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The Default Dilemma

September 7, 2007
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Related Topics: Retirement/Pensions, Workforce Planning, Compensation
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There is no question that the pension reform measure passed in August 2006 solved a lot of the issues that 401(k) plan sponsors have wrestled with in recent years.

Specifically, those employers had been debating whether to automatically enroll employees into their plans, and if they did, which investments to use as the default. Their concern was that if they automatically enrolled employees into an option, employees could come back years later and sue them if the investments performed poorly.

But the Pension Protection Act of 2006 eased a lot of concerns by offering plan sponsors protection from fiduciary lawsuits if they automatically enrolled employees into certain investment options deemed appropriate by the Department of Labor. The DOL proposal provides safe harbors for three default options: balanced funds, lifecycle funds (also known as target-date funds) and managed accounts. Safe harbors exempt employers from fiduciary liability and nondiscrimination testing, which can be a time-consuming process for plans.

Now, 12 months later, it seems that the Pension Protection Act has employers wrestling with a whole new set of questions as they try to figure out which default investment option to use with their 401(k) plans.

The stakes are high, since employees tend to stay in whichever investment employers choose, experts say. Eighty percent of plan participants never trade investments in their 401(k) plans, according to the Vanguard Group.

Even though the new rules don’t take effect until January 2008, a number of plan sponsors are having these discussions now, says Don Stone, president of Plan Sponsor Advisors, a Chicago-based 401(k) consultant.

Many employers were surprised to see that stable-value funds, which a large number of companies had traditionally chosen for automatic enrollment, were not on the Department of Labor’s list of qualified default investment alternatives. These funds have been a preferred default investment option for many plan sponsors because they are conservative, experts say.

In a March 30 letter, the American Council of Life Insurers urged the White House’s Office of Management and Budget to address the Department of Labor’s proposed list of default investment options and add stable-value funds to it.

In June, the Investment Company Institute, a Washington-based organization that represents the mutual fund industry, fired off its own letter to the Office of Management and Budget, saying that adding stable-value funds as a default option "would be inconsistent with the purpose of measures enacted in the Pension Protection Act" because they are too conservative for the majority of investors.

While the insurance industry and mutual fund industry both have a vested interest in their arguments (insurers make money from the sale of stable-value funds, just as mutual fund companies make money from the sale of target-date funds), observers say they don’t know which party will win.

At press time, the Department of Labor had not issued a final ruling on the matter.

Each of the default investment options approved by the Department of Labor comes with its own set of pros and cons, and it’s up to each employer to decide what makes sense for its own employee population, says Lori Lucas, senior vice president and defined-contribution practice leader at Callan Associates, a San Francisco-based consultant to institutional investors.

"Each company needs to clearly think about what makes sense for their employee demographics and what’s going to appeal to their employees," she says.

Workforce Management spoke to 401(k) plan consultants around the country about the pros and cons of the default investment options approved by the Department of Labor, as well as stable-value funds.

Balanced funds
    What they are: Balanced funds generally have a mix of stocks and bonds that reflect a specific risk profile. Typically, these funds have a 60-40 ratio of stocks to bonds—an asset allocation that consultants agree should suit a wide array of investors. These funds will periodically reallocate to maintain their stated asset allocation.

PROS: Analysts like these funds because they are easy for participants to understand and many have long track records, so plan sponsors and participants can get a good sense of how they perform. "The most common refrain we hear from plan sponsors is that they already have a balanced fund in place, and it’s a really solid fund, so they don’t see a reason to change," Lucas says.

These funds offer diversification without the costs of managed accounts or lifecycle funds, says Rick Meigs, president of 401khelpcenter.com, a Portland, Oregon-based consultant. The average expense ratio of balanced funds in large retirement plans is 80 to 100 basis points. But since many employers have had these funds in their plans for years, they have accrued assets and so can get price breaks on the funds by accessing cheaper share classes of the funds, consultants say. The size of the discount depends on how much the plan has in assets.

