Perspectives December 5, 2013

Defusing the Target-Date Time Bomb

The trend of auto-enrolling employees into defined contribution plans is accelerating.
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Consider this volatile mix:

1.     Auto-enrollment is proliferating,

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2.     Target-date funds are used heavily in auto-enrollment,

3.     Target-date funds are equity-rich,

4.     Many younger workers are auto-enrolled into target-date funds,

5.     Gen Y is highly risk-adverse, and

6.     The next severe market downturn could see droves of participants selling at the bottom and not getting back in.

 

Industry data varies, but it seems safe to say that more than half of plans now do some form of auto-enrollment.  By far, the most common use of auto-enrollment is with new hires.  Not all new hires are younger workers, but it is probably safe to assume that many of them belong to Gen Y. 

About two-thirds of auto-enrollment programs utilize target-date Funds (TDFs) as the default investments.  Default investments tend to be “sticky.”  People who lacked the inertia to opt-out or to select their own enrollment options to begin with are unlikely to take the initiative to learn about and undertake the process of changing their investment elections—at least, not while the market is doing well.

The TDFs into which these individuals are being enrolled are equity-rich.  Members of Gen Y would likely have equity allocations of 80% to 90% in the long-dated TDFs.  However, much has been written about the risk-adverse nature of Gen Y.  Through their formative years, the U.S. experienced a severe recession and the worst bear market since the Great Depression.  Many are struggling with high education debt, and are grappling with a very challenging job market.  They have neither the disposition nor the financial wherewithal to incur large losses.

In our practice, we have risk-profiled many a Millennial. Some understand that they have a very long time horizon and say they can ignore market cycles.  A lot, however, profile out in the “conservative” or “moderately conservative” range.

One need look no further than the annual Dalbar studies of investor behavior to understand individuals are very prone to making emotionally driven investment decisions.  Industry data about flows into and from equity funds corroborates this.  During periods of severe market weakness, it’s human nature to want to “get out before it’s all gone”.  Not only does that lock in the loss, but the unpleasantness of the experience might keep a younger participant from contributing to their 401(k) for many years thereafter.

So, what can we do about this? 

  • We can educate younger participants about the risks of emotionally-driven decision errors,
  • We can stress the importance of matching their investments to their risk tolerance,
  • We can remind them that long-dated TDFs are equity-rich, and consequently can be volatile,
  • We can help them select less volatile investments when that’s appropriate, and
  • Gen Y is known for appreciating “straight talk”.  We can tee up the information and help them make great retirement saving decisions.

 

Jim Phillips, President of Retirement Resources, has been in the investment industry for more than 35 years, the past 18 of which have been focused in the area of qualified retirement plans.  Jim worked for major national investment firms for 14 years before “going independent” in 1990.  Jim is an Accredited Investment Fiduciary, has contributed to two books on 401(k), and his articles have been published in Defined Contribution Insights, PLANSPONSOR’s (b)lines and ASPPA’s 403(b) Advisor, and Jim is a RetireMentor on MarketWatch.com. His work has been acknowledged with multiple Signature Awards from the PSCA, he has been named to the 2012 and 2013 list of Top 100 Retirement Plan Advisers, by PLANADVISER Magazine, and he was a finalist in 2012 for the Morningstar/ASPPA 401(k) Leadership Award. Jim has been a frequent speaker at national conferences, including SPARK, ASPPA, AAO and the PLANSPONSOR and PLANADVISER National Conferences.   

Patrick McGinn, CFA, Vice President of Retirement Resources, is a CFA charterholder and has been in the securities industry since 1993. In addition to the Chartered Financial Analyst designation, he is an Accredited Investment Fiduciary and a member of the Boston Security Analyst Society. Together with Jim, Patrick has co-authored a number of articles which have been published in industry publications on topics about managing successful 401(k) and 403(b) plans. His work has been acknowledged with multiple Signature Awards from the PSCA, and he has been named to the 2012 and 2013 list of Top 100 Retirement Plan Advisors, by PLANADVISER Magazine. He was a finalist in 2012 for the Morningstar/ASPPA 401(k) Leadership Award.  

 

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
Data & Research December 5, 2013

More Plans Institutionalize Investment Lineups

A new report finds that more employers are institutionalizing their 401(k) investments lineups.
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The report, “2013 Trends & Experience in Defined Contribution Plans: An Evolving Retirement Landscape,” was conducted by Aon Hewitt to determine trends in Defined Contribution (DC) retirement benefit strategies, plan designs and investment structures. Findings show a growing number of employers are placing greater emphasis on improving and institutionalizing their 401(k) investment lineups to boost participant returns and increase savings levels.

