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Automating the 401(k)

Terry Savage

When the Pension Reform Act was passed a few months ago, it contained some lofty goals for encouraging employees to invest wisely within their 401(k) plans. Now Labor Secretary Elaine Chao has proposed specific rules to spur companies to get the ball rolling on this project.

Over the past 25 years, almost every major company has switched from a defined-benefit "pension" plan to a defined-contribution 401(k) plan -- named after the section of the tax code that created these plans. The change has caused problems that have worsened over the years.

Lack of Planning

Not long after the advent of 401(k) plans, it became apparent to observers that many younger workers saw little need to plan for the future; they were unaware that time was their most valuable asset. As the experts came to realize that a large number of baby boomers would have little besides Social Security to support them in retirement, campaigns were mounted to encourage increased contributions to retirement plans.

But then, those who did contribute were faced with another dilemma: How should they invest that money? Employers, fearing liability, were unwilling to provide advice beyond basic booklets discussing diversification. Plan participants followed the latest investing fad, or concentrated their money in company stock (used for matching purposes) or in "safe" investment alternatives that in most cases would not generate the growth necessary for retirement.

All that changes with the rules announced this week, which make it easier for fiduciaries -- those responsible for creating and implementing defined-benefit plans -- to adopt automatic-enrollment and investment-diversification features.

Specifically, the Department of Labor rules acknowledge three appropriate automatic-investment plans for 401(k) accounts:

• Life cycle funds
• Balanced funds
• Professionally managed accounts

If a company automatically funnels employee contributions into one of these formats, it will enjoy a "safe harbor" and be immune from legal action claiming negligent investment advice.

Planning for Life

Life cycle funds have been growing in popularity since they were first introduced about a decade ago, and are already found in many 401(k) plans. These funds instruct individuals to choose a retirement year, and then the managers diversify investments based on that goal, becoming more conservative -- while still investing in equities -- as the fund shareholders approach retirement.

Morningstar estimates that life cycle funds currently have $127 billion in assets. Considering the new DOL ruling, it is likely that demand for these investment vehicles will continue to grow.

Balanced funds have been around for years. They typically use a combination of conservative stocks, preferred and dividend-paying stocks and high-quality debt instruments to create a portfolio that is designed to produce returns over the long run. Portfolio managers make adjustments to the investments based on their outlook for the various markets.

Managed accounts are the relative newcomer to 401(k) investing. As the name implies, these are professionally managed accounts within a 401(k) plan, based on the participant's risk preferences and retirement horizon.

Professional managers are chosen by the employer, and are restricted to investment choices within the plan. Allocation decisions are made by the manager on a discretionary basis.

Financial Engines, an online provider of investment advisory services, is a leader in this growing new space of managed accounts within retirement plans.

Companies have long used Financial Engines as a "fiduciary" to provide individualized investment advice to plan participants. Employees create secure individual profiles detailing their contribution levels, income, retirement goals and risk tolerance. The service then produces specific recommendations for diversifying investments.

Recognizing that the process, simple as it is, intimidates many employees, Financial Engines enhanced its offering to include portfolio management. That is, companies provide their services and individuals can literally turn over the decision-making process to Financial Engines professionals. It's not investment advice ... it's investment management.

According to a recent Hewitt Associates study, 7.5% of large employers are either currently offering or are planning to introduce a managed-account option to their plan participants in the coming year.

Some employers plan to include it as the default option for new hires. Others may automatically enroll existing employees in the managed-account service. (Individual employees may opt out of enrollment, of course.)

Financial Engines has working relationships with many of the top plan record keepers to provide advisory services, including Vanguard and JPMorgan Chase. Other companies also are competing in this space, including ProManage and GuidedChoice. In addition, Morningstar offers individual account management within 401(k) accounts for many smaller companies.

(If you'd like a free look at the Financial Engines individualized investment-advice service, click on its logo at my Web site, www.TerrySavage.com. Note: the company's individual money-management service is available only through employers.)

One advantage of using a managed account -- as opposed to a life cycle fund -- is that the manager will analyze your investments outside of your 401(k) plan, which could include other company pension benefits, corporate stock or even an IRA rollover that you have invested elsewhere.

The fees of the managed accounts, including the underlying fund costs plus the cost of advice, total about 60 basis points -- or just over one-half of 1% -- per year. That means an employee with $10,000 in her 401(k) account would pay about $5 a month in fees -- about the same that most life cycle funds charge, minus the personalized advice.

It's easy to see that the new Labor Department rules open the door to long-term investment advice -- a component that many employees have been missing in their 401(k) plans since companies abdicated their retirement-planning responsibilities.

Now you don't have to become an investment pro. Your company plan can give you access to the professional advice you deserve. And that's The Savage Truth.