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A Better Way to Help 401k Investors Choose Among Options

November 06
01:09 2012

(The following is the third in a five-part series of articles devoted to helping fiduciaries, especially individual trustees and ERISA plan sponsors, best align investment goals with beneficiaries’ needs.)

Of course, the 401k plan sponsor and any other individual trustee has a better way to help beneficiaries, including 401k investors, successfully define the appropriate investment goal: be focused and pragmatic. Notice the dominant theme in each of the Common Investor Mistakes we’ve previously noted. Each mistake incorrectly places the investment outcome ahead of the tangible goal of the investment portfolio. Said another way, the investment outcome represents the means while the tangible goal represents the ends. Investors must take pains to avoid any sort of Machiavellian justification. The investment ends never justify the investment means, and plan sponsors and trustees looking to reduce fiduciary liability should know this more than anything else. Why? A lawyer may suggest that good results obtained through imprudent methodologies can keep the individual trustee from being sued, but do not count on getting those good results all the time. The fiduciary can best meet the needs of the beneficiaries by focusing exclusively on those needs of the beneficiaries and by pragmatically assessing the investment implications of those needs of the beneficiaries.

The fiduciary must focus exclusively on the needs of the beneficiaries. In some cases, a legally binding trust document will define those needs. For example, from the plan sponsor’s perspective, the 401k plan exists only to address the employee’s retirement goal. Of course, employees are free to do what they want (not that that’s a good thing) and may choose to allocate their 401k for a house, children’s education or some other non-retirement goal. This is especially likely in plans that permit loans. For this reason, many plan advisors recommend against offering loans. Plan sponsors can help employees better concentrate on the goal of retirement through regular and focused education. By providing pre-made worksheet templates that look for specific data (i.e., current net worth, current income and expenses, projected retirement date, contribution rate as well as post-retirement income sources like social security, pensions and outside employment), 401k trustees will guide the employees in a way that emphasizes their retirement needs and goals.

In cases other than retirement plans, a trust document either may not exist (e.g., for an individual’s personal taxable portfolio) or may include only general language in terms of the needs of the beneficiaries. When specific language does not exist, the fiduciary must personally assess the needs of the beneficiaries. In this manner, trustees of individual trusts should have a documented interview with the beneficiaries. The trust lawyer (yes, even professional trustees rely on trust lawyers) may advise how to formally document this interview. When dealing with a personal taxable portfolio, this “interview” (you may be interviewing yourself) should also be documented. Part of this interview includes a snapshot of each beneficiary’s current balance sheet (net worth) and income statement (cash flow). More importantly, the interview must begin to identify the goals of the beneficiary as specifically as possible. The individual trustee will eventually tie these goals to the trust’s investment portfolio through that portfolio’s investment goals.

To successfully complete this portion of the trustee’s duties, the individual trustee must have some degree of confidence as to the current priority of the beneficiaries’ goals – both pre- and post-retirement. The fiduciary should not attempt to guess these priorities. The beneficiaries themselves must define these priorities in the most unambiguous of terms. In the event of limited resources and multiple goals, the trustee must then practice some judgment as to which goals will be allocated which resources. It is not unusual for the fiduciary or the individual investor to be placed in the position of having to remove a particular goal as a result of insufficient resources.

Split-Interest Trusts – A Special Note: In some cases, a trust can have two or more beneficiaries with contradictory interests. A 401k plan is one such example, but this is addressed by offering multiple investment options. On the personal trust side, we have split-interest trusts. In the past, trusts employed the traditional beneficiary structure of naming an income beneficiary and a remainderman. These trusts granted the income beneficiary exclusive use of the trust income. Upon the death of the income beneficiary, the remainderman received all the remaining assets of the trust. These “Split-Interests” proved to be the source of considerable tension and conflict for the trustee. For example, if the trustee invested to increase the income, he would sacrifice the long-term growth of the trust assets. This would please the income beneficiary but displease the remainderman. On the other hand, a trustee who selects investments which maximize growth would tend to create a portfolio which sacrifices income. This would please the remainderman but displease the income beneficiary. Today, trust lawyers try to avoid the Split-Interest conflict by avoiding language that specifically assigns trust income. Instead, the trust attorney will generally use language that assigns a certain annual percentage of trust assets to the traditional income beneficiary while assigning any remaining assets to the remainderman upon the death of the traditional income beneficiary. Split-Interest trusts, however, still exist and individual trustees may find themselves in the position of managing a Split-Interest trust.

