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Is Investing for Income the Only Option the 401k Plan Sponsor can Offer Employees Seeking to Meet Certain Financial Objectives?

May 26
00:02 2011

(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

Investors have traditionally chosen income as an objective in the mistaken belief it is the best way to use an investment portfolio to pay for ongoing expenses. Trusts have historically committed this Deadly Sin, and so have endowments – at least until 889195_81127894_danger_erosion_stock_xchng_royalty_free_300the late 1960s as the previous installment of this series explains. Is it a surprise, then, that 401k investors often unknowingly practice this same transgression. What’s an ERISA fiduciary to do in order to dissuade such poor decision making on the part of plan beneficiaries?

Before we get to the answer, it might help to review situations that may be occurring right now in your 401k plan evidencing this behavior on the part of employees.

Why does an investor focus on income in the first place? For one thing, many investors don’t truly understand the nature of their investments. They can more easily grasp the receipt of income (perceived as a bird in the hand) than the far greater potential of capital appreciation (seen as two in the bush). Moreover, many folks whose parents and grandparents grew in the depression might still have the “spend the income, preserve the principal” mantra ringing in their ears. Additionally, younger investors could still be suffering from the shell-shock of the market decline in 2008/2009.

But perhaps the best reason casual investors focus on income is because that’s what they’re used to. If they put money in a bank savings account, they’re used to earning interest income (well, at least until a couple of years ago). By the very act of working in a company, they’re used to earning employment income (again, and unfortunately for far too many people, maybe up until a couple of years ago). Finally, there’s a tendency for people to think in terms of accounting buckets, and allocating income – something one can count on – into those buckets seems a lot safer than allocating a piece of one’s entire portfolio.

So investors build portfolios in search of some promise of income. Here they have two options, both fraught with risks they may not expect. They can build either a pure bond portfolio or a portfolio consisting of dividend paying stocks. (Yeah, I know what you’re thinking: There’s a third hybrid option containing elements of both. Well Mr. Smarty Boots, guess what? That third option will also contain elements of risks from both – and those risks don’t necessarily offset each other.) In a 401k plan, this could mean a bond mutual fund, a money market fund or a stable income fund.

A pure bond (or “fixed income”) portfolio exposes the investor to the risk of failing to achieve the investment objective; hence, a higher potential for investor failing to obtain life goals as a direct result of not being able to pay for current expenses. Professional investment advisers can probably identify a whole slew of dangers associated with fixed income portfolios, but we’ll limit ourselves to the two that apply to all sorts of bonds and, in particular, U.S. government bonds.

As identified in the article “401k Plan Sponsors: Is Your Investment Policy Statement Still Using Outdated Language?” (Fiduciary News, May 17, 2011.), the traditional investment objective of “income” exposes the investor to the danger of inflationary erosion. In an inflationary environment, expenses go up each year. By definition, a fixed income portfolio produces only a fixed income. Over time, expenses will exceed the amount of income generated by the portfolio. This is precisely the problem discovered by the Ford Foundation in the late 1960s. In addition to the problem of rising expenses in the face of a fixed income, the investor also faces the reality of no growth in principal, which can be a significant problem during an era of inflation.

It gets worse. Not only does the investor suffer from inflation (i.e., upon maturity he finds his original principal can now buy less than what it could buy at the time of the original investment), but now the investor also suffers from the danger of reinvestment uncertainty. A fixed income portfolio generates an income based on the interest paid by the issuer of the bond. As bonds mature, new bonds must be purchased. The interest rate paid by the newer bonds may be higher or lower than the interest rate paid on the older bonds. In an era of broadly higher interest rates (based on historic interest rates) there is a greater likelihood that interest rates will trend lower and approach their historic average. In an era of broadly lower interest rates, there is a greater likelihood the principal from maturing bonds will be invested at a lesser interest rate. Should this happen, in addition to attrition of principal caused by inflation, the investor will generate less income in actual dollars.

The results of failure can be catastrophic to investors. Both of these dangers will cause the investor to miss their investment objective – paying for specific expenses. As a result, the investor may have to undergo lifestyle changes in order to maintain the same standard of living. These lifestyle changes may inhibit the investor from attaining certain lifetime goals. The best bet of bond investors – stable long term interest rates and no inflation – represents a historically highly unlikely scenario.

The investor has another option. He can create a pure income generating stock (dividend) portfolio. Many 401k plans offer equity-oriented income funds. In this case, different sets of dangers expose the investor to the risk of failing to achieve the investment objective. As a consequence, there’s a higher potential for failing to achieve the investor’s life goals because current expenses cannot be paid for.

Investing in dividend paying stocks does not totally remove the danger of inflationary erosion. Because stock dividends do exhibit some growth, inflation erosion can be reduced. We can say the same for the danger of reinvestment uncertainty. While this danger is not totally removed, it can be reduced because, even if the dividend yield (similar to the interest rate of the bond) fluctuates, the real dollar value of the dividend may stay the same or even increase as the price of the stock goes up (i.e., the investment produces capital growth).

But dividend stock investors don’t escape that easily. There’s always the danger of an earnings decline in the underlying company. As with any investment in stocks, the investor takes a chance that the particular company will continue to enjoy earnings growth. In reality, earnings growth is far from consistent. This can result in vastly different real dollar values of dividends from year to year. In the worst case, the company goes bankrupt, leaving the investor with no income and no principal. (Hopefully, the investor’s professional investment adviser knows how to either avoid these types of companies or knows how to reduce the damage should one of the companies goes belly-up.)

As with all stock investing, the investor must also deal with the danger of unknown market factors. Factors unrelated to the specific company may influence the real dollars generated by dividend. For example, in the late 1990s we experienced a relatively low yield on stock dividends across the broad market. While some felt this reflected an overpriced market, other felt then-current Federal tax policy, which, in effect taxed dividend income twice, discouraged both investors from seeking dividend income and companies from increasing dividends in a manner consistent with history. It could have been both were true (although I’ll accept the argument only the largest stocks were overvalued in the late 1990s). It certainly was true that stock dividends began to rise with the Bush Tax Cut in 2003.

As before, these dangers can cause the investor to fail to meet the investment objective. If this is the case, the investor may have to undergo lifestyle changes in order to maintain the same standard of living. Again, these lifestyle changes may inhibit the investor from attaining certain lifetime goals.

If the objective really is to pay current expenses, there is another alternative: Invade Principal. One of the most celebrated axioms has been to avoid invading principal. As with many other simple truths, following this advice has led many an investor astray. What’s needed are true total return investment options. The next article addresses how to accomplish this.

Part I: What do Robin Hood, Investment Income and Fiduciary Duty have in Common?
Part II: Plan Sponsor Warning: What’s Wrong with Emphasizing Income?
Part III: Is Income Really the Only Way for a 401k Fiduciary to Meet an Objective
Part IV: If Income Doesn’t Matter, What Should Plan Sponsors Look For?
Part V: How the ERISA Fiduciary Can Avoid the 1st Deadly Sin – Whither “Time Diversification?”

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


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