Article II: Investment Process for 401k and Other Contribution Plans
THE CULTURAL SETTING OF THE INVESTMENT PROCESS IN 401K PLANS
(AND OTHER CONTRIBUTION PLANS)
H.S. Dreher Capital Management, LLC
For the past ten years, “401K Plan” has been synonymous with “Defined Contribution Plan,” in much the same way that “Xeroxing” became a ubiquitous term in the copying industry. This, even though many other Contribution plans exist and are in active use, examples being IRA’s, Keogh’s and SEP’s. But it is not our purpose here to define Qualified Retirement Plans and their variations. Nor is our objective to furnish a list of “must-have” investments for Contribution plans. Unlike most articles we have seen on Contribution plans, this one attempts to review the prevailing economic and cultural circumstances that affect the investment process. We believe that all QRP’s are complex phenomena comprised of political compromises and socioeconomic demographics. While our message will not be popular with many QRP providers—who gather the assets and collect the related fees—it is possible that Contribution plan participants can benefit from our discussion of the cultural changes that are affecting them.
The operative word in 401K and similar Contribution plans, in our opinion, is CONTRIBUTION. Importantly, Contribution plans are in stark contrast with Defined BENEFIT Plans. Understanding the philosophical differences between these two plans reveals the sinister nature of the movement toward Contribution plans, a movement that is capable of delivering tragic consequences for workers entering and approaching their retirement years.
Defined Benefit Plan:
By definition, a Benefit plan guarantees the participant a benefit upon retirement. The most widely known of these plans is the old fashion Pension Plan. After spending a career working for the same company, retirees receive a pension for life. They don’t have to worry about rates of return on investment during or after accumulation of capital for retirement; their income will be available as long as the company stays in business (and even longer if the benefits are insured by the Pension Benefit Guarantee Corporation or other funding solutions). Employees of all rank—executives to janitors—put in their time, specialize in what they do best, and the company guarantees their retirement benefit. In a simplified manor, that is essentially the pension system, or defined Benefit retirement plan.
Defined Contribution Plan:
By adopting a Contribution plan, wherein employees and sometimes employers make defined contributions on behalf of employees—the stereotype being the 401K—a subtle but very ominous thing happens: employees make their own investment decisions. (This includes determining how much to contribute as well as what investments to make.) This may not seem like a big deal, but consider that if they screw up, there is no one to guarantee them any retirement benefit, except whatever Uncle Sam can supply with Social Security. So the ramifications of this change are not subtle. Under this system, employees of all rank—capable or not—must make investment decisions throughout their careers that will determine their retirement benefits. Once again in a simplified manner, this is the essence of defined Contribution plans, which is the direction our retirement system is heading whether it is good or bad.
An Irreversible Trend:
The movement toward Contribution plans has been underway for two or three decades, and it is irreversible; it is more likely to accelerate rather than recede. Consider some of the powerful forces behind this phenomenon.
Job Mobility. Our society continues to grow short-term oriented—embracing liquidity, career changes, dual-income households and freedom of movement. As this trend continues, the portability of retirement plans becomes important. The old system of long careers with the same employer followed by the comfortable pension in retirement is an outdated model. Today’s employees want instant vesting and the ability to change jobs. A Contribution plan satisfies this demand much better than the old fashion pension plan based on the long-career model.
Costs. Like everything else in the universe seems to have, companies—employers—have a life. This means they have a beginning, middle and an end. The “end” can be a problem. The obligation of post-retirement benefits, including medical, often becomes a financial burden for our older companies as theirretiree populations grow. General Motors, for instance, according to an article in Barron’s a few years ago, pays more for retirement benefits per car than it does for steel. (We’re not saying GM is “at the end,” but it is one of this country’s older corporations.) So it is possible that our present concept of Benefit plans simply isn’t affordable in the long run.
Responsibility. Given these costs, shifting the responsibility for retirement to employees becomes very appealing, at least from a corporate viewpoint. Contribution plans do this more efficiently than Benefit plans.