The fiduciary must pragmatically assess the investment implications of the needs of the beneficiaries. This breaks down into two steps: 1) the assessment phase; and, 2) the projection phase.

To be pragmatic, the 401k plan sponsor and the individual trustee must have a clear awareness of the nature of the trust assets, including their monetary value, where they are held, how they can be accessed for trading purposes and whether that access has any limitations. Since the immediate objective will be to delegate investment management of those assets, the individual trustee must be certain the trust document and/or prevailing law permit such delegation. In most cases, this will be obvious. In situations where the mechanics of delegation is less apparent, consult with the trust lawyer. At this point, the fiduciary might also want to consult with the trust accountant or other financial specialist to identify other practical (though not necessarily legally required) investment restrictions. For example, in a taxable trust one such practical restriction may come about due to the existence of securities with a low cost basis. In such a case, selling these securities immediately might not be preferred as the sale could generate an excessive tax liability. In an example using a 401k plan, the plan sponsor might limit investment options to registered investment companies (i.e., mutual funds) because they offer the highest degree of regulation compared to other legally allowable investments. This completes the assessment phase.

The next step – the projection phase – requires some contemplation. With a fairly concrete idea of the starting point, the fiduciary must begin to understand where he can reasonably get the portfolio to within the beneficiary’s time frame. Various advisers use various templates and processes to accomplish this. Noah B. Rosenfarb, CPA, a wealth coach for Freedom Wealth in Short Hills, New Jersey, advises clients to plot out the next 3-7 years of cash flow. Damian Rothermel of Rothermel Financial Services, LLC in Portland, Oregon likes to break retirement planning up into five year increments bounded by an “Emergency Fund” on the short-term end and, on the other end, classifying everything beyond 15 years as “Long Term Growth.” In general, a good rule of thumb (based on Ben Graham’s proxy for “risk-free rate”) would be to define “short-term” as anything under 2 years and “long-term” as no shorter than 5 years (although some advisers consider anything more than 3 years as long-term).

The easiest manner in which to complete this phase involves constructing a spreadsheet that lists each of the goals or, more appropriately, “dreams,” for each beneficiary. (In the case of the 401k investor, this would be a great exercise for a periodic general education seminar.) We use the term “dream” not to diminish the purpose of the trust. Often, the grantor of the trust and the beneficiary see the trust as addressing very real needs. Instead, we feel “dream” correctly connotes all the possible purposes a trust might have – from the very mundane but important role of providing food, clothing and shelter to the more ambitious but equally important role of providing for an ideal lifestyle, i.e., one that would satisfy the beneficiaries’ fondest dreams. Each goal should have an associated target date for completion.

The target date, not to be confused with the similar term that applies to a certain type of mutual fund, implies the investment duration, i.e., either “short-term” or “long-term.” Before the investor, whether in a 401k plan or in a personal taxable portfolio, addresses anything regarding investment style or philosophy, he must first categorize his c as either short-term or long-term. In a 401k setting, this means making it clear which menu options are designed for short-term goals and which are designed for long-term goals. And just because a 401k plan caters specifically to retirement, it’s not correct to assume all employees will have only long-term goals. In fact, those nearing retirement may discover they have short-term needs that must be addressed.

Once the goals have been listed and their time requirements determined, we can then get to the nitty-gritty. (Warning: It involves math.)

But we’ll save that for next time.

Part I: The Easiest Way to Reduce Personal Fiduciary Liability for Plan Sponsors and Other Non-Professional Trustees
Part II: Experts: 3 Common Investor Mistakes All Retail and 401k Investors Should Avoid
Part III: A Better Way to Help 401k Investors Choose Among Options
Part IV: A How-To Guide: Investing Using the Total Return Method or the Assigned Asset Method
Part V: The Choice 401k Investors Must Make Before They Choose

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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