Tag Archives: auto-enrollment

The 401(k) Debate: Bright Siders v. The Naysayers

  By petillo | July 17, 2011 - 7:09 am | 401k, Boomers, financial planning, index funds, Mutual Fund Investing, personal finance, Profitable Investments, Repercussions: A Retirement Review, Retirement Planning Target 2025, social security, women and finances, women and retirement
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If things are good, for some they won’t be good enough. If it turns out that things are not so good, someone will ultimately benefit for this off-chance negativity. It is the glass half full argument and one conducted by many in the media last week. If you missed it, you didn’t miss much. If they were talking about you and your participation in your 401(k), you probably never noticed.

Was the conversation started by the Wall Street Journal last week merely a journalistic prod at those who run these retirement plans or was it intended to alert the three percenters, the majority of new enrollees to their 401(k) plan who it seems have not increased this default contribution since they were auto-enrolled? Hard to say. But it did wake everyone up.

The gist of what the Journal was pointing out was relatively straightforward: Those that were auto-enrolled at 3% because of the Pension Protection Act of 2006 rarely increase their contribution past that threshold. This could, as Anne Tergensen reported, allow inertia to set in. And that is to be expected.

She wrote in her article suggesting that the 401(k) law actually undermines the participants in those plans and speculated that the requirement is actually creating a nation of under-investors. And this may be true.

And then there were those who immediately came to the defense of the PPA suggesting had it not been in place, these “newly enrolled” employees would not have given their plans an opportunity. So the 3% rule was better than no rule.

Coming into play is the human emotion involved in investing and those that are trying to focus on the act of investing itself  are missing the player’s participation. It’s like two parents arguing over how best to teach a child – in front of the child.

There are some simple facts to face and some not-so-simple observations about the investor we are speaking about as if they couldn’t hear us talking. First off, we’re not children. Yes we need to be led to do what’s best for us and the PPA did just that. It made many people who otherwise would not have invested at all – or at least not right away, get into the markets. But then it put far too many of those new enrollees into target date funds and this may have been why no one added or increased their contributions.

Next up, the arbitrary threshold of 3% is too low but has been determined by those who watch us as to be the breaking point. Too low and the critics would suggest why bother. Too high and the participants would quite possibly opt out. Ms. Tergensen describes the PPA as a program: “designed to shore up the pension system, also encouraged wider adoption of auto-enrollment in 401(k) plans. It removed obstacles such as state laws that restricted the practice and shielded employers who use certain types of investments from liability for losses suffered by participants who are auto-enrolled.” That last part is important.

While companies have focused on limiting their liability, their plans may have fallen short of offering the expected investments. This lack of choices, often overlooked by many sponsors and for the vast majority of the plans, in need of an upgrade, tends to freeze the decision making process. New employees, once in the plan, aren’t sure where to go next. They probably have educational expectations and many plans have improved on this element of a well-planned retirement. Yet that first choice, often the target date fund, might be a major contributor to the inertia.

The Employee Benefits Research Institute looked at the shift in a before and after fashion and suggested: “analysis that focused not on a comparison of VE [voluntary enrollment] and AE [auto-enrollment] , but rather how to improve plan design and worker education to optimize the results under AE plans with automatic escalation of contributions.” These plans they noted did have an major impact on the lower-income worker, giving them a plan that they might not have had access to or even considered. They do point out, that in order to hit the often advised 80% of pre-retirement income (included with Social Security), three-percent would not come close to providing. (You can read the latest report on this topic by the EBRI here.)

While there seems to be a bright side and a dark one, the plans are getting used by a wider swath of the population. But often for the wrong reason and the wrong way. I have discussed 401(k)s with many individuals and financial people and far too many look at the borrowing power the plans provode, the first time withdrawals for home purchases and even college as a plus, seeing the plan as an emergency account equipped with loan provisions and hardship withdrawals. Each of these options can shave years of earning power from the plan once they participant reaches retirement age.

The plans, shielded from some of the liability largely shirk their fiduciary responsibility in the process. Simply enrolling and offering them educational opportunities isn’t enough. These plans need to have index funds, They need to have annuities (inside a 401(k), the sex of who is buying the product is not disclosed, giving women the opportunity to determine more precisely how much they will actually be getting in retirement – it gives men the same option too). And they need to be cheap – a lot cheaper.