Access to Capital. This trend toward Contribution plans is so pronounced that many of our nation’s newer companies don’t even offer Benefit plans. In a January survey of the 30 Value Line companies with the largest equity market capitalizations, five of the companies did not have a Benefit—pension—plan: Microsoft, Wal-Mart, Cisco, Berkshire Hathaway and Dell. In fact, one of the first things we examine when investing our clients’ capital is the condition of a company’s Benefit plan: if it’s under funded, we treat this amount as additional debt, which lowers the price we are willing to pay for the company’s stock. We are even beginning to rule out altogether companies that have Benefit plans. Although we are small potatoes when compared to all the capital out there, sooner or later companies’ access to the capital markets could be restricted if the structure of their retirement plans is regarded as a liability that potential investors—shareholders as well as bankers—don’t want to assume.
The Investment Process
Evolution does not always follow the best path. While employees are being handed responsibility for their own retirements, they are handicapped by an investment environment cluttered with a hierarchy of fees.
Plan administrators charge employers and/or employees to keep track of each employee’s retirement plan value.
Custodians charge for holding the plan assets and, in many instances, giving 24/7 access to plan assets with the ability to make daily changes.
Mutual fund managers charge management fees.
Many custodians, administrators and investment managers are related. The result is that plan participants make investment decisions based on advice that is tainted with conflicts of interests. Some employees are even required to purchase insurance products, such as annuities, to participate. This occurs even though the tax-deferred benefits associated with annuities are redundant in tax-deferred plans. (But plan participants still pay the extra fees.)
Choice Equals Responsibility:
Somehow during this movement from Benefit plans to Contribution plans, discharge of the employer’s fiduciary responsibility has become synonymous with investment choices. In other words, employers begin with a responsibility for their employees’ retirement benefits. They transfer some of this responsibility by adopting a Contribution plan. The more investment selections in the plan, the more responsibility they can transfer. As we stated, evolution does not always take the best path. Access to good advice might have been a better way to measure the extent to which an employer transfers responsibility for retirement to an employee. But the number of investment choices, entangled with the fees outlined above, is generally recognized as the standard measure for discharging this responsibility.
Once employees make their contributions, combined with whatever—if any—contributions from their employers, what can they expect as far as investment return is concerned? With the trend toward more choices, selecting investments can be confusing. As far as investment returns, most studies suggest that stocks return between 9% and 10% over a long time horizon, with bonds generally outpacing inflation by 3%. To demonstrate the disconnect between plan participants and these historical figures, consider that before the great three-year bear market of 2000-2002, surveys revealed that 17% was a minimum expectation of investment returns for individual investors. Thus, at the worst time, plan participants managing their own investments focused entirely on rates of return without incorporating the concept of risk into their investment models.
Then, to compound the problem, “investment experts” were quoted in the financial press at the bottom of the bear market saying that investment returns would be below average for the next ten to twenty years. (Now that the markets have recovered most of their losses, or made impressive gains, lowering expectations for equities may be appropriate, but it was sure bad advice at the time.) And many investors were whipsawed by selling out at the bottom of the equity market to purchase bonds that had already appreciated in price. By recognizing what the markets have to offer over the long term, investors can make investment choices based on diversification instead of chasing returns. Doing so will help them address the risk side of the equation.
Investment Return Versus Investor Return:
As John Bogle, founder of Vanguard, has said, unfortunately there is a gap between investment return and investor return. In the taxable world, investors must share their gains and income with the Government, pay commissions and pay management fees if they use mutual funds or professional management. In the tax-advantaged world of QRP’s, plan participants must pay the high fees described above, plus commissions in some cases. They also must deal with a bureaucracy that in many instances is laden with conflicts of interest. In short, regardless of whether the future reproduces the 9% equity returns of the past, or the actual return is lower, plan participants will be separated from these returns by structural factors.
