Tuesday afternoon we posted an item on Bloomberg television's recent feature on hidden costs in defined-contribution retirement plans. In that short assessment, we noted that plan costs come in three flavors: explicit (mutual fund expense ratios, insurance charges, recordkeeping, administration, sales loads, advisory fees), implicit (mutual fund trading costs, impaired dividend reinvestment), and behavioral (participants managing their plan assets suboptimally in one way or another).
This is necessarily imprecise, but we think the amount of attention each category of costs receives is inversely related to the extent of its effects. High explicit costs are (relatively) easy to identify and, where fiduciaries want to do the right thing, easy to correct. High implicit costs are tougher to identify, but still reducible when there's sufficient interest in doing so. Behavioral costs are exceptionally difficult to quantify, in part because the current regime of individual accounts privileges rank-and-file participants' autonomy over plan-level management (and, therefore, effectiveness).
But again, it's the behavioral costs--the toughest to quantify and the least-understood--that often wreak the most destruction on participants' long-term outcomes. As we noted back in November, the best plans feature low expenses and high-quality decision-making (see adjacent table).
Which is why we were so pleased to see Financial Engines release the results of its study of participant behavior (available here after you enter some basic identifying information). The findings, as you might imagine, were not particularly encouraging. But as we've long argued, there's nothing wrong with the defined-contribution system that can't be fixed with a few good (i.e., painfully obvious) ideas and a healthy dose of fiduciary responsibility.
Writing at WebCPA.com, Stuart Kahan has a good, short summary of the Financial Engines report. We're going to dig into the report itself and post a more substantive evaluation (probably early next week), but we did want to make special note of one general conclusion Kahan mentions in his piece. Here are the key passages:
Participants earning the lowest salaries are the most likely to make investing mistakes. More than half (53 percent) of participants with annual salaries below $25,000 have portfolios with very inappropriate risk and/or diversification, compared to 33 percent of those earning more than $100,000 per year.
In terms of salary, 63 percent of those earning less than $25,000 per year fail to save enough to receive the full employer match, compared to 24 percent of those with salaries between $50,000 and $75,000, and 12 percent of those with salaries greater than $100,000 per year.
None of this is especially surprising. Lower-income workers may be less financially sophisticated, but they certainly have less access to sophisticated help.* The real problem here is that a system driven primarily by participants' elective reductions of their own present income will necessarily put lower-income workers at a significant disadvantage. So not only have plan sponsors and the financial services industry (by resorting to the false security of 404(c), among other mistakes) pushed responsibility for account management down to rank-and-file participants; the system has doubled down on the problem by placing low-income participants--those who need the most help and have the worst retirement security prospects--in an especially difficult position.
This is not a satisfactory state of affairs, but we (policymakers, sponsors, service providers, participants themselves) have the means to improve upon the decidedly imperfect status quo. And time is of the essence...
* Let's not make too much of this sophistication argument; plenty of affluent, highly-educated participants make big mistakes too, in many cases as a result of overconfidence.
"Who Benefits from Today's 401(k)?" Financial Engines, June, 2008
Stuart Kahan, "How Well Are We Handling Our 401(k)s?" WebCPA, June 20, 2008