If individual investors could manage money like Bill Miller, they could all sleep better knowing that their twilight years would be spent in hammocks beneath palm trees in tropical locales. Unfortunately, the famed fund skipper’s genius hasn’t rubbed off on the average Joe just yet. So, as the 25th anniversary of the 401(k) came and went last Friday with little fanfare, it’s worth repeating that saving for retirement hasn’t gotten any easier since its inception.
In fact, a new study published by Barclays Global Investors and Matthew Greenwald & Associates suggests that future retirees actually will be worse off than existing retirees. With defined-benefit plans being phased out, more investors are being forced to fend for themselves when making the right investment choices for their retirement fund. Defined-contribution plans offered through employers have become the primary instrument by which Americans save for retirement. While this has been a windfall for mutual fund companies over the years, there are some glaring flaws in its structure that hinder the success of the individual, the study argues.
The problem with relying on a 401(k) plan is that it requires individuals to make the same judgments and choices typically reserved for chief investment officers at endowments, pensions and foundations. While the notion that regular-Joe employees have the talent to act as their own CIO is a noble one, it’s just not going to happen, the study says. As more and more firms shift to defined-contribution plans, there is a mounting concern that nest eggs will be too small to live off when people reach retirement age.
Defined-contribution plans have historically underperformed defined-benefit plans by 3 percent to 4 percent; defined-benefit plan sponsors—many of whom are also defined-contribution sponsors—are now keenly aware of the importance of achieving defined-benefit quality in their defined-contribution plans, according to the study. The reason being is that retail investments carry higher fees than their institutional counterparts, which is a big drain on performance. And they don’t attract as many talented portfolio managers with the expertise to make prudent asset-allocation decisions.
Four in five sponsors of the 200 largest pension plans polled by Barclays and researcher Greenwald & Associates report that their companies also have a defined-contribution plan. And most defined-contribution plan sponsors cite “inadequate participation and savings rates” in their plans, the study shows. The study was conducted in May and June by contacting benefits managers, CFOs and human resources executives at the 200 largest U.S. pension plans.
When asked which of five issues would have the greatest impact on defined-contribution plan adequacy, one-third of these managers selected improved contribution rates and improved participation rates. From a broader perspective, nearly nine in 10 indicated that improved contribution rates are among the top three issues that would most impact adequacy, followed by improved participation rates (61 percent), better education and communication (54 percent), increased use of pre-mixed asset-allocation funds (47 percent) and increased availability of lower-cost institutional funds (34 percent).
The data gleaned from the study suggest that at least two components are needed to have 401(k) plans become a more effective retirement vehicle: a better contribution and savings rate and an improved investment-management component.
A proposed fix that many respondents highlighted was better risk-management techniques, including the use of lifecycle funds as core investment choices. Almost nine in 10 managers believe having a lifecycle fund option helps, or would help, their plans. If they were to move to automatic enrollment for their defined-contribution plans, two in five plan sponsors say they would change their default investment option to a lifecycle fund. However, one-quarter would make no changes, and one-third do not know what changes they would implement.
“Individual investors don’t have the interest, time or the knowledge to manage their own retirement plan, so lifecycle funds make a lot of sense,” says Lance Berg, a spokesman for Barclays Global Investors.
Changing the quality or number of funds is another way sponsors are tweaking their plans. Six in 10 offering a defined-contribution plan are considering changes to the investment choices currently offered to their participants. Among those mulling a change, more than one-third are considering increasing the number of investment choices or keeping the number the same but changing the investment mix, while one in five are considering reducing the number of choices.
Currently, 25 percent of those eligible to participate in 401(k) plans don’t do so—even when the company offers a matching contribution, according to the Investment Company Institute. And less than 10 percent of investors save the maximum allowed, which, beginning in 2007, will be $15,500 and $20,500 for a person 50 or older. The average contribution rate among 401(k) participants is about 6 percent, well below the recommended reserve of 10 percent to 15 percent of a worker’s salary.
A legislative effort to ramp up participation and savings is already in the works. The recently enacted Pension Protection Act is expected to equip employers with the right tools to ensure workers are saving enough for a comfortable retirement, including instituting automatic enrollment and automatic increases when workers get a bump in salary. However, it’s still too soon to determine what impact the law will have on savings.