The Float

Participants (and Others) Behaving Badly

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...

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* 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.

Sources

"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

Bloomberg 401(k) Story

If you're a citizen of this planet, and whether you have assets in a defined-contribution (DC) retirement plan or not, you simply must spend 25 minutes watching Bloomberg's recent report on the extent and effect of hidden expenses in 401(k), 403(b) and 457 plans.

The report is a powerful indictment of the status quo, even as it misses a few points that we think are central to the ongoing argument about what plan participants should pay (and pay for). Here, we'll just point to a few items that we thought were especially apt:

• Bloomberg's Mike Schneider notes early in the feature that a 2007 AARP survey indicated that 8 of 10 respondents said they didn't understand the expenses they paid in their DC plans. We'd hazard a guess that, due to implicit costs (some of which were illuminated by the Bloomberg report), the other 2 of 10 respondents don't know what they're paying either.
• John Hancock, Fidelity, and Nationwide refused to allow their spokespersons to appear on Bloomberg's air. Disappointing. Not surprising, but disappointing. The delicate dances their flacks would have had to do would make good teevee.
• As ever, costs are three-fold: explicit, implicit, and behavioral. We're all for exposing service providers' cynical skimming operations, but we'd like to see more attention paid to the often-disastrous effects of participant decision-making.
• The following statement from the National Education Association is an embarrassment to educators everywhere: "It's hard to deliver a program like this with a low fee because there are commissions paid to agents." No, it's not hard at all. And it's pathetic to suggest otherwise. A good first step would be to eliminate variable annuities from DC plans--or at the very least de-emphasize them in favor of less expensive, more appropriate investment vehicles.
• Greg Kasten notes that revenue-sharing payments are "sort of a pay to play type of arrangement." No doubt! As he says in the story: "The mutual fund has to make a payment to the insurance company, or the insurance company won't recommend the mutual fund." Here's another easy step: Pay for services on a fee-only basis, with no kickbacks or hidden deals whatsoever. That's the only way to ensure that fund selection and replacement are done on the merits.
• This was news to us, and we're not entirely sure what to make of it without a little more context, but Wal-Mart's apparent agreement with Merrill Lynch to not disclose the fee report for the Wal-Mart 401(k) is almost unbelievable. We say "almost" instead of "absolutely" because we've seen too much to disbelieve anything.

We'll be back with more on this topic soon. For now, we give big props to Bloomberg for airing this story. We hope the media stay on this beat. There's still more for reporters, editors, and producers to learn, and thus more for them to teach sponsors and participants alike about this enormously important topic.

We invite you to check out a few of our many discussions of issues related to DC retirement plans.

Source

Mike Schneider, "The Truth Behind Hidden Fees in 401(k) Plans," Bloomberg Television, June 19, 2008

Major Bloomberg Story

Notwithstanding our best-laid plans, this week has turned into a blogging vacuum. Monday we're back at it--with feeling.

Next week we'll give significant attention to the major Bloomberg story on hidden expenses in defined-contribution retirement plans. This is big stuff, important stuff, and we'll give it the full treatment when we're back in the saddle.

For now, we encourage you to take a look at this short preview at 401khelpcenter.com, then watch the televised feature, which, at the moment, is mid-page at Bloomberg.com.

DB v. DC in WV

With our blogging vacation behind us, we have some catching up to do around here. One particularly interesting item that appeared over the last week is Janice Revell's story on the choice faced by public school teachers in West Virginia: Stay with the 401(k)-style defined contribution plan that replaced the schools' traditional pension system, or abandon the DC plan in favor of returning to a defined-benefit pension system.

We'd excerpt the story, but we'd end up passing along just about the entire thing, so instead we'll insist that you spend two minutes reading this very revealing piece. Just about every element of the bigger story in the U.S. retirement system is here: underfunded pensions, employers' cost-conscious transition from DB to DC plans, expensive/underperforming insurance-focused products, poor decision-making by participants, and, as a consequence of all of that and more, grossly inadequate outcomes for rank-and-file participants.

Revell is right to wonder about taxpayers' potential costs in all this. But the teachers' interests represent the other side of this troublesome coin: American workers who need--but generally aren't getting--the best possible retirement savings programs.

Source

Janice Revell, "Take this 401(k) and shove it," Money, May 20, 2008

Equity Exodus

We've spilled a lot of pixels on the topic of rank-and-file investors' decision-making in defined-contribution retirement plans. And we're pretty sure this, from PlanSponsor.com (free registration required), speaks for itself...

Participants moved assets from equities to fixed-income investments during 80% of the trading days in March, according to the Hewitt 401(k) Index.

In fact, during the first quarter of 2008, participants transferred $2.8 billion from equities to fixed-income investments on a net basis, which is the largest quarterly equity outflow during the history of the Hewitt 401(k) Index.