Lack Of Advice:
At the risk of giving financial advisers too much credit in the IQ department, we would suggest that turning employees loose to invest their own money in the environment described above is analogous to doctors giving their patients medical books—old ones—and telling them to make their own diagnoses. Or for attorneys to send their clients into court to fend for themselves. Too often we see the results of investors being presented a list of choices, with each choice accompanied by a one or three-year return. Naturally, investors select the investment with the highest return. In doing so, they don’t consider risk, they don’t consider diversification, and their selections usually are the ones that are at the bottom of the list for the next three years.
Advantages And Disadvantages:
As discussed, increased responsibility on the part of employees for their own retirement make their investment results very important. And the task of making investment selections is not an easy one, even without the handicaps cited above. By being familiar with the cultural setting of Contribution plans, we think plan participants can make more informed decisions. It might help them to consider the advantages and disadvantages of their investment surroundings.
Beginning with disadvantages,
- employees making their own plan investments are competing with the experts, who may have special training and access to superior information flow.
- As mentioned, the proliferation of investment choices can be confusing.
- The extra fees discussed above will reduce the investment returns that are achieved.
- In too many instances, employees are operating in a structure containing conflicts of interest. In their efforts to accumulate plan assets, and the fees that follow, the investment community has placed their own interests ahead of the interests of plan participants.
Offsetting these disadvantages are some powerful advantages.
- Positive investment returns are allowed to compound tax-deferred until the assets are withdrawn, so it’s the employee’s job to do as much as possible toward attaining a positive return.
- Turning the growing number of choices into an advantage for employees, most investors can select funds that allow them to diversify among many asset classes, such as income, international and different capitalization sizes. We would suggest that plan participants consider their financial assets outside of their plans when making these selections so they can develop an investment strategy that guides their selections. In our experience, adhering to an investment strategy yields better long-term investment returns than does chasing returns by investing in mutual funds with the best short-term records.
- Also as a result of increased choices, investors can select investments, such as index funds, that have low management fees. We believe that making choices for the long term with low expenses will result in pleasing results, regardless of how they are measured. (Of course, like everyone else, we have no special ability to predict the future, and past experience cannot be guaranteed.)
The shift from Benefit to Contribution plans holds important consequences for employees caught up in the powerful forces outlined above. Some employees, for example, during their careers have seen their Benefit plans terminated. We believe that as the retiree population of our older companies continues to grow, more companies will be forced to eliminate their Benefit plans. Sears, for instance, recently announced that it would terminate its pension plan. (Of the twenty-five companies in the Value Line survey mentioned above that maintain Benefit plans, twenty-one of the companies’ pension plans were under funded.) In these cases, it is common practice for the employee to be handed a lump sum in lieu of future benefits, which is usually rolled into an IRA managed by the employee. Those unfortunate enough to have begun equity investments with this capital at the beginning of the 2000-2002 bear market, unless extremely well diversified, experienced painful losses. Their new Contribution plans—401K’s—are of little help in making up the losses of a lifetime of benefit accumulation.
The investment choices employees make in their Contribution plans are critical. For these selections will determine their standards of living during their retirement years. Plan participants, in fact, are taking on a responsibility that is being eschewed by their powerful employers with more resources. Because the investment process is so important to the financial well-being of plan participants, we would encourage them to consult with financial professionals: develop an appropriate investment strategy that embraces the use of diversification and identify investments that fit into this strategy.
A cultural shift from Benefit plans, such as pension plans, toward Contribution plans, such as 401K plans, has been underway for some time. This change favors employers over employees, because employer responsibility for employee retirement is transferred to the employee in the process. Furthermore, powerful forces are behind this change, and it seems more likely to accelerate rather than recede. Included in the new employee responsibility is deciding how much to contribute as well as what investments to make, both in the accumulation stage before retirement as well as in the distribution stage post retirement. In the investment world, the playing field holds several disadvantages for the employee. But there are also some important advantages, and if plan participants put these to work as suggested–especially developing an investment strategy–they may be able to overcome many of the disadvantages. It is important for employees to focus on the investment process, because it is likely that their investment returns will have the greatest influence on the living standards they can enjoy in retirement. Where possible, employees may want to consult investment professionals, such as their stock brokers or financial advisers, to coordinate plan investments with other financial assets.