Far too many 401(k)s have exhibited an effort to lower the cost of the offerings in the plan without lowering administrative costs. And as I have mentioned on previous occassion: the smaller the plan the higher the cost of maintaining it.

Yes, three percent is a good start but still well below the average contribution rate of 7-8% for all workers. The real target number is closer to 10-15% for workers in their 30′s and 40′s, an awkward time for many to increase their contributions. More disconcerting is the low percentage of workers aged 55 (19%) who have $250,000 or more in place.

As the popular song from Monty Python’s “Life of Brian” comes to mind: “And…always look on the bright side of life… Always look on the light side of life…” I wonder who is right. It could be all of us! But as Nathan Hale of CBS.Moneywatch suggests: if the Journal wanted to write about the dire straits of our retirement system, there is rich vein to mine.”

Mutual Fund Investing: Where Herd Mentality Still Roams

  By petillo | May 22, 2011 - 8:16 am | 401k, economics, financial planning, Mutual Fund Investing, Profitable Investments, Repercussions: A Retirement Review, Retirement Planning Target 2025
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It has been decades since behavioral economics took hold as a science of investor actions. Designed to study the irrational decisions that we all are apparently hard-wired to make, the field grew into a respectable and well-quoted discipline. Which is fine. We know we have incredibly limited potential to redesign ourselves, despite the pushing and prodding in one direction, the look-in-the-mirror study of our own foibles and the instructions on how to improve this very human lot in life. But we muster on. And this is why, even despite the improved access to our 401(k) plans does our retirement still suffer.

Studies done quite recently suggested that most folks will simply accept the status quo if given a confusing situation. Investing is just such a case-study in chaos, less so for the experienced investor, but even for that group, a churning pool of information keeps them struggling to keep up. But the behavioralists  insisted that auto-enrollment in a retirement plan would create great strides for the plan and even greater rewards for those who may have – and still do have the option of – opting out.

Auto-enrollment we have found out is a trip through the wardrobe. We may all have taken the first step. But what awaits us on the other side, in almost every instance, is our irrational mind. And in almost every instance as well, a less-than-wonderful 401(k) plan. But more on the plan later. Let’s just focus on what we have done recently as we embrace our biases, follow our illusions and believe in the fallacies.

There have been several alarms ringing on Wall Street and those who invest in mutual funds have turned a deaf ear. Herd mentality, the primitive instinct to follow the herd because doubt in the face of danger can present death was considered a valuable possession. Somewhere along the line though, things changed.

In our wonderful modern brains, this instinct has evolved into a trait, or so say the behavioralists, the makes us run towards the danger because everyone else is. What once once a survival instinct is now a suicidal tendency, at least in the world of investing. (Look at it this way: It would be similar to seeing a crash on the highway and deciding that driving your car into the pile would be in everyone’s best interest, including your own.) Evidence of this is beginning to crop up and our big “modern” brains are at fault.

There are three types of mutual funds or mutual fund investment strategies that have shown a tendency to attract these kinds of investors: emerging markets, commodities and a category I’d be willing to wager you didn’t realized existed, floating rate funds. (Amy Or of Marketwatch.com describes them as “Unlike fixed-rate loans, floating-rate loans can capture rising interest rates and are deemed a good inflation hedge” and with some uncertainty about when if sooner-not-later, interest rates begin to rise, these funds will be able to capture the change in market conditions.

Recent herd-like inflows of over $14B suggest that the usually high load fees and the underperformance of late matter little. It is where, these investors believe they should be. But because, as so often is the case with herds like this, so many have heard the siren’s call, the opportunity to make any more moves to the upside have been hampered. That means a lot of people will eventually follow the herd off the cliff, ost of whom bought at the top.

When they aren’t betting on debt, they are looking at commodities. These funds, focused on such tangibles as oil, silver and gold will to most of us, seem to be destined to go higher. And if you bought into this sector recently, you have  high hopes that it wasn’t at the top. But silver suggested it was, as did oil, and the drop in prices found those same people scrambling to get out. Most bought in with expanded exposure in their supposedly well-balanced portfolios and are now paying the price for having believed that diversity was just another word for profit.

And emerging market investors are beginning to realize that perhaps they too have been failing to listen to the global heartbeat. Europe is not finished with its economic woes. Commodity prices may have fallen but they still remain uncomfortably high for countries looking to emerge and now, predictions of slowing growth at expanding powerhouses like China have begun to worry the savvy investor. You newbies are deeply embedded in the herd still.

