Retirement Insecurity and 401k Plans

By Margaret E. Haering, Member, CSCPA Employee Benefit Plans Interest Group

Only 30 percent of Americans expect to have enough money to retire.

As baby boomers head into retirement with their modest savings and falling home values, expect a firestorm of criticism about the shortcomings of 401(k) plans.

A typical self-directed 401(k) plan can deliver an adequate retirement income, but only if an employee defers sufficient income, generates consistent investment returns, and keeps those assets intact until retirement.

Many employees are not up to the task. They procrastinate about enrollment, defer too little income and invest poorly. To make matters worse, they borrow from their 401(k) accounts or cash them out when changing jobs. The median 401(k) balance is only $60,000 for employees approaching retirement.1

The Pension Protection Act of 2006 (“PPA”) addressed some of the behavioral causes of low retirement plan participation by permitting employers to automatically enroll employees and to increase their 401(k) contributions annually. The PPA also provided new guidance for default investments and investment advice. While these features have already increased 401(k) participation rates, they are unlikely to benefit those nearing retirement.

No one has suggested that providing a self-directed 401(k) plan that leaves workers inadequately prepared for retirement is a breach of fiduciary duty – at least not yet. However, many feel that a discussion of retirement income inadequacy is long overdue. The challenge for employers is to increase the likelihood that employees will enter retirement with sufficient assets to meet their needs without seeming to guarantee the outcome. The remainder of this article focuses on practices that employers are adopting to help employees improve their chances
for success.

Contribution Levels

Traditionally financial planners have recommended that employees aim to replace between 70 and 80 percent of pre-retirement income.2 However, some now suggest that a replacement ratio of 100 percent is needed because of inflation, rising medical costs, increased longevity, and uncertainty about Social Security.

The default deferral rate for PPA “safe harbor” auto-enrollment plans is three percent of compensation the first year, rising with annual automatic escalations of one percent to a maximum of six percent. Such modest deferrals are not enough to generate “adequate” retirement income.

Some employers are educating employees about the amount of income deferral actually needed to fund an adequate retirement and the length of the accumulation period required to achieve that goal. They are also spelling out the consequences
of delay. According to a 2008 Replacement Ratio Study by AON Consulting, those who wait until age 45 (or later) to start saving will need to defer at least 15 percent of income each year.

Investment Options

Almost all plans now provide asset allocation funds or target date funds as qualified default investments for employees who don’t want to invest their money themselves. While target or life-cycle funds offer professional management and hold out the prospect of long-term growth, they must be carefully selected and monitored. There are many new, untested products on the market, and the industry has not yet developed an effective way to benchmark their results.

All target or life-cycle funds offer a managed portfolio that adjusts asset allocations based upon the investor’s age and assumed risk tolerance. However, asset allocations vary considerably for products using the same retirement date. Some maintain equity positions as high as 65 percent during retirement. Others reduce equity exposure dramatically as retirement approaches.

A few target funds invest in individual securities, but most are “funds of funds” that invest in a blend of the parent company’s existing investment vehicles. The underlying funds may be actively managed mutual funds, index or exchange-traded funds, or a combination. The quality of the underlying funds is critical. Some vendors use their target funds as a way of bolstering assets in their start-up or lagging mutual funds.

Understand the costs associated with the product. “Funds of funds” may carry two layers of fees – one for managing the target fund itself and a second layer charged by the underlying funds. An extremely low management fee for the target fund could mean that most expenses are buried in the underlying fund fees.

In 2006, the Turnstone Advisory Group released the first quantitative and qualitative study of the life cycle funds sponsored by the larger mutual fund companies. The study assessed various funds’ ability to deliver on their implied promise of delivering a given level of performance for a desired (and appropriate) level of risk.3

Controlling Costs

The recent spate of class actions over 401(k) fees has focused attention on the effect of high costs on investment returns. In increasing numbers, employers are turning to outside consultants for help in understanding and limiting fees paid from participants’ assets. The Department of Labor recently issued proposed regulations to require disclosure of investment fees and any deductions from a participant’s account for administration.4

Plan Operation and Design

Participants in 401(k) plans rarely change investments and often ignore recommendations to rebalance when market fluctuations have caused asset allocation to slip out of the intended ranges. One feature employers can add to help employees manage their accounts more effectively is to make automatic rebalancing a default option.5

Focused Communication

Different segments of the workforce vary in their usage of 401(k) plans. There are wide disparities in the amounts deferred and the returns earned between low- and high-income workers. There are also likely to be measurable differences in behavior based on gender, age, ethnicity, and financial literacy levels. Educational outreach directed to discrete parts of the workforce should be considered as a way of influencing behavior.

Address Retirement Readiness

With stunning regularity employees make important decisions about retirement without the necessary information. Many employees want help as they transition into retirement. Some employers are heeding the call by providing workshops to help employees measure their financial readiness, determine the optimum time to start Social Security benefits and budget their retirement expenses.

For those with inadequate savings, the opportunity to continue working to build up retirement savings and Social Security benefits could be an increasingly important option.

The do-it-yourself nature of 401(k) plans creates a risk that large numbers of workers will reach retirement without sufficient assets to meet their needs. Some employers are helping their employees address that reality.

Margaret E. Haering is an attorney and Accredited Investment Fiduciary Analyst®. She is Assistant Director of the State Comptroller’s Retirement & Benefit Services Division, where she assists with management of three defined contribution plans. The views and opinions expressed in this column are solely the author’s and in no way reflect the position of the State Comptroller’s Office or the Retirement & Benefits Services Division.

1 Pamela Perun, “Storm Clouds Ahead for 401(k) Plans?” Urban Institute Retirement Policy Program, Brief Series No. 22, July 2008.

2 The 2008 Replacement Ratio Study, conducted by Aon Consulting and Georgia State University,
aon-consultings-replacement-ratio-study, shows the varying percentage of pay that needs to be saved each year based on the participant’s age and salary.

3 “Popping the Hood, An Analysis of Major Life Cycle Fund Companies,” (2006)

4 See Department of Labor, proposed regulations, on Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans, 73 Fed. Reg. 43014, July 23, 2008.

5 Automatic rebalancing has substantial benefits, but before adding that feature to the plan, check whether mutual funds in the plan carry redemption fees that might be triggered by rebalancing transactions.