds, but they
will document the hell out of it," she says.
CONS:
The major drawback of using stable-value funds as
the default is that most consultants donft believe these funds
will generate the investment returns needed for employees to
save enough for retirement. Experts generally say that
investors will need 70 percent to 100 percent of their
pre-retirement income to retire. "Stable value has a place as
part of a bigger portfolio, but it canft be the only
investment option," Stone says.
Since employees rarely reallocate
their 401(k) investments, using stable-value funds as the
default seems shortsighted, says Phil Suess, principal and
defined-contribution segment leader at Mercer Investment
Consulting.
And unless the Department of Labor
changes its stance, it looks like employers who do choose to
offer stable-value funds as the default investment option
wonft get a safe harbor from discrimination testing,
consultants say.
Safe harbors aren't everything
When it comes down to it, plan sponsors can choose whatever
investment options they think are right for their plans,
experts say.
"Qualified deferred investment
alternatives are just safe harbors," says David Wray,
president of the Profit Sharing/401(k) Council of America, a
Washington-based organization representing plan sponsors.
"Itfs up to each company to decide if they need that safe
harbor."
Specifically, choosing one of the
approved default options means plan sponsors get that safe
harbor. But if employers have a good reason to adopt a default
option that is not one of the Department of Laborfs qualified
deferred investment alternatives, they can do so, Walton says,
adding a proviso: "They need to have great documentation of
all of the factors that they considered and why they chose the
investment they did."