At first blush, it looks like 401(k) plan participants have well-diversified retirement savings portfolios. Some 50 million workers have $2.6 trillion in 401(k) assets-with a little over 50% in stock funds, according to the Employee Benefit Research Institute (EBRI) in Washington, D.C. The rest is in bond funds, money market funds and stable value funds.

But if you think 401(k) investors have mastered the art of smart diversification, think again. The seemingly savvy balanced 401(k) portfolio split masks a slow trickle of 401(k) stock investments into fixed-income accounts.

Plus, it's not necessarily smart analysis that has triggered the relatively even split, observers say, but rather, fear and investor paralysis.

A deeper look at the numbers paints the picture. That 50%-plus stock allocation reflects a drop from about 66% before the 2008 financial meltdown.

Over the past 32 months, ended in August, $8.3 billion has moved out of stocks into fixed-income accounts, says Hewitt Associates in Lincolnshire, Ill. In August alone, $347 million-0.31% of 401(k) assets-followed this trend, with transfers almost daily.

Eighty percent of the funds transferred in August moved into bond funds. About 10% of assets, primarily from new employees, went into target date funds-the default investment option offered by many plan sponsors. The rest went into stable value and money funds.

"People are scared to death," says Kelli Send, a senior vice president at the financial planning firm Francis Investment Council in Milwaukee, Wis. Their 401(k) "is their single largest asset aside from their home."

Research published by the Michigan Retirement Research Center in 2009 appears to back up Send. Participants are making asset-allocation mistakes, says the paper, co-authored by Wharton professor Ning Tang and others. This, despite the fact that most plans offer a good selection of investment options for diversification. The mistakes could cause an employee's wealth to be reduced by 20% at retirement, says the paper, "Efficiency of Pension Menus and Individual Portfolio Choice in 401(k) Pensions."

Sixty-eight percent of participants either have not made any savings or investment changes or they have stopped contributions because of the recession, according to a January 2010 survey by Francis Investment Council. The poll spanned more than 1,100 plan participants. Send adds that one of five employees reduced their contributions because of rising health insurance premiums."Economic uncertainty, the desire to pay down debts, job losses or wage reductions within the household is holding them back," Send says.

Many employers also have reduced or eliminated company contributions to their plans. The value of employee-sponsored retirement plan benefits as a percentage of pay has declined by double-digit levels over the ten years ended in 2008, said a July 2010 report by Towers Watson in New York. The hardest hit industries were in the wholesale and retail sectors of the economy.

However, many employers also are working to cut investment fees. Many are conducting fee studies aimed at saving millions of dollars by replacing high expense open-end mutual funds with lower-cost ones, according to Workforce Management magazine.  One plan sponsor, for example, brought in low-cost funds and ETFs from Vanguard and Barclays to replace three higher-cost funds. Akzon Nobel, a Chicago-based chemical company with $1.6 billion in plan assets, says it saved $31,000 by moving to a Vanguard Index fund, $67,000 by switching to a Vanguard money fund and $340,000, by moving to Barclays target date funds. Meanwhile, the plan sponsor also saved $120,000 by having Fidelity Investments waive quarterly fees, according to Workforce Management.

"A growing number of 401(k) plan executives are demanding to know how much in excess revenue is generated by their plans and how they can get their hands on that money to cut costs and enhance services to participants," the report says.
Exchange-traded funds providers also are slashing fees in 401 (k) plans. Among those: Vanguard, Fidelity,  Barclays,  and Charles Schwab. And employees who make recurrent investments or use a stable of funds to diversify pay no commissions. Investment companies, such as Wells Fargo, have reduced the fees on its target date funds when used in the retirement plans.

The uncertainty pervasive among  401(k) investors, however, spells attractive business opportunities for investment advisors. More advisors are doing business with plan sponsors as consultants or money managers. Employees who used professional advisors improved their savings rates and had appropriately diversified portfolios, according to a September 2010 study by Charles Schwab, a service provider for 1.5 million company retirement plan participants.

The Pension Protection Act of 2006 made it clear that registered investment advisors can participate in 401(k) plans and collect a fee. "Interim regulations that take effect next year will force plans to provide full transparency and full fee disclosure," adds Jonathan Bergman, the chief investment officer with Palisades Hudson Asset Management in Scarsdale, N.Y.

Recently, Bergman helped several area companies set up asset-allocation models and fee structures, using select Vanguard Target Maturity funds as a default option in their plans. "There is a market for it," Bergman says. "The time is right for as much education and diversification as possible."

Gerald Wernette, the director of retirement plan services with Rehmann, a financial services, accounting and consulting firm in Farmington Hills, Mich., says that he's talking to many plan sponsors about setting up highly diversified "collective funds." These funds, managed by fee-only investment advisors, are similar to bank-managed trust funds. They use a wide range of no-load mutual funds, low-cost exchange-traded funds and tactically managed asset-allocation mixes.