The report shows the number of companies adding non-mutual fund alternatives—such as collective trusts and separate accounts—to 401(k) lineups has increased over the past seven years.

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While 59% of employers offered at least one such option in 2007, that figure has increased to more than 90% today. Forty-four percent utilized these vehicles as their primary fund options in 2013, up from 19% in 2007. According to Aon Hewitt, plans with more than $1 billion in assets are more likely to have over half of their investment options in non-mutual funds than plans with less than $1 billion in assets (61% versus 21%).

“Lower-cost institutional funds can substantially benefit participants because their fees are usually 30% to 50% lower than retail mutual funds,” says Winfield Evens, director of outsourcing investment strategy at Aon Hewitt in Lincolnshire, Illinois. “Institutional funds have long been an integral part of defined benefit plans, but have taken longer to become common in DC plans. Additionally, institutional fund fees are typically designed so that the more assets invested by the plan, the lower the expense ratio—which directly benefits participants in the form of higher returns.”

Diversified Options

Data from the report also shows that a growing number of employers are diversifying their 401(k) fund lineups by offering participants access to a wider range of investment options. The percentage of employers offering emerging market funds has doubled in the past two years, from 15% in 2011 to 30% in 2013. The percentage of plans offering short-term bond funds has increased as well, from 8% in 2011 to 14% in 2013.

Employers are also offering index—or passively managed—funds across a growing number of asset classes. “The index approach has been a mainstay among large-cap equity funds, but now we are seeing the passive approach become much more common in other asset classes,” says Rob Austin, director of retirement research at Aon Hewitt.

According to Aon Hewitt’s report, widespread investment classes that had a large increase in the index approach include mid-cap equity (59% in 2013 versus 42% in 2011), intermediate bond (53% in 2013 versus 42% in 2011) and international equity (50% in 2013 compared to 31% in 2011).

Fees and Participants

In the report, Aon Hewitt examines recordkeeping fees and how they are passed on by employers to plan participants. Findings show these fees are now paid in full by employees in more than three-quarters of plans.

Today, 26% of plans charge recordkeeping fees as a periodic line item to participants, up from 14% in 2011. The number of plans assessing recordkeeping expenses via fund-based fees—such as using mutual funds with revenue sharing agreements—decreased from 83% in 2011 to 52% in 2013.

According to Aon Hewitt, charging a flat rate for administrative or recordkeeping fees can have a significant impact on a participant's balance over time. For example, when such fees are charged as a $50 flat rate every year, a typical participant with a starting salary of $75,000 ends up having a balance at retirement that is $200,000 more than he or she would if the fees were instead charged as 0.25% of assets each year.

“Plan sponsors are discovering there are many cost-effective ways to significantly increase participants’ savings through reviewing and improving basic components of the plan,” says Austin. “In many cases, relatively minor changes in plan design can greatly benefit plan participants’ efforts to improve their retirement future.”

Other Findings

Plan sponsors are focusing more on costs. More than three-quarters say they have made efforts to reduce fund or plan expenses in their DC plans over the past two years, compared to just over half in 2007. In terms of methods used to reduce fees, 62% of plan sponsors switched share classes to lower-cost alternatives and half said they swapped out funds for lower-cost alternatives.

The report shows that fees are a top way of selecting fund options, with historical investment performance and the fund investment process rounding out the top three. In contrast, name recognition and availability in public sources was at the bottom of the priority list with plan sponsors.

“One of the most direct ways to increase participant balances is to increase their returns, which can be done effectively by decreasing investment fees without sacrificing investment quality,” says Austin. “Even small changes in 401(k) fees can have a significant impact on employees' nest eggs over time. For example, decreasing fees from 1% to 0.75% per year has the same effect on a typical participant as contributing an additional 0.50% of pay. This ultimately translates into thousands of dollars more in retirement savings.”

For the report, Aon Hewitt surveyed more than 400 DC plan sponsors, representing over 10 million employees in plans that total $500 billion in retirement assets. Information on downloading report highlights, as well as how to purchase a copy of the full report, can be found here.

Aon Hewitt is a provider of global talent, retirement and health care solutions.

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