Behavior Modification
Many of the questions that defined contribution (DC) plan sponsors have these days—about things like potential vendor changes and fund-lineup shifts—really boil down to one question, adviser Ben Mitchell says. “What they really do not know is the answer to: ‘Is my plan broken and, if it is, how can I fix it?’” says Mitchell, President of Florida Benefit Specialists in Fort Lauderdale, Florida.
Those are pretty big questions, and many employers may not like the answers. There has been a lot of talk in the past several years about how behavioral finance applies to DC participants, and can paralyze their ability to make decisions—when they have too many investment options, for instance. However, less has been said about the psychology of plan sponsors’ decisions, and how they can hesitate to make important calls, too.
The economic and market volatility has left sponsors shaken and, “without a doubt,” pushed employers to evaluate on a fundamental level whether their DC plans work, says Jack VanDerhei, Director of Research at the Washington-based Employee Benefit Research Institute (EBRI). Now, they face some tough decisions.
“The issues have always been the same. What has changed is the amount of money involved,” says David Wray, President of the Chicago-based Profit Sharing/401k Council of America (PSCA). Plans in their early years have modest total assets and average account balances. By now, many plans have participant balances exceeding $100,000 and total assets in the hundreds of millions, or even billions, he says.
Sources talked about four challenging decisions many sponsors must make, and how advisers can help:
> Match shifts: worrying about the impact. “Here in Florida, there are still some plan sponsors in the process of terminating their matches,” Mitchell says. The economic downturn hit the state hard, he says, “so there are a lot of folks still trying to keep the lights on.” Of sponsors nationwide who suspended their match, Wray says, perhaps half have reinstated it.
Adviser Barbara Best estimates that one-third of her clients—who have average plan assets of $54 million—reduced or suspended their match or contribution, with laying off more people the only alternative for many. “Those decisions are really driven by budgeting and survival,” says Best, Oakbrook Terrace, Illinois-based Principal at Capital Strategies Investment Group. Altering the match has risks, given its crucial role in participation. “[Plan sponsors] are worried that, if they take it away, a lot of participants will just drop out of the plan,” says Teri Hutchison, regional retirement client consultant at Gallagher Retirement Services in Glendale, California.
So, watch out for the decisionmaking bias known as “groupthink,” meaning that, in stressful conditions, “some groups are more interested in maintaining unanimity than in truly evaluating all the possibilities,” says Gary Mottola, a senior research analyst at the Vanguard Center for Retirement Research, who has studied the dynamics of investment committee decisions. An adviser can play a key role as an independent and external point of view, he says, since research has found that even a single dissenting opinion can mitigate decisionmaking biases.
Last year, Alex Assaley and his AFS Financial Group colleagues had a lot of “hard discussions” with one-quarter of their clients, primarily sponsors in struggling industries—such as construction, architecture, and manufacturing—about whether to suspend their match or stop a long-standing annual profit-sharing contribution. “We talked about what is the most important thing to the organization, and to the morale of employees,” says Assaley, Bethesda, Maryland-based adviser, corporate retirement plans. “Our job as advisers was to try to keep them focused.” Ultimately, he adds, fewer than 10% of clients suspended their match or did not make a profit-sharing contribution.
Mitchell tries to temper the emotion of a match decision with the facts. “The first thing we want to deal with is, what is the impact on nondiscrimination testing in future years?” he says. If a plan suspends its match and rank-and-file employees decrease participation, he adds, highly compensated employees may have to give back some of the match they received for the sponsor to pass testing. “The second thing we do is ask, how will it affect the company as a business?” he says. Cutting the match means the employer loses out on a tax deduction, he says, but that may be the lesser worry for companies losing money or market share in their core business.
Some advisers have worked with sponsors to change the match design without suspending it. “You do not want to have a fixed-match program where part of the time there is a match, and part of the time there is not,” Wray says. “Some companies are reinstating their matches but making them discretionary.” Explains Best, “The message is, ‘We have to take some away when times are tough but, as we recover, we will share more with you.’”
> Fund switches: the herding instinct. More than half of Hutchison’s plans have made lineup changes in the past couple of years—but, not easily. “It is one of the most difficult decisions, if not the most difficult, that committees can make,” she says.“A lot of times, plan sponsors are hesitant to disrupt the status quo of the plan,” Assaley says, “but, once they start getting concerns or complaints from members of the committee or employees, it speeds things up.” Adds Best, “People wonder, is the fiduciary in trouble if they keep a fund that is underperforming?” Many sponsors now struggle with the past year’s fund performance results, she says, as lower-quality securities such as highly leveraged companies outperformed higher-quality securities. “For a lot of clients, if you look just at the Morningstar peer group and the index, they are underperforming,” he says. Her advisory firm’s investment policy statement for clients “has specific criteria that require us to place a fund on watch,” she says. “However, there is less specificity as to the triggers to replace or remove a fund from the plan—this is our preference and our clients’. We need to be mindful of short-term performance, but longer-term criteria are essential to monitor. You can’t fall for the recent superstars.”
That speaks to the core of what Mottola says many investment committees struggle with when evaluating funds. “Performance tends to be an overwhelming driver, and that area is ripe for behavioral biases,” he says. Sponsors may tend toward “herding,” for example, as they drop or add a fund because they think everyone is doing it in response to performance. They could also compromise decisions with “confirmation bias,” by seeking information that confirms their preconceived views of an investment’s track record.
