Growing Pains

By Carolyn Hirschman Jun 1, 2002

HR Magazine, June 2002 Employers and employees alike have lots to learn about 401(k) plans , and that's where human resources comes in.

All the arguments about how to reform 401(k) pension plans boil down to a simple point: Many Americans aren’t saving enough for retirement, despite employers’ best attempts to motivate them. It is one of the most frustrating and perplexing problems in the field of employee benefits. For decades, employers have helped employees put away money for their retirement years through profit-sharing plans, defined benefit plans and, more recently, defined contribution plans. The 401(k)—legalized in 1978 and introduced in the early 1980s—is the undisputed king, steadily gaining share among all types of retirement plans.

Lauded for their portability, simplicity, flexibility and low cost to employers, 401(k) accounts—so named for the section of the Internal Revenue Code that authorized them—held $1.7 trillion, or 19 percent, of all pension assets two years ago.

The role of 401(k)s in retirement will only get larger, pension experts say. “I think they’ll be the retirement picture,” especially as defined benefit plans go through their “last gasp,” says David Wray, president of the Chicago-based Profit Sharing/401(k) Council of America.

The rise of defined contribution plans shifted the burden of retirement planning from employers to employees, about 42 million by most estimates. The plans’ participant-directed approach, in which employees voluntarily defer part of their salaries on a pretax basis, requires important, difficult decisions. How much money should I put aside per pay period? What types of investments should I make? When will I retire? How much money will I need then?

Some employers have bent over backwards to educate employees on how to make the right decisions. Some have hired outside vendors to help employees allocate their investments. The vast majority of 401(k) plan sponsors are wondering what to do, particularly in the aftermath of plunging account values during the stock market turbulence of the past two years and the controversy over huge losses suffered by Enron Corp. employees when the company collapsed last year.

As companies take a fresh look at their 401(k) plans, particularly the ways that the plans are managed, HR will not be on the sidelines. It will be up to benefits specialists to have answers and suggestions for a number of 401(k) issues, especially on ways to ensure education for employees on how to make the most of 401(k) plans. It will become increasingly important for HR to get up to speed on the workings of their companies’ 401(k) plans, the laws and rules governing plans and the kinds of changes in 401(k) structure that some experts are advocating.

A Sound Design

Though many pension experts say the basic structure of 401(k) plans is sound, some are calling for changes—from tinkering to radical overhaul—to prevent Enron-like disasters. Participants in Enron’s retirement plan lost more than $1 billion. The near-retirees who lost most of their savings were heavily invested in stock of the now-bankrupt energy-trading company.

Their situations are heartrending—but not the fault of the 401(k) system, pension experts say. “The reason people lost [money] in Enron was not because they were pension participants, but because they were shareholders,” says Mark Ugoretz, president of the ERISA Industry Committee, a Washington, D.C., organization that lobbies on behalf of large employers on benefits issues.

Says Wray: “The fundamentals are still in place. The 401(k) works incredibly well. It’s not broken.”

There’s no evidence that participation in 401(k)s has fallen or will drop in reaction to the situation at Enron. In a Charles Schwab & Co. survey of 401(k) plan participants, conducted in February as Enron investigations were in the spotlight, 72 percent of the 620 respondents said they had changed their investment strategies through actions such as diversifying and obtaining more research.

The Enron cloud’s silver lining could be a wake-up call to plan sponsors and participants to pay more attention to retirement investing. “Hopefully, people will be more aware of the need to diversify their assets,” says Albert Brust, executive vice president of the National Defined Contribution Council in Denver.

Bad Behaviors

But the design of 401(k) plans puts the onus of managing money on employees. The importance of diversification, the time value of money, the difference between stocks and bonds and other principles of finance and investing are little understood by 401(k) participants. More sophisticated practices—such as projecting retirement needs and rebalancing a portfolio to react to changing personal circumstances and market sector performance—are even less well known and are underused. Some people just don’t get it; others figure they’re too busy to do the homework or feel intimidated by the material.

“Employers do tons of education, but individuals are still individuals,” says Dallas Salisbury, president of the Employee Benefit Research Institute (EBRI) in Washington, D.C. He blames the current state of financial illiteracy on society’s penchant for spending over saving and on schools’ failure to teach students the basics of money. Others say that employers haven’t done enough education, or that employees don’t take enough responsibility.

Whatever the cause, employees’ bad behaviors are well-documented. About one-fourth of eligible employees don’t participate in 401(k)s offered by their employers, according to Salisbury, a member of the Society for Human Resource Management’s Board of Directors. Of those who do participate, only 11 percent contribute the maximum amount allowed. And too many people cash out accounts when they leave their jobs—paying taxes and penalties instead of rolling over the money into another employer-sponsored plan or individual retirement account (IRA).

Many investors have good intentions but are wearing rose-colored glasses—or blinders—suggests a survey of 800 defined contribution plan participants by Boston-based John Hancock Financial Services Inc., released in April 2001. Only half of all respondents had determined how much money they will need for a financially secure retirement, and only half had an asset allocation plan.

Wayne Gates, general director of Hancock’s investment and pension area, called the findings “deeply disturbing” given the 401(k)’s status as the primary vehicle for retirement savings. “If [workers] don’t get it right, they will have no second chance—and no safety net,” he says. The result? A delayed or less comfortable retirement.

Muddy Legal Waters

Many HR managers are scratching their heads over how to solve longstanding problems of participants’ behavior. The gray area of employers’ legal liability for providing education and advice inhibits many companies from doing much at all. “Everyone’s kind of nervous about this,” says Donald J. Myers, a Washington, D.C., partner in the Pittsburgh-based law firm Reed Smith.