In March, the overall transfer activity level was slightly above the 12 month trailing average--0.05% of balances were transferred on a daily basis. Additionally, five days of the month experienced above normal transfer activity, and two of those were "high" volume days--March 10, where transfer activity was more than twice "normal" levels, and March 18, where activity was three times normal.

Note that March 18 saw an enormous move higher in the broad equity market. Alas, this sell-low capitulation came straight outta central casting.

Source

"Participant Equities Exodus Continues in March," PlanSponsor.com, April 21, 2008

401(k) Fee Disclosure

We don't understand--in fact, we don't come close to understanding--industry arguments that enhanced disclosure of 401(k) expenses would somehow be counterproductive.

Yes, getting the numbers exactly right is pretty much impossible. Helping sponsors and participants understand what they're getting for what they pay will take some work--and, given the pervasiveness of non-fiduciary practices in the retirement plan marketplace, some serious explaining. 

But when we dust off our econ textbooks, they seem to say something about information being an important component of functioning markets. Let's get the information out there. Let's help people understand it. Let's facilitate meaningful competition among industry players. Who'll benefit? Everyone. Everyone, that is, except for those who prefer to conceal their non-fiduciary practices.

Reader PM tipped us off to this editorial in Sunday's Los Angeles Times. It's spot on:

Faced with an aging workforce, corporate America has tried to cut costs by making employees take responsibility for funding their retirement. Pensions, or "defined benefit" plans as they're known in the parlance of chief financial officers, are becoming a relic of the Industrial Age. In their place, employers are offering 401(k)s, or "defined contribution" plans. And increasingly, they're passing all the costs associated with those plans on to Jack and Jill Cubicle. Companies may kick in some dollars to match workers' savings, but the burden is on employees to set aside part of their paycheck for their dotage.

Unfortunately, as this newspaper detailed in a series of articles in 2006, many employees aren't being told how much of their nest egg is being frittered away on fees paid to the companies managing their 401(k)s. Buried in the fine print of incomprehensible forms or not disclosed at all, those fees can consume thousands of dollars over time. To address that problem, several lawmakers have introduced bills that would require mutual funds, insurers and other providers of retirement plans to make complete disclosures of their fees to employers and workers. The House Education and Labor Committee gave its blessing last week to one by Chairman George Miller (D-Martinez), H.R. 3185, which would also require companies to offer workers the chance to invest at least part of their 401(k)s in a low-fee index fund to avoid potential liability for losses.

The measure has drawn stiff opposition from securities firms, which have complained that employers and workers would be confused and even deterred by a detailed disclosure of the various categories of fees. Some would prefer to reveal just the fee total. That would be a step forward, but supplying a detailed breakdown would also help employers and workers compare different providers' charges for the same administrative services. Those comparisons could prod employees to demand better deals and give employers the leverage to negotiate them.

Miller's proposal may be made moot by new regulations promised by the Labor Department and the Securities and Exchange Commission that would mandate more disclosure of investment fund fees. But Congress shouldn't trust the Bush administration or the SEC to act. Arrangements between employers and retirement plan providers that hide fees from those who pay them prevent market forces from holding down those charges. If employees are picking up the tab, they should have a range of options for their 401(k) contributions. And none of those options should be able to conceal the amount that would be burned off in fees.

All that is true enough. But as we've argued before, what matters is participants' outcomes. All else equal, low, transparent expenses are good. We think they're necessary (but not sufficient) components of fiduciary plans. After all, if defined-contribution plans continue to push investment management responsibility down to rank-and-file participants, our retirement savings system will come up short of its great potential.

Source

"Make 401(k) fees transparent," Los Angeles Times, April 21, 2008

About That 401(k)

One recurring theme in today's Bear Stearns coverage: The toll taken on Bear's employees, many of whom have seen much of their personal wealth--which is much harder to replace than a mere job--vaporized in a hurry. For all the crocodile tears shed for Masters of the Universe like Jimmy Cayne and Joe Lewis, the fact is that there are thousands of people who have taken a big, truly consequential hit to their personal finances.

One question: What percentage of the assets in Bear's retirement plan (or plans) was invested in BSC? We haven't seen anything on this question just yet, but we'll keep our eyes open. Whatever that percentage was, we're pretty sure it was too high.

Source

Katherine Burton and Sree Vidya Bhaktavatsalam, "Lewis, Barrow Hanley Lose Combined $2 billion on Bear," Bloomberg, March 17, 2008

Market Turmoil and Retirement Insecurity

Here's an interesting piece from Reuters' Pedro Nicolaci da Costa: "Rocky markets highlight retirement insecurity." The premise here, that weak equity markets have retirees and near-retirees concerned about their nest eggs, is more that plausible. It's undeniably true. And it's one consequence of the historic shift from defined-benefit to defined-contribution retirement plans (emphasis added in bold):

With Americans relying more heavily than ever on the stock market to fund their retirements, Wall Street's slide has some starting to worry they will struggle financially in old age.

Even worse, the housing crisis has reduced what employees are able to sock away, and some are even tapping their retirement money for everyday expenses like food and gasoline.

