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Bolstering the 401(k)

In light of the stock-market meltdown, HR leaders are turning to new products and tools designed to strengthen defined-contribution plans.

Saturday, May 2, 2009
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Target-date funds easily won over the hearts and minds of production workers at Diamatrix in Fairless Hills, Pa., when the manufacturer of transportation equipment introduced them in July 2004.

"Many were very enthusiastic and, shall we say, relieved, to leave some of the decision-making regarding their investment selections in the hands of professionals," says Maureen Arnoldy, the company's director of human resources. She adds that employees had often felt overwhelmed by the 13-plus investment offerings available in Diamatrix's defined-contribution plan.

Touted as one of the most promising approaches to investing, target-date funds feature a premixed portfolio whose asset mix is automatically rebalanced and becomes more conservative as the employee's targeted retirement date approaches -- a slope of evolutionary change known as the "glide path."

The funds are particularly appealing to 401(k) plan participants who lack the time, desire or investment savvy to keep tabs on their account balances.

However, TDFs weren't exempt from last year's stunning market losses, and Arnoldy laments that many of the firm's roughly 300 employees "aren't even opening their statements because they know what they're going to say."

Here's why: A congressional budget analysis showed that the nation's financial crisis drained $2 trillion from retirement accounts in a 15-month period leading up to the fourth quarter of last year. Despite an improvement in employee contribution rates, the average 401(k) balance plunged 27 percent in 2008, to $50,200 from $69,200 in 2007, according to Fidelity Investments.

These plummeting returns are contributing to the enormous pressure on HR leaders to arm their workforces with better fund choices and a more expansive toolset for making informed decisions about retirement planning. In addition to offering TDFs, more and more companies are also making available auto-pilot features to simplify enrollment, deferrals and fund choices.

They're also offering investment advice and annuitized new products designed to make defined-contribution plans act more like defined-benefit plans by guaranteeing payouts for life.

The hope is that these new tools and features will help 401(k)s (which were originally conceived as a supplement to traditional pension plans) and other DC vehicles become more sturdy and reliable investment vehicles for the American worker. In reality, although they do have the potential to significantly strengthen those workers' prospects for a secure retirement, there are also a number of caveats that HR leaders can't afford to ignore. 

"A Great Invention"

TDFs date back to the mid-1990s, when Fidelity Investments was the sole player in this market until T. Rowe Price and Vanguard entered in 2002 and 2003, respectively. It was a time when "the lessons of diversification from the 2000 and 2002 bear markets were brought home," says Greg Carlson, an analyst with Chicago-based Morningstar. Carlson says there are now about 380 TDFs, more than half of which are older than three years.

Some industry experts say that, while TDFs have their share of flaws, they can clear up individual investor confusion amid the nation's savings crisis, so long as they're managed to the specified retirement date.

TDFs even have a government stamp of approval as one of three qualified default investment alternative options in 401(k) plans under the 2006 Pension Protection Act (the other two options being balanced funds and managed accounts). The U.S. Department of Labor estimates that more than one-third of all DC savings will be in TDFs by 2015, compared to just 3 percent in 2006.

Ted Benna, who's often referred to as the "father of the 401(k)" and who now serves as chief operating officer at Malvern Benefits Corp. in Jersey Shore, Pa., says TDFs provide a broadly diversified portfolio with automatic rebalancing and risk reduction. Another huge benefit, he adds, is that participants only have to decide how much per month they want to withdraw from one fund, rather than multiple funds.

"Target-date funds are a great invention," says Joseph C. Nagengast, a principal at Target Date Analytics in Marina del Rey, Calif. However, he adds, the consensus is that TDFs aren't a panacea, and even those who sing their praises are equally adamant about the need to address the serious shortcomings associated with them.

For example, Nagengast says, one problem with TDFs is that fund managers got caught up in a performance horse race during the market's up years and abandoned prudent risk management as participants approached their retirement target dates. As a result, overly aggressive funds triggered devastating losses that have caught the attention of lawmakers.

In a recent congressional hearing on how the economic downturn has affected retirement security, the U.S. Senate Special Committee on Aging focused on TDFs in 401(k) plans. Committee Chairman Sen. Herb Kohl, D-Wis., urged U.S. Secretary of Labor Hilda Solis and U.S. Securities and Exchange Commission Chairwoman Mary Schapiro to immediately begin reviewing TDFs, noting that "despite their growing popularity, there are absolutely no regulations regarding the composition of target-date funds."

One area that may be ripe for review is a suggested ratio of stocks and bonds in TDFs as funds near their target.

