Fidelity Investments recently reported that hardship withdrawals in 401(k) plans rose to their highest point in 10 years over the 12-month period through the second quarter of 2010.
Granted, only 2.2 percent of participants had taken a hardship withdrawal during that period, but that was a 10 percent increase over the previous year. Fidelity also reports that a record 22 percent of all 401(k) participants have an outstanding loan on their account.
Many industry pundits point to these statistics as signs of lingering economic hardships affecting defined contribution plan participants. But these statistics may also suggest potential disillusionment with 401(k) plans.
After all, a 60 percent equity and 40 percent fixed income portfolio—which is the typical 401(k) participant’s allocation—would have returned only 3.02 percent annually during the past 10 years. In the past 4½ years, for instance, the Callan DC Index shows that defined contribution participants would have earned an annualized return of only 0.11 percent.
And there’s more bad news. Since early 2006, 401(k) plans have underperformed against the average corporate defined benefit plan by nearly 2 percent per year.
Are participants right to throw in the towel? And if not, what can plan sponsors do to educate and guide them?
Looking at the rolling 10-year performance of a 60 percent equity and 40 percent fixed income portfolio—the typical portfolio of a defined contribution investor—since 1980, the four worst periods occurred beginning with the fourth quarter of 2008—including the second quarter of 2010.
Some context can help here. For example, if in contrast one were to look back to 1991, a very different picture emerges. Ten-year annual returns for the same diversified portfolio in this period would have averaged 17 percent. In 1999, it was necessary to truncate the long-term forecasted average returns that investors could select to no more than 15 percent.
Participants at that time were so giddy about dot-com possibilities that they preferred to forecast 30 percent annual returns if they could. But, just as people were ill-advised in 1999 to extrapolate probable returns based on frothy market strength, investors today are also likely ill-advised to base long-term return expectations on recent market weakness. Indeed, few economists are forecasting either 17 percent or 0.11 percent average annual returns for well-diversified portfolios over the long term. The reality is more likely to be somewhere in between during the next 20-plus years—a common time horizon for many 401(k) investors.
Providing participants with this type of historical perspective can help assuage the feeling that there’s little to be gained by taking investment risk in 401(k) plans.
Telling participants to “stay the course” is all well and good, but what else can plan sponsors do to help with their investment performance? Worded another way, is there anything plan sponsors can do to help participants narrow the gap between their 0.11 percent 4½-year annualized return and the 2.1 percent annualized return during the same period by defined benefit plans?
• Expand the fund lineup. This, of course, runs counter to popular wisdom. For many years, the mantra of many well-informed plan sponsors has been to streamline the investment fund lineup. Academic literature supports the idea that overwhelming participants with too many investment choices is a good way to create investor paralysis and poor usage of the defined contribution plan. However, there are some select areas where plan sponsors may wish to consider providing additional diversification potential. For example, the typical defined contribution plan has 3.9 domestic large cap funds and 3.2 domestic mid-/small-cap funds. However, it has just 1.7 developed international equity funds. Naive plan investors may take such investment menu bias as a signal to have a much greater allocation in domestic equities than in international equities. This has resulted in a typical allocation to international equities of 7.3 percent vs. 33 percent in domestic large-, mid- and small-cap equities. Yet many investment professionals see considerable long-term growth potential in international equities.
• Reduce fees. Many plan sponsors are already making it a habit of reviewing plan defined contribution fees on a regular basis. However, there may still be areas where lower-fee share classes of mutual funds, or less expensive vehicles such as separate accounts or collective trusts are available and make sense within the plan. For example, an active large-cap value fund with a $50 million mandate commands an average institutional mutual fund fee of 0.85 percent, but an average collective trust fee of 0.55 percent. Depending on the effect of additional administrative fees, strategic changes to alternative investment vehicles may add up to meaningful improvements in participant returns.
• Consider investment advice. Fewer than half of large plans offer online investment advice, and about one-quarter offer managed accounts. Yet Hewitt Associates and investment adviser Financial Engines Inc. were able to find significant improvements in return during the past three years among those using advice solutions—citing inappropriate risk levels and inefficient portfolios as the culprits in undermining the relative performance of nonadvice users’ portfolios. Some plan sponsors point to modest utilization of such products—10 to 15 percent participant utilization per advice solution is not uncommon. As such, advice products may best be viewed as part of a suite of solutions, including target date funds and traditional educational programs, and not as a silver bullet to improving investor performance.
• Talk up the importance of high contribution levels. Encouraging participants to increase their contribution levels is a tough conversation these days, given economic conditions. However, the reality is that unless participants are contributing at least 9 to 12 percent of pay to their defined contribution plan over their full career, they are unlikely to reach the retirement goal of replacing most of their pre-retirement income. Features such as automatic escalation can help. Rethinking the company match can be an important tool; after all, research shows that participants are likely to defer as much of their pay as necessary to receive the full matching contribution. This is true whether the match is $1 for $1 up to 3 percent of pay, 50 cents on the dollar up to 6 percent of pay, or potentially an even higher required deferral.
Of course, if plan participants are experiencing personal financial woes, the only real solution might be simply to encourage and make it easy for them to recommit to their 401(k) as soon as possible. In a similar vein, plan sponsors may wish to consider allowing participants to repay loans after termination—so that terminated participants’ loans don’t become withdrawals, further damaging their financial future.
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