All this has reopened a debate over 401(k) retirement plans offered by many employers in the United States, which give employees responsibility to save for their own retirements and also some control over their investments.

"The 401(k) system today in the United States has been an acknowledged failure," said Alicia Munnell, director of the Center for Retirement Research at Boston College's Carroll School of Management. "It transferred all the risks and responsibilities from the employer to the individual."*

That's exactly right. But there's another passage in this piece that strikes us as a little too glib:

The decline in the market has highlighted those risks. Share indexes on Wall Street have lost 14 percent of their value since hitting a peak in October. For someone retiring now with say, $500,000 in savings, that would translate into a drop of around $70,000.

Well, that's true...if someone retiring now were invested not only 100% in equities, but 100% in a single asset class, namely large-cap U.S. stocks. We've argued that purchasing power risk means those approaching retirement, and those in the first few years thereof, should maintain significant exposure to equities and equity-like (i.e., non-fixed-income) assets. But certainly not 100%, and not without diversifying across size and space.

But let's assume that a newly-minted retiree did have 100% exposure to the S&P 500 over the last few months (which itself is evidence of the big problem with fully self-directed retirement plans: very poor decision-making, unguided by anything like professional, let alone fiduciary expertise). That would be a source of significant stress. There's no doubt about it, and investor anxiety is perfectly understandable.

But the retiree's finish line isn't next month--or next year. It's his life expectancy (or beyond, in some cases). So as painful as these short-term dislocations can be, and as uncertain as long-term return prospects are, it's imperative that investors not use short-term anxiety as an excuse for altering a long-term plan.

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* Here's another important observation from Munnell: "401k plans are really too hard for individuals to navigate....People make mistakes at every step along the line. The balances that are showing up are quite small and are going to provide a grossly inadequate retirement income."

Source

Pedro Nicolaci da Costa, "Rocky markets highlight retirement insecurity," Reuters, March 4, 2008

Interest Rates, Pension Funds, and Asset Allocation

Yesterday we posted an item on expectations for equity market returns in the coming years, using Warren Buffett's latest shareholder letter as a point of departure. Buffett's argument--that expectations of 10% annualized returns, net of expenses and taxes (where applicable), were not likely to be fulfilled--applied to individual investors as well as institutional heavy hitters. But that argument centered on pension liabilities in corporate America and the public sector, and late last night we ran across a Bloomberg story that reinforced Buffett in a big way:

Philadelphia's $4 billion pension deficit is causing the city's retirement-fund manager to shun Treasuries at a time when the Bush administration needs him most.

Yields on 30-year U.S. bonds that fell to a record low of 4.10 percent this year are forcing pension funds to favor equities, corporate debt and commodities in an attempt to cover unfunded liabilities and meet return objectives of about 8 percent. Even the federal government's own Pension Benefit Guaranty Corp. said on Feb. 19 that it plans to shift $15 billion to stocks from debt.

"The reality is there's not a lot we can do'' other than buy high-risk securities to close a pension shortfall in a short period, said Chris McDonough, chief investment officer of the Philadelphia Pensions Department. The sixth-largest U.S. city will probably also issue debt, he said.

Fixed-income holdings at 1,100 funds fell to 23 percent in 2006 from 27 percent in 2003, said Dev Clifford, a consultant at financial market research firm Greenwich Associates in Greenwich, Connecticut. Results of a survey covering 2007 will be released this month and likely show that funds own an even smaller percentage of bonds, he said.

The problem, of course, is that asset class returns are (relatively) high where capital is (relatively) scarce. If pension funds engage in a major asset allocation shift away from treasuries, the boost to equities could be significant...but would also be short-lived. This may seem counter-intuitive, but such a shift would actually depress future expected returns in the asset class, thus limiting any potential advantage, which itself would be contingent on many other factors, to early movers.

Source

Daniel Kruger and Sandra Hernandez, "Bush Deficit at Record as Treasuries Deter Pensions," Bloomberg, February 3, 2008

More on LaRue v. DeWolff

More good stuff on LaRue, in three installments from Stephen Rosenberg...

• The Supreme Court Decides LaRue, In Probably Predictable Fashion
• Interpreting LaRue
• A Couple of Other Perspectives on LaRue

In that last item, Rosenberg excerpts the following passage from George Chimento's advisory note on LaRue:

With all this additional liability, is it wise to sponsor self-directed plans, with the extra expenses associated with open-end mutual funds and daily investment switching? Are participants really better off self-managing their retirement assets, doing something they were not educated to do? Perhaps it's safer, and better for all parties, just to have an "old fashioned" managed fund, without participant direction, and to employ properly certified investment managers who can be delegated fiduciary liability under ERISA. A dividend of LaRue is that it may cause employers to step back and reconsider the current, expensive, and dangerous fad of self-direction.

That's an enormously important question--and the answer, however slowly it emerges, just might usher in monumental changes to the defined-contribution marketplace.