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Why 401k Plan Sponsors (and Investors) are Going Back to the Future

December 04
00:34 2012

There once was a time when employees worked and companies hired, each safely assuming, if they only put employee money away in a safe place, some expert professional investment adviser would manage that portfolio in a manner to provide a steady stream of income when employees retired. This was the era when employees worked their entire life for one company and had the courtesy to die shortly after retiring. This was the era of the pension.

Then companies discovered, by giving employees a chance to share in the profits of the company, employees would have greater incentive to work more productively. Once again this money was pooled into a single portfolio. Once again, by hiring an expert professional investment adviser, companies and employees could “save it and forget it,” knowing any extra investment earnings would supplement their retirement living. This surplus income came with fortuitous timing as retirees decided to live longer. This was the era of the pension and profit sharing plans.

But then the awful realities of accounting and demographics caught up to companies and employees. Companies discovered pension plans were either draining corporate treasuries or, worse, were more valuable than the company itself, enticing corporate raiders to buy the company, unceremoniously liquidate its assets and pocket any pension surplus. Employees didn’t like the resulting job loss and, in general, hopped from company to company, never staying long enough to qualify for the pension.

Meanwhile, the idea of the profit sharing plan morphed into the 401k plan. The 401k plan had the advantage of employees managing their own investments. In a period of massive market growth, the idea of do-it-yourself investments attracted many, and seemed to reduce the fiduciary liability of the company. It represented a win-win both companies and employees could live with. To satisfy this urge for greater and greater precision, companies offered more and more options, using professionals to manage narrow sectors (that fit conveniently into a particular Morningstar’s style box) and leaving the ultimate allocation to the employee.

In recent years, it turns out employees prefer professionals to manage the entire portfolio, not just the individual sectors. Timothy G. Parker, a partner at Regency Wealth Management in Midland Park, New Jersey, says there’s been a “movement away from style box approaches is because end users didn’t utilize them and were perhaps confused by the choices.” Studies in investment behavior bear this out (see “Avoiding Decision Paralysis: How to Create the Ideal 401k Plan Option Menu,”, November 17, 2011).

In the old days – the days before Modern Portfolio Theory caused a proliferation of seemingly random asset classes – mutual funds sold themselves as single portfolios that allowed investors with smaller savings to achieve the same broad diversification of assets larger investors could afford. Simply stated, an investor researched the mutual fund portfolio manager’s investment style and, if the investor liked that style, the investor would purchase that single mutual fund. There was no need to “diversify” among additional mutual funds since the mutual fund was already diversified. In fact, it was commonly understand buying even as few as two mutual funds led to over-diversification, in essence, creating a high cost index fund (see “Over-diversification and the 401k Investor – Too Many Stocks Spoil the Portfolio,” October 27, 2011).

This was before mutual funds became the de facto standard for 401k options. Prior to this period, during the infancy of the 401k concept, employees were generally limited to just three options, with each option managed as a single portfolio by an expert professional investment adviser. Picture a single profit sharing plan portfolio undergoing mitosis and splitting into two or more portfolios. At this point, 401k investors (usually) picked a single option based on the portfolio manager’s investment discipline. It wasn’t hard to substitute mutual funds for these portfolios of individual securities. In fact, in many ways, it made administration of the 401k plan more efficient. Once mutual funds became the standard option, the cost of adding additional options diminished and the “need” for (actually, the opportunity to sell) additional option categories blossomed.

By 2006, behavioral finance research and Congress had become acutely aware of the problem of too much choice. Employees were not saving enough and, to make matters worse, made investment choices far too conservative for a retirement portfolio. The Pension Protection Act of 2006 allowed companies to forgo some portion of their fiduciary liability if they automatically enrolled employees into a single default investment option (or one of several defaults based on the person’s age). This had the effect of returning the 401k plan back to the original notion of the profit sharing plan – participation was automatic and an expert professional investment adviser managed the assets as a single portfolio reflecting the demographic realities of the employee base.

Since then, the idea of returning to the “one portfolio” has been “gaining momentum in the retirement planning sphere…” writes Scott Holsopple, president and CEO of Smart401k of Overland Park, Kansas in his column (see “Managed Portfolios and Your 401k,”, November 27, 2012). According to Holsopple, and particularly relevant given most of these “one portfolio” options are Target Date Funds, “Managed portfolios are not strictly a set-it-and-forget it option. There’s no such thing, and you should be leery of anyone who tells you otherwise.”

We already written a series of articles on the issues surrounding target date funds (see “A Hidden Fiduciary Liability for Plan Sponsors: The Five Most Critical Problems with Target Date Funds,” September 14, 2010). Our focus here is on those one portfolio funds beyond target date funds. Parker points out the “primary advantage of the managed option is a professionally diversified and managed portfolio in one fund.” This definition can include target date funds, but it also includes flexible funds, balanced funds, lifestyle funds and all-equity multi-cap funds.

And therein lies the problem whose solution some smart marketer will make a lot of money solving. While one portfolio funds inhibit a broad array of mutual fund categories, not every fund in those categories can necessarily be considered a “one portfolio” fund. Worse, Morningstar, unlike Lipper, doesn’t include all these categories in their designations (mostly because they fall outside the Style Box scheme they’ve so carefully crafted over the years). Several years ago, Jason Zweig accidentally stumbled upon this failure of Morningstar in an article for Money Magazine (“Is your fund pro finally a prince?” March 1, 2006).

“Categorizing these types of funds is a challenge and is best done through a change in the way 401k choices are introduced (the investor education),” says Parker. “This puts the onus on the sponsor and the service providers to educate investors on a new way of thinking.”

Parker says this is “not an easy task,” but hints it may have some benefits in the end. “A reduced number of funds might help investors get past the paralysis of too many choices,” he says, “and allow them to consider which fund(s) might work best to complement the rest of their portfolio outside the 401k.” He feels “many investors fail to consider their entire portfolio,” but adds, “hopefully a new way of educating clients about investing will solve both of these issues.”

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s new book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on this subject, including how to create an investment policy statement that defines a set of menu options consistent with the “one portfolio” concept (as well as leaving room for those few remaining do-it-yourselfers).


About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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