A study by the Vanguard Center for Retirement Research shows that plan participants who do not invest in TDFs tend to exhibit greater extremes in their equity holdings than those who do, with 30 percent possessing risky, all-equity portfolios and 16 percent sticking with highly conservative, zero-equity portfolios. The stock exposure of TDF investors ranged from 40 percent to 90 percent, depending on their age and retirement timeline.

But that's not to say these plans are immune from a volatile market. TDF losses were all over the map in 2008, according to Carlson, who says they ranged from single digits to upwards of 40 percent in some of the more aggressive portfolio mixes, particularly those with 95 percent of funds invested in equities. He cautions plan sponsors and participants alike about TDF selection, citing shorter-dated offerings from AllianceBernstein and Oppenheimer that took on a great deal of equity risk and posted substantial losses.

Nagengast says that, when properly implemented, "the target-date model still serves individual investors better than if they were left to make their own management, allocation, security selection and rebalancing decisions."

Flawed Measures

It's also challenging to gauge TDFs' relative performance.

There can be fundamental differences between funds with the same date in their names that could, nonetheless, have two completely different equity weightings, resulting in apples-to-oranges comparisons. While one 2010 fund may, in fact, target that year, Nagengast cautions that another could actually target the year 2040 as part of "some tortured logic."

About two-thirds of fund managers attempt to hold onto funds past the target date by extending the glide path, he says, noting that they use longer lifespans as an excuse when aiming for the year 2040 on a 2010 fund, which exposes investors to market risk at the beginning of retirement -- when they can least afford it.

"Participants think 2010 means 2010," says Nagengast, "and then find out they just lost 40 percent of their account balance because the manager isn't targeting 2010 but, instead, some fictional actuarially determined death date, in which case the funds should be renamed '2040' so that participants understand that's what they're buying into."

Some fund managers actually blame last year's devastating losses on participants' failure to understand that these are long-term investments, he says, suggesting that plan sponsors should no longer tolerate managers who ignore retirement-date risk.

Nagengast's firm created the Plan Sponsor On Target Indexes in recognition of these difficulties. He says a standard suite of target-date indexes based on fundamental principles is a more effective measure than peer groups based on average allocations of existing funds.

Other TDF benchmarking tools that have emerged in recent years include the Dow Jones Index, introduced in 2005 as the first one of its kind on the market, followed by the Dow Jones Real Return Target Date Indexes and Standard & Poor's Target Date Index Series, both of which were introduced last year.

There's also the Morningstar Lifetime Allocation Index Series, which bases its measures on a model that embraces detailed studies on how an individual's finances change over time and ideas associated with modern portfolio theory.

When attempting to measure TDF performance, the aim is to "compare a fund that has similar risk characteristics to a benchmark that has similar characteristics," says Thomas Idzorek, chief investment officer and director of research and product development for Ibbotson Associates in Chicago, a Morningstar company.

He says once this baseline measurement is established, the next step would be to think beyond stock and bond exposure by considering, for example, intra-stock and intra-bond allocations, as well as which benchmarks feature real-estate holdings or commodity exposure.

"What's good is that there's choice when it comes to benchmarks that is rivaling the wide variety of funds that are out there," he adds, noting that the most important objective is to determine whether individual investors are on the right glide path based on their capacity and preference for risk. "The reality of making that kind of decision isn't a benchmark-centric activity," he says.

Innovations in Annuities

HR leaders have other recent innovations to consider besides TDFs. At least two large financial companies have introduced new annuitized products for defined-contribution plan participants. Prudential has introduced IncomeFlex, an investment option that offers plan participants a guaranteed minimum-withdrawal benefit for life that combines the ability to capture market gains and remain protected against downturns without losing the flexibility to control fund assets before and during retirement.

In essence, IncomeFlex participants have the right to withdraw predefined amounts from the fund each year without incurring any fees. If these funds are depleted before they die, the guarantor pays that predefined amount for the rest of their lives.

Robyn Credico, who heads up Watson Wyatt's defined-contribution consulting practice in Arlington, Va., says the irony is that "everyone now thinks it's a brilliant idea to have an annuity in a defined-contribution plan, which is amusing since we just spent the past 10 years getting rid of those requirements because they were too administratively challenging."

However, she points out, unlike many annuities on the market, IncomeFlex offers a death benefit and is available to employees as young as age 50, though the earliest they can withdraw money is 55. One potential drawback of the arrangement is in communicating the arrangement's complexity to employees, she says.

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Nevertheless, Credico likes that it enables participants to earn an annual annuity while also cashing out a lump-sum distribution of retirement savings. "It's the best of both worlds in the sense that employees don't have to make the decision to buy the annuity, which is automatic and ties into the concept that the employer match can buy income security," she says.