Since these funds rebalance back to a specific weighting of stocks to bonds, sophisticated investors can create an overall asset allocation around it, says Sue Walton, senior investment consultant at Watson Wyatt Worldwide. Whether a significant number of employees would take advantage of that attribute is questionable, she says.

CONS: While praising the simplicity of balanced funds, analysts also note that their one-size-fits-all approach doesn’t work for all investors.

"Balanced funds may be appropriate for a lot of people, but if you have employees in their 20s and people in their 60s, it’s hard to argue that it’s appropriate for all of them," Lucas says, noting that younger investors tend to have a greater risk tolerance than older ones. Only 18 percent of plan sponsors surveyed by Callan say that they plan to use balanced funds as the default option in their 401(k) plans.

Also, balanced funds tend to be limited in which asset classes they represent, Stone says. "Typically in a balanced fund, you are not going to get as much diversification as you can," he says.

These funds usually invest in bonds, cash and domestic equity. "Not a lot of them have international exposure, and that’s an asset class many investors would want right now," Stone says.

Lifecycle funds
What they are:
These products, also known as target-date funds, automatically reallocate according to the year investors plan to retire. A target-date fund for 2040, for instance, is aimed at employees who plan to retire that year. The fund’s asset allocation moves from aggressive to more conservative to help investors reach their goal.

PROS: Lifecycle funds are the 800-pound gorilla when it comes to default options in the 401(k) industry. Seventy-one percent of plan sponsors want to use a lifecycle fund as a default, according to Callan.

"These funds are generally easy to understand—participants just pick a date and that’s it," Stone says. Essentially, many companies like this type of fund because it doesn’t require plan participants to do anything, which is good since most of them wouldn’t do anything anyway, consultants say.

"If they never look at their investments again, at least they are in the proper asset allocation," Walton says.

Also, since these funds are popular now, competition is driving providers to come out with better and more diversified versions of these products, Lucas says.

CONS: Just because these funds are the most popular among plan sponsors doesn’t mean these funds are a shoo-in as the default option for 401(k) plans, consultants say.

First, since many of these funds are new, there are few with three- or five-year track records, making it difficult for plan sponsors to gauge their performance, Lucas says.

These funds often contain only the provider's proprietary funds, Walton says. "That’s not necessarily bad, but not every company does every fund well," she says. "And as the fiduciary, plan sponsors need to be comfortable with the underlying funds within the portfolio."

Lifecycle funds also have higher fees than their balanced-fund counterparts. Fees for the underlying funds within an actively managed lifecycle fund usually are around 80 basis points, and sometimes there is an overlying fee, bringing it up to 100 basis points, analysts say.

Some 401(k) plan sponsors might object to the assumption that lifecycle funds make, which is that investors’ asset allocation should become more conservative as they approach retirement, Meigs says.

Today, people are living longer, and plan sponsors shouldn’t assume that they will cash out when they turn 65 or that they only need the money for a few years, he says.

"A 60-40 mix of stocks to bonds still makes sense when an investor is 65 years old," he says. "Too many lifecycle funds are too conservative for older investors."

Some employers are just philosophically opposed to lifecycle funds because they do everything for employees. "A lot of companies want employees to take an active role in saving for retirement," Stone says. "They are worried that if they encourage employees not to have to think about anything, then they are creating a liability for themselves."

Managed accounts
    What they are: Managed accounts let providers ask participants about themselves and their assets to create a customized portfolio. Many of these programs allow participants to plug in their information online.

PROS: Managed accounts are considered to be the ultimate in customization because they try to take into account various factors beyond the age and income of the employee. "Managed accounts can take other assets into account—such as outside 401(k)s or spouses’ income and retirement savings," Stone says. "It’s a more holistic view of an individual’s overall investment portfolio."