You may have been auto-enrolled, but the walk through the wardrobe left you in the middle of the Serengeti. And you probably won’t get the memo that you are in danger until it is too late. This thinking about getting you in, attempting to educate you, guide you, slip you into an ill-suited target date fund came by way of Thaler and Sunstein’s book called Nudge: Improving Decisions About Health, Wealth and Happiness. In is not the same as knowing what to do or how to act when you arrive. The information tsunami hasn’t lessened and may have even gained strength over the last several years and investors, particularly the neophytes, will still drown before they learn to swim.

How running with the herd once saved you only to become the complete opposite will remain a mystery. And getting people into these plans by using science to study our unpredictable-ness is still a good idea, even if it seems suspect. But once there, the status quo is good. But who says what the status quo is? You may never get a clear bead on the answer,  Until you realize the herd is leaving the room.

Your 401(k): Design Flaws Might be the Thief – Part one

  By petillo | February 3, 2011 - 4:00 am | 401k, financial planning, Profitable Investments, Repercussions: A Retirement Review, Retirement Planning Target 2025
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We spend a lot of time and effort focused on the fees you might be charged by your 401(k). This of course, isn’t a wasted effort. But it might be misdirected. A good plan, as we have noted here numerous times, is one with a focus on the right investments for the participants. And we have also noted just as often, that choosing the right investments for your particular situation is key to achieving the results you desire.

There are basically two discussions here: one, are you making the right choices and two, is the plan helping you make those choices? Few if us look to the plan design when we are initially hired for a job. In fact, more than one professional I have spoken with laments that we accept whatever plan we are offered as a sort of given. We focus instead on some of the other benefits a new job might offer, such as health benefits, vacation time and pay. While those are noble considerations, we often take access to a 401(k) plan as a given.

But no two plans are created equal. And although many new hires relegate the 401(k) plan at a new employer as something that is simply there, a good plan, more specifically, a good plan design will have a greater effect on your efforts to get to the retirement you may (or should) get than many people consider.

So what is a plan design? The perfect 401(k) plan gives access to all employees of the company in an equitable manner. But this is not always the case. In fact, plans need to pass a discrimination test. The IRS has created rules that limits the maximum deferral by the company’s “highly compensated” employees. This rule suggests that based on the average deferral by the company’s non-highly compensated employees (NHCE, which is most of us) sets the standard so to speak, which allows highly compensated employees (HCE) to do the same. If the less compensated employees are allowed to save more for retirement, then the executives are allowed to save more for retirement.

There is a test for this sort of compliance referred to as the ADP test. According to the IRS, this test does the following:

“Under the ADP test, the average salary deferrals of the HCEs and NHCEs are calculated and compared on an annual basis based on the plan year. Each employee’s deferral percentage is the percentage of compensation that has been deferred, pre-tax, to the 401(k) plan. The deferral percentages of the HCEs and NHCEs are then averaged to determine the ADP of each group. To pass the test, the ADP of the HCE group may not exceed the ADP for the NHCE group by 1.25 percent or 2 percentage points.

“Similar to the ADP test, the ACP test applies to matching contributions and/or employee after-tax contributions. The plan satisfies the nondiscrimination requirements of the law if it passes the ADP and ACP tests.”

This is why there has been so much emphasis on plan participation by all. It raises the limits on what those high earners in the company can sock away for their retirement. Auto-enrollment is one of the key elements in helping a plan pass this test. The employer really wants to pass the test. If it fails, it must give the money back to the highly compensated employee who is then taxed on it.

The cost to the employee: You have to pay taxes on the returned money. The best thing to with it at this point is to invest it into a Roth IRA. Are there lingering effects on the other employees? Possibly and this might further deter participation in the plan, which was lagging behind the contribution level of the higher paid workers. These plans are meant to be equitable for all employees.

The cost to the employer: Because most small business need to test their plans frequently (about 25% fail the test), the cost is passed on to the plan as an administrative fee. Their is the goodwill cost as well and no highly compensated employee, usually charged with a senior role in the business likes to have any invested money returned because the plan wasn’t run correctly.

Next up: Comparability/cross tested design can cost the employer money and add still more fees to the plan.