One particularly appealing aspect of IncomeFlex is that there's a guaranteed return of 5 percent that's established as a baseline onto which employees who participate in the plan can invest more aggressively if they so choose, says John R. McGovern, vice president of human resources for Sunkist Growers in Sherman Oaks, Calif.

The company, which froze its defined-benefit plan in 2004, recently began offering IncomeFlex to its 500 employees, many of whom were concerned that they'd outlive their retirement benefits, he says.

Mark J. Foley, a vice president of Hartford, Conn.-based Prudential Retirement's Institutional Income Innovation Group, says Prudential's prudent risk management enables it to guarantee a 5 percent return even when participants are able to change allocations or make withdrawals.

"We collect fees that can be used to create and manage appropriate reserves, and diversify the mortality risk among a broad pool, which individuals could not do on their own," he says.

The arrangement also enables participants to "catch the upswing on the market and not have to worry so much about the down side of the market," he says.

Meanwhile, for the overwhelming majority of 401(k) plan sponsors that have resisted freezing their matching contributions, Barclays Global Investors has introduced an investment plan designed to optimize those matches. Each SponsorMatch fund features an annuity portfolio designed to provide an income stream, a beta portfolio that mirrors the asset-allocation policies of the world's 200 largest retirement plans and an institutional alpha portfolio that provides diversification benefits, as well as enhanced return potential.

"Like Watching Paint Dry"

The emergence of TDFs, automatic enrollment, investment advice and greater use of online resources have helped employers play a much more active role since 2002, says David Wray, president of the Profit Sharing/401(k) Council of America in Chicago. "Educational programs are much more aggressive and robust," he says.

These innovations were borne out of necessity, traced to wild market fluctuations between 2000 and 2002 stemming from the previous recession when, he says, many older working Americans were too aggressively invested and got hurt.

"Are they willing to give up control and the potential of future reward in order to get more risk-free solutions?" he asks. "We will just have to wait and see, but it's a good thing that the marketplace is responding with lots of new ideas."

Nearly half of plan sponsors now offer automatic enrollment, with fewer than 10 percent of enrollees dropping out, while auto-deferral features are becoming increasingly sophisticated and earnings are being deferred at higher rates in more diversified portfolios, says Pam Hess, director of retirement research at Hewitt Associates in Lincolnshire, Ill.

One such example is "contribution escalation," which automatically increases deferral rates over time -- an increasingly prevalent practice now offered by half of all employers. An employee who joins a plan contributing 5 percent of pay would see 1 percent annual increases up to 10 percent or 15 percent of pay, according to Hess.

However, although technology has gone a long way toward raising the bar for retirement planning, there's still no substitute for a human touch. Diamatrix employees have been eagerly queuing up since October for their free quarterly chat at the worksite with a certified financial planner who provides investment advice and willingly gives out her cell phone number for follow-up consultations.

"People come out of these sessions feeling much more comfortable with their financial decisions, or they have a better understanding of what they should be doing," Arnoldy says.

But for now, there's little comfort in knowing that the nearly $15.9 million balance in 557 401(k) accounts at Diamatrix are down from almost $25.2 million in September 2007 -- a figure that includes drops in performance and terminated-participant withdrawals. Of those participants, 383 have at least some money invested in TDFs, with 32 percent of all plan assets invested in these funds.

Sunkist's 500 employees, 90 percent of whom participate in the company's 401(k) plan, historically are conservative investors who know the importance of having a diversified portfolio. About 40 percent of the plan's assets are in the stable value fund, with about 30 percent in a domestic equity fund, 13 percent in a balanced fund and another 13 percent in a small-cap fund, says McGovern.

Sunkist's employees may be in good company. Even with all the panic from Wall Street spilling onto Main Street, Hewitt Associates research has found that 401(k) plan participants only shifted 5.7 percent of their balances last year from equities into mostly bonds, money market and stable-value funds, which was slightly more than the 3 percent they typically move each year.

Still, there was no way for Sunkist's workforce, like many others, to avoid substantial losses in the brutal bear market. The roughly $68 million in employee contributions in the plan from the middle of last year fell 21 percent to $53 million by the start of 2009, with the employer match losing about $1 million.

Hope springs eternal for McGovern, who notes that the company has tried to explain to employees -- via regular e-mail updates and information put out via its intranet -- that, historically, the market comes back. As distinguished economist Paul Samuelson once said, according to Nagengast: "Investing should be like watching paint dry or grass grow, and if you want excitement, take $800 and go to Las Vegas."

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