For plan sponsors, the advantage of offering managed accounts over lifecycle funds is that a company can offer a managed account program that creates portfolios based on the funds already in the plan, Walton says. "That means there are less funds for the plan sponsor to conduct due diligence on," she says.

CONS: The main disadvantage of managed accounts is the fees. Managed accounts can charge anywhere from 25 to 100 basis points on top of the expenses of a fund, which means an employee could end up paying up to 150 basis points, says Pam Hess, director of retirement research at Hewitt Associates.

While paying such high fees might make sense for those 401(k) participants with a lot of outside assets who are willing to take the time to provide personal information, few employees fall into that category, observers say.

"Most participants don’t have other assets, so it doesn’t help them much," Stone says. "Who it helps are those employees with fairly high average balances who are inclined to take the time to provide their information."

But managed accounts are evolving and fees will come down, so plan sponsors should keep abreast of these offerings, Lucas says.

"Managed-accounts providers are discussing creating a tiered pricing structure by which people who are defaulted into managed accounts and don’t use all the features could pay a lower cost than those who do," she says.

Stable-value funds
    What they are: Stable-value funds invest in bonds bound by insurance "wrappers." If the rate of return of these funds falls below the rate of return set by the insurance wrapper, the insurer pays the difference.

PROS: If the portfolio gains beyond the wrapper’s set return, the fund pays the insurer the difference. These funds tend to generate higher returns than money market funds at slightly more risk.

In the past, a number of 401(k) plan sponsors opted to make stable-value funds their default options because it’s pretty much assured that investors won’t lose money and won’t come back to sue the company for investment losses. Now that the Department of Labor has given the nod to lifecycle funds, balanced funds and managed accounts, that’s no longer a benefit of stable-value funds, experts say.

However, many plan sponsors see benefits to stable-value funds as default options, particularly for short-term investors. Under current law, employees who have been defaulted into a 401(k) plan have 90 days to get their money back. If their contributions are defaulted into a stable-value fund, getting them the money back is easier than if it was invested in a more active portfolio that could have realized investment losses, says Joe Hessenthaler, a principal at Towers Perrin.

Also, if an employer has high turnover, many plan sponsors opt for stable-value funds because it’s easy for employees to cash out, Lucas says. "But it seems a little shortsighted to focus on those individuals," she says.

And then there are those companies that have done their homework and have found that their employees would prefer to be defaulted into stable-value funds—and as long as they can prove they did their homework, there is nothing wrong with that, Walton says. "I have plenty of clients who will stick with stable-value funds, but they will document the hell out of it," she says.

CONS: The major drawback of using stable-value funds as the default is that most consultants don’t believe these funds will generate the investment returns needed for employees to save enough for retirement. Experts generally say that investors will need 70 percent to 100 percent of their pre-retirement income to retire. "Stable value has a place as part of a bigger portfolio, but it can’t be the only investment option," Stone says.

Since employees rarely reallocate their 401(k) investments, using stable-value funds as the default seems shortsighted, says Phil Suess, principal and defined-contribution segment leader at Mercer Investment Consulting.

And unless the Department of Labor changes its stance, it looks like employers who do choose to offer stable-value funds as the default investment option won’t get a safe harbor from discrimination testing, consultants say.

Safe harbors aren't everything
    When it comes down to it, plan sponsors can choose whatever investment options they think are right for their plans, experts say.

"Qualified deferred investment alternatives are just safe harbors," says David Wray, president of the Profit Sharing/401(k) Council of America, a Washington-based organization representing plan sponsors. "It’s up to each company to decide if they need that safe harbor."

Specifically, choosing one of the approved default options means plan sponsors get that safe harbor. But if employers have a good reason to adopt a default option that is not one of the Department of Labor’s qualified deferred investment alternatives, they can do so, Walton says, adding a proviso: "They need to have great documentation of all of the factors that they considered and why they chose the investment they did."

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Workforce Management, August 20, 2007, p. 41-47 -- Subscribe Now!

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