"We are having conversations [with plan sponsors] to bring alternative investments into their mix of assets," Wernette says.
Insurance companies also are making inroads into the 401(k) marketplace. It's been estimated by the Profit Sharing/401k Council in Chicago that fewer than one in five defined contribution plans offer annuity distribution options in their plans.
But things could change. The Obama administration is looking into the use of immediate annuities to help workers reduce longevity risk in their retirement savings plans. And as of this writing, Senate bill S. 2832 was under consideration by the Committee on Health, Education, Labor & Pensions. The bill would require plan sponsors to show on their annual benefit statements how the value of retirement accounts translates into lifetime guaranteed monthly income payments.

MetLife has a suite of four annuity products in qualified plans. Other carriers with immediate annuity or annuity-like lifetime income products for employees about to retire are Genworth, Prudential and Mutual of Omaha.

It could take time, however, before plan sponsors aggressively include annuities in their plans. They have expressed concerns about employees moving their entire retirement savings into an immediate annuity offered by the plan. State guarantee association insurance funds only cover up to $100,000 in annuity income if an insurer goes bankrupt.

Due diligence must be conducted on the financial strength of the insurance company, its risk-based capital measures, its reserves, its general account investment portfolio and the duration of its fixed-income investments. Other issues include annuity portability, cost, risk and fiduciary exposure.

"Plan sponsors have historically been reluctant to get involved in product issues unless forced to," says Noel Abkemeier, an actuary at Milliman Inc. in Williamsburg, Va. "They feel their fiduciary responsibilities deter them from appearing to endorse a product. This may make it difficult to get products inside a plan."

There is also an opportunity for advisors to capture more of the IRA rollover market. The high balance rollover market is made up of about one million individuals with $370 billion in assets. Just 25% of plan participants who performed rollovers of $200,000 or more in mid-2008 rolled all or some of the funds into an account held by existing plan providers, which typically are the mutual fund companies that manage the 401(k) subaccounts. At least, that's according to a study by the Spectrem Group in Chicago.

Instead, 53% rolled over at least part of the balance to companies where they hold other investments and another 39% transferred funds to companies where they had existing IRAs. There is some overlap in these statistics because an IRA may be part of an individual's investment account.

On the 401(k) loan side: Despite the recession, only 18% of all 401(k) participants had outstanding loans according to year-end 2008 data. Steve Blakely, an EBRI spokesperson, estimates that loan activity in 2009 and 2010 is about the same.
Aggregate data, however, appear to camouflage the activity of at least one leading 401(k) provider. In August 2010, Boston-based Fidelity Investments, the nation's number one provider of workplace retirement savings plans, reported that loan and hardship withdrawals were on the rise.

Fidelity administers 17,000 plans, representing 11 million customers. And the average 401(k) account balance is $62,000. "The majority of participants continue to make savings though their work plans a priority," says James M. MacDonald, the president of workplace investment at Fidelity Investments. "However, the current economy has forced some workers to borrow from their 401(k) accounts to pay for critical living expenses, ultimately jeopardizing their future retirements."

MacDonald said in September that loans initiated over the past year grew to 11% of total active participants from about 9% one year earlier. The portion of participants with loans outstanding also increased two full percentage points in the second quarter to 22%. The average loan amount at the end of the second quarter was $8,650, with an average loan duration of three and one-half years.

During the second quarter of this year, 62,000 participants initiated hardship withdrawals, where only 45,000 did in the same period the year before. Hardship withdrawals can only be taken for medical expenses, to buy a primary home, for educational or burial expenses, or to prevent eviction or foreclosure or damage to a home, according to the Internal Revenue Service.

Not all loans are prompted by dire financial situations. The lack of small business loans has led many entrepreneurs to tap their 401(k)s as a way to obtain instant cash flow. The strategy, known as the "Rollovers as Business Startup" (ROBS) works this way: A businessperson creates a Subchapter C corporation, but does not issue stock. The new company sets up a retirement plan. The businessperson then rolls over his or her existing 401(k) into the new corporation. The company then issues stock and transfers the stock to the new retirement plan in exchange for cash. The IRS requires that properly structured plans meet antidiscrimination rules and that stock transferred into the newly created retirement plan be properly valued.

Over 4,000 businesses used ROBS funding last year, according to a study by FRANdata, an Arlington, Va., company that tracks data on franchise businesses. More than 60% of ROBS transactions were used to start franchise businesses. That type of financing, FRANdata says, had an $8 billion impact on the economy in 2009, generating a total 62,000 direct and indirect jobs.

Financial planners say that before one of your clients attempts a rollover as a business start-up, they should have a solid business plan and consult with a tax attorney. Wernette, of Rehmann, says he talked to several clients about this financial strategy, but advised against it because the start-up businesses were too risky.

"I had a number of clients who looked into it as a source of business capital," Wernette says. "It is something to consider as a way to get capital for a start-up business, but only if you have a solid business plan. Otherwise you can see your retirement savings go up in smoke."