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How 401k Plan Sponsors Can Best Teach Employees to Quit Emphasizing Income

July 10
01:21 2012

One of the biggest complaints concerning 401k plans from financial professionals deals with investors’ implausible enthusiasm for income-oriented investments. The 2006 Pension Protection Act tried to address this very concern by encouraging default options which emphasized equities over bonds. Alas, fate decided to thwart this effort by producing one of the worst equity markets almost as soon as the legislation became effective.

The dramatic market swoon in late 2008 early 2009 gave 401k investors, especially younger ones, such trauma many of them vowed to avoid stocks forever. That’s not good news. Almost all 401k investors need investments that promise long-term growth, and income-oriented options just about guarantee disappointment and failure when time comes to retire. If only 401k plan sponsors had a fool-proof method to educate their employees on the dangers of “safe” investing.

Last year, ran a series of articles that attempted to perform such a service. (The series starts with “7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 1st Deadly Sin – ‘Income Matters.’”) Besides explaining what Robin Hood, income and fiduciary duty all have in common, it provided a framework for 401k plan sponsors to help their employees avoid placing undue emphasis on income.

In a sense, income represents the vestigial measure dating back to the agricultural economies of Medieval times. It was the only real value one could derive from often illiquid capital assets (namely, land). As a result, income was the primary focus of a fiduciary. Eventually, fiduciaries discovered what was wrong with emphasizing income. Guided first by the 1830 court ruling in a case known as Harvard College v. Amory, two reports from the Ford Foundation in 1969 forever changed the landscape.

The first Ford Foundation report stated, since endowments (and many modern trusts) were not split-interest trusts, beneficiaries had rights to both income and principal. This meant there was no need to require trustees to emphasize income. The second Ford Foundation report showed how much more a portfolio could grow when not shackled by the requirement to invest for income. Since 1969, most endowments and professional investment advisers invest for total return, not for income.

Despite this 4+ decades old report, why do two popular 401k options encourage investors to invest for income when most fiduciaries know (or show know) of the dangers of doing so? It seems older investors still hang their hat on the “spend the income, preserve the capital” adage of their Depression-Era parents and grandparents while younger investors have “tuned-out” of long-term investing altogether. A 401k plan sponsor who merely follows the wants of his naïve employees tempts the fate of fiduciary liability. Money markets, stable value funds and even mutual funds that invest in bonds (which are, by definition, equities, not bonds), can leave retiring employees with too little assets to pay for their expenses as well as leave them exposed to the ravages of inflation.

Data reveals the amazing truth about the success of total return investing. So, what’s the best way 401k plan sponsors can offer total return options? First, it helps to teach employees how total return investing is in their best interests. Studies similar to those featured in the second Ford Foundation report show long-term investors (like those investing in 401k plans) are almost always better off investing for total return as opposed to income. This is because, over time, the volatility of equity investments dampen and their higher returns become more apparent.

The concept of time diversification remains controversial, but here’s why the practitioners and 401k investors have one up on the academics. The academic complaints about time diversification amount to arguing over how many angels can dance on the head of a pin, while the actual results are something every plan sponsor and employee can see. Finance professors might argue the relative merits of “risk” and “safety,” but common-folk sure know the difference between a “safe” – but guaranteed – failure and taking on “risk” to even have an ounce of a chance for success. Most would pick the latter option, no matter what computer says to do otherwise.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


  1. Stephen Winks
    Stephen Winks July 13, 11:56


    FinanceWare has achieved high 90% client satisfaction ratings with in Wells Fargo by establishing an understanding of the probability that the consumer has in achieving their retirement objectives. When applied to 401(k) plans, this sort of progress evaluation would resolve the short term chasing the hot dot challenge with consumers. The focus is on the progress made and probability achieved rather than picking a hot dot on a scattergram.


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