Advisers can do a couple of things to help prevent decisionmaking bias, Mottola says. Encourage healthy debate and dissent, which can involve persuading senior executives to make clear that they want debate; have a diverse committee makeup; and appoint a rotating “devil’s advocate” among committee members, who argue issues’ opposing side. Make sponsors aware of the decisionmaking biases often seen in this area, he suggests, since most probably do not know.
Advisers also can provide lots of objective analysis of funds. “We do quite a bit of research to peel back the onions, to explain the source of the underperformance,” Best says. She and her colleagues look at things like risk-adjusted return, stock selection, industry weighting, and manager style. “We are trying to get clients more comfortable with the notion that a fund being on the watch list is not necessarily a bad thing,” she says. “We do not want them to chase the hot funds that have done well recently.”
In addition, advisers can encourage level-headed decisions by helping put a solid underlying process in place. When Assaley and his colleagues start working with new clients in the small to mid-size market, he says, “We still frequently see no process: Investment reviews or changes are put in on an ad hoc basis. With a new relationship, the first step we take is to look at what they are doing, and not doing, to satisfy their fiduciary responsibilities. We kind of start from scratch, and help them understand what their responsibilities are, and the policies and procedures they need to put in place.” That can mean adding quarterly investment reviews or updating an investment policy statement, for example.
> Provider switches: too much work, too little time. Interest in potential vendor conversions has resurfaced, too. “At the end of ’08 and early ’09, most plan sponsors put the brakes on everything,” Assaley says. “They had so much going on that the 401(k) plan had to be on the back shelf for the time being.” However, now he sees a lot more interest in reviewing provider relationships. “An awful lot of plan sponsors are looking to save money,” says Mitchell, who specializes in working with small plans. If a plan has at least $1 million in total assets and at least a $10,000 average balance, he says, many vendors will negotiate a deal to keep the business.
Employers long have hesitated to switch providers, and the current hectic environment only exacerbates that. “The idea of transitioning is always scary for a plan sponsor, which already has a lot of work to do,” Assaley says. Vendor changes always mean a lot of complexity and a big time commitment for employers, Hutchison says. “It is very difficult to get plan sponsors to make a decision to go through a conversion,” she says. “People are running lean and mean right now. They are not necessarily able to have a person dedicated full-time to the conversion.”
Advisers can help by quarterbacking the conversion process, Assaley says. “Keep the client active and involved, and keep communication going among all parties,” he suggests. Throughout the process, Hutchison does weekly calls with the sponsor and new vendor. These calls hold vendors accountable for progress, she says, and a timeline gets updated after every conference call. The weekly call also has an agenda and minutes, she says, so that anyone who could not make it can stay informed.
Advisers often assuage clients’ fears by helping avoid the need for a conversion, Assaley says. When sponsors have service problems, he finds that, “almost all the time,” he and his colleagues can work with the vendor to make improvements. They also proactively do vendor benchmarking and analysis, usually at least every three years, to see if a vendor still best fits a plan.
Best also works to identify potential improvements in existing vendors’ service. Providers increasingly will add new value-added services for a sponsor, she says, such as handling hardship-withdrawal qualifications or offering more targeted communications and education. “Our preference is to be able to make what is in place work better,” she says. “If it does not work, then they [employers] do what they have to do.”
> Automatic enrollment: Can employees afford it? Plan-design changes may be afoot for some. “Toward the end of 2008, a lot of initiatives like changes to automatic enrollment and automatic escalation that had been in the pipeline got put on ice,” says Seth Masters, AllianceBernstein’s Chief Investment Officer of blend strategies and defined contribution. “So many things were changing so fast that it was difficult to make forward-looking decisions of any kind. There was basically a freeze by most companies. I think it is thawing now.”Holdout sponsors have their fears, though. “They have difficulty putting participants in the plan, especially with the economic situation,” Hutchison says. “Sponsors worry: Can they afford it? Three percent might be a lot to someone making minimum wage.” Agrees Assaley, “There is no question that the reason some plans have not done it is because of concerns over employee frustration that money is coming out of their paycheck.” A match also means substantial costs for employers, many already cash-strapped.
To help with their concerns, Assaley shares experiences with other clients. “In most cases, the result we see is that, if they even notice it, after a couple of pay periods, their discomfort goes away,” he says of employees. “Inertia kicks in.” Only about 2% of automatically enrolled participants at Hutchison’s clients drop out initially. “It is really an education process, to both the participant and plan sponsor, because they do not truly understand how it works,” she says. “When you tell participants that you are going to be taking money out of their check, they really need to understand what is happening to that money.” An adviser can head off trouble by providing education that explains to participants the simplicity and long-term benefits of automatic enrollment, she adds.
In addition, advisers can customize the design to employers, Best says. For example, if a retailer has heavy turnover and worries about the hassles of immediately enrolling new employees who may not stay long, that employer can offer immediate eligibility but not have automatic enrollment kick in for three months, she says. “Based on their demographics and the turnover and trends, we can modify how they use automatic enrollment,” she says.
Employers have more interest now in modeling the potential impact of plan-design features such as automatic enrollment and escalation, rather than just going with the perceived industry standard, VanDerhei says. “There is a lot more focus on what the employer is trying to achieve, and what employees are concerned about,” he says. “All of these things that have been debated ad nauseam are now being modeled in a coherent fashion. Employers are figuring out: ‘How paternalistic do we want to be?’”