Sea Change

Companies now play a much more active role in guiding employees' 401(k) investment decisions.

Evidence indicates that such funds do better than the average employee on his or her own. Fidelity looked at people who have been in their plans for the past 10 years (1999–2009) and measured how those who assembled their own portfolios did compared with those who had Fidelity target-date funds that corresponded with their age. Of that group, a whopping 70% “showed a lower return than their age-based funds over the course of the decade.”

But there is room for improvement. “Too many plan sponsors still view target-date funds as commodities, using the proprietary target-date funds of their recordkeeper without performing appropriate due diligence in the selection process,” says Lucas of Callan Associates. Because there is tremendous variation in glide paths (that is, rebalancing as retirement approaches) and returns, she says employers should conduct in-depth research on the funds and expand such offerings if need be.

One key differentiator, which must be communicated adequately to employees, is between target-date funds that stop reallocating at the target retirement date and those that are continuously managed through an expected lifetime. In many cases, “people thought that when they picked the 2010 fund, that was the date at which they got a big pile of money,” says Vorchheimer. “Meanwhile, the people who ran these funds were [factoring in] another 25 years for expected life span, so the equity concentration in the funds for people closest to retirement was probably much higher” than some people expected.

In February, Securities and Exchange Commission chair Mary Schapiro announced that she wanted SEC staff to look into this confusion. “In the year ahead, we are going to confront the issue of the potential for target-date fund names to confuse investors, or lull them into a false sense of security,” she said, noting that rules on additional disclosure as well as on the marketing of such funds are in the works.

Having an investment professional build a customized target-date fund using the plan’s existing investment options is one way to avoid such pitfalls, and may result in lower fees to boot. Some companies hire consultants to construct different target funds based on their plans’ existing investment options. This approach makes a lot of sense for plans with more than $1 billion in assets. One drawback: if the funds use stable-value funds as part of their asset allocation, the “wrap provider” (that is, the firm that guarantees the principal of the stable-value funds) may raise a red flag regarding the looming liquidity implications.

Indeed, “as a plan sponsor, you need to be very careful that you don’t run afoul of the contract with your stable- value fund wrap provider,” says Lucas. “If you’re considering this, the first thing you would want to do is talk to the stable-value fund manager and see if it can test the waters with the wrap providers [it partners with].”

Rethinking Annuities

Annuities may prove to be the missing link between current 401(k) plans and the pension plans of yore. President Obama has hinted at them being a required part of any plan, and the Labor Department is currently soliciting comments (due May 3) on what role these instruments, which pay a set amount of money over a fixed time period, could or should play. Proponents say they can mitigate longevity risk (the risk of outliving your assets) by allowing participants to buy an annuity that, for example, would kick in at age 85, allowing them to spend down in a more manageable way the remainder of their assets over the intervening years.

Today, however, annuities are most often used as an external (that is, outside the 401[k] offerings) rollover option for people hitting retirement, and even then by only 14% of the companies recently surveyed by Hewitt. As for allowing employees to invest in them during working years, only 2% of companies currently offer that option.

The main problem is one of liability. Annuities are generally run by a single insurance company, and in this post–AIG meltdown era experts say many people may not trust one company enough to bank a significant portion of savings with it. Lack of portability is also an issue. In short, says Vorchheimer, interest in annuities “is bubbling, but the government is going to have to mandate it, or it’s going to take a very long time” for plan sponsors to add them.

Despite the strong gains of 2009, most employees still have plenty of catching up to do. Over the long term, the ignorance-is-bliss approach won’t serve them well. Fortunately, companies have more tools at their disposal, and they know they need them — a spot poll on www.cfo.com found that three-quarters believe they need to do more to educate employees about 401(k) plans. Unfortunately, with no silver-bullet solution in sight, companies will also have to educate themselves about the pros and cons of each of these emerging options.

Alix Stuart is senior editor for human capital and careers at CFO.

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