401(k) participants need help. Advisors who care about the individual participant are in a great position to help them reach their retirement goals.
However, despite the good intentions of advisors, far too many 401(k) plans are underperforming. Here are some ways advisors can turn that tide:
Encourage higher contribution rates
Perform better fund selection
Promote the use of Target Date funds
Perform an annual fiduciary plan review
Encourage higher contribution rates. The 401(k) plan is an excellent vehicle for employees to save money for retirement. Unfortunately, participants still do not accept nor understand that the responsibility for saving enough for retirement falls mostly upon them. Therefore employees must be effectively challenged to save.
For example, according to the Employee Benefit Research Institute (as of August 2009), the median 401(k)-type plan balance for families with a current employer are:
Age Balance
< 35 $6,643
34 - 44 $22,460
45 - 54 $43,985
55 - 64 $69,252
65 - 74 $56,212
Advisors can dramatically increase the contribution rate through compelling education. From my years of consulting, I learned that what we measure we improve. Measuring the contribution rates before and after your education quantifies its effectiveness.
Perform better fund selection. Advisors should move beyond the "Best of the Best" approach to fund selection. This method of selecting funds by looking at the past performance of the fund universe is harmful to participants.
"Only 17.3% of large-cap funds with a top quartile ranking over five years ending 2001 maintained a top quartile ranking over the next five years ending 2006. Only 10.4% of mid-cap funds and 17.7% of small cap funds maintained a top quartile performance over the same period." [S&P Mutual Fund Performance Persistence Scorecard, Year-End 2006]
Each of these falls below the 25% that random expectations would predict repeating a top quartile ranking. This is a sobering reminder about the validity of the disclaimer "Past performance is not indicative of future results."
Unfortunately the "Best of the Best" methodology relies heavily on past performance as an indicator for future performance. And the impact to the participant is characteristically negative.
When the underperforming fund is removed from the line-up and mapped to the new top performing fund, the participant is forced to sell low and buy high. This process is repeated over the life of the plan by well meaning advisors who inadvertently cause the participant to repeatedly sell low and buy high. That is a tragic mistake.
A better way for advisors to assist participants to reach their retirement income goals is to construct a fund line-up that provides for solid, consistent performance over time.
My firm, Acropolis, suggests a line-up of broad-based, low-cost, index funds which have a high correlation to the index they track. Year after year, index funds typically outperform a significant majority of their actively managed peers.
Promote the use of target-date funds. Market timing and performance chasing are perhaps the biggest mistakes that participants make.
To help participants avoid these behaviors, lifestyle funds and target-date funds serve better than individual asset class funds or industry specific funds.
Target date funds are generally better than lifestyle funds because most individuals have a difficult time assessing their risk tolerance. Over the course of my professional career, the same people that were bullish in 1999, were bearish in 2002. They were bullish again by 2006, but bearish in 2009. Now they have turned bullish again.
Lifestyle funds, based on an individual's "risk assessment," place them in a portfolio ranging from aggressive to conservative. Instead of adjusting their lLifestyle fund based on changes in their personal circumstances, far too many participants change lifestyle funds in reaction to the media-most often selling low and buying high.
Target-date funds, on the other hand, have protected participants from this cycle of buying high and selling low. Since the participant realizes that the fund will move from aggressive to conservative without their intervention, they seem more comfortable staying put in times of unpredictability. In addition, Target-date funds, in order to maintain proper asset allocation, rebalance frequently causing buys at the bottom and sells at the top. This is the behavior that we want to encourage.
Perform an annual fiduciary plan review. While there are many benefits to an annual plan review, a few of the key questions which must be answered are:
Is the plan still meeting the goals of the owners of the company?
Is the plan in compliance with ever changing regulations?
Is the plan incorporating new features?
Most outside plans my firm has reviewed have not yet added a Roth 401(k) feature. While this feature is not right for each individual, it is probably right for a subset of employees and costs nothing to add.
Another feature we find not often strategically used is the New Comparability Profit Sharing formula which allows for different allocation amounts to different groups of employees. This formula can provide a means to allow for a greater percent of the profit sharing contribution to go to employees that the company desires to reward, for example, highly compensated employees.
As advisors to 401(k)s, it is incumbent upon us to properly prepare our clients for retirement. As a group, we need to step up and give all participants the help they need and deserve.
Michael Lissner, CEPA, is a partner in Acropolis Investment Management LLC, a St. Louis-based, fee-only wealth management firm, serving individual investors and 401(k) plan sponsors. Acropolis specializes in retirement planning and currently has over $750 million in AUM. For more information visit www.acrinv.com.