The Employee Retirement Income Security Act of 1974 (ERISA) requires 401(k) plan sponsors to provide enough data so participants can make informed decisions, but there’s no legal obligation to do more. However, many companies offer formal education programs to help foster responsibility and loyalty, and financial advisers say the Enron scandal has prompted a surge in demand for education services. These programs typically include 401(k) enrollment meetings, on-site financial planning seminars, printed materials, videos and financial-planning software.

“Employees who understand finances are more productive,” claims Katie Libbe, vice president of marketing and products at American Express Retirement Services in Minneapolis.

Although many employers provide investment education, advice is a different matter. Education provides general financial information so that people can make their own decisions. Advice provides individualized recommendations, often for a fee.

Nothing legally prevents employers from hiring financial professionals to provide advice, and employers are not liable for investment losses if they’ve been prudent in selecting and monitoring the advisers. But in practice, most employers steer clear of giving advice because they fear getting sued by employees for any resulting poor financial performance.

U.S. Department of Labor guidelines encourage employers to use independent advisers for providing advice to avoid conflicts of interest. An investment firm that manages a company’s 401(k) plan can provide advice only if it applies for and receives a “prohibited transaction exemption” from the Labor Department. Among other requirements, the firm must agree to flatten its fee structure for various investments, eliminating the conflict of interest that exists when it steers investors to funds that earn the firm higher fees.

As it stands, 38 percent of 401(k) plan sponsors offer advice, and 31 percent of participants used advice when it was offered, according to the most recent annual survey—of 909 plans—conducted by the Profit Sharing/401(k) Council.

Many companies, especially small businesses, would like to offer individual advice through their primary 401(k) vendor. Pending bills in Congress would allow such providers to offer advice on their fund selections if they disclosed all fees for various investment funds. For now, the best bet is to use different providers for managing the 401(k) plan and offering investment advice. (See “Investment Advice: High-Tech or High-Touch?”.)

Do More? Or Less?

The legislative debate over advice raises the question about employers’ proper role in educating employees. Two schools of thought have emerged. The first holds that employers should make a major commitment to improve financial education. The second maintains that it is better to outsource the entire 401(k) program, right down to individuals’ investment decisions.

State Farm Insurance chose the education approach in 1999, starting with two financial-education seminars offered to its 80,000 U.S. employees. Today the Bloomington, Ill.-based insurer offers 12 free workshops on topics such as investing for retirement, education funding and cash management. State Farm spends about $800,000 annually on financial education, including workshops, books and personal financial planning software—efforts that have paid off in 87 percent participation in its 401(k) plan.

“Upper management bought into it because it was the right thing to do for employees,” says Martin Sallee, manager of State Farm’s benefits and services department. State Farm not only has maintained its traditional defined benefit plan but also has made employees 18 or older eligible for participation in the 401(k) on their first day on the job.

Feedback from a pre-retirement program for workers 50 and older suggested a desire for investment information sooner in employees’ lives and careers, says senior benefits analyst Vonda Rodgers. Focus groups helped HR plan a full educational program, which is taught by a major consulting firm that State Farm declines to identify.

Ken Rouse, a financial-education consultant in Phoenix, says programs like State Farm’s could become more widespread if HR took on “the moral responsibility” to convince senior executives of their value. “If enough HR people say we believe we’ve got to spend the money and time and make this work, then something could happen in the next few years,” he says. “If it doesn’t come from HR, I can’t imagine where it’s going to come from.”

Critics of this strategy call it a pipe dream. “The typical American worker does not even have it on his or her radar screen to be a better investor,” claims Brooks Hamilton, an employee benefits attorney in Dallas.

Hamilton and others contend that modernized iterations of professionally managed 401(k)s offer the solution for U.S. workers’ poor savings habits. Under Hamilton’s proposed “American Freedom 401(k),” employers—with participants’ approval—would outsource investment decisions. Employees would be automatically enrolled with default contribution rates of 4 percent to 6 percent of pay. Consumer-type loans and hardship distributions to plan participants from their accounts, now permitted by most plans, would be prohibited. But a new “hardship loan” would be available from plan assets for conditions that meet the current criteria for a hardship distribution.

It’s not a proven concept. And ERISA would have to be amended to provide employers a safe harbor from lawsuits for meeting requirements of the plans. But it builds on earlier 401(k) innovations such as “lifestyle” funds, which offer preset formulas of stock and bond investments in various proportions appropriate to each investor’s age and risk tolerance. Such funds simplify participants’ asset allocation decisions and periodically rebalance their holdings with no further participant input.

Some companies are trying Hamilton’s idea on a limited basis. Safelite Glass Corp., a national glass repair service based in Columbus, Ohio, struggled for years with very low participation in its 401(k), says benefits administrator Lisa Beaty. The plan began in 1992, when Safelite froze its defined benefit plan.

With 6,000 employees at 700 locations in 50 states and persistent high turnover, Safelite found it difficult—and still does—to create a financial education program, Beaty says. Hamilton, Safelite’s third-party administrator, recommended a 401(k) overhaul in 1997, resulting in what Beaty calls “a Big Brother” arrangement.

Safelite’s new plan used two main features to boost savings. The first—automatic enrollment, with a default contribution rate of 2 percent of pay—more than doubled the participation rate, to 95 percent. The second feature was “professionally directed investments,” with investment firm Morgan Keegan & Co. Inc. choosing from among a mix of stocks, bonds and other investments for each participant.

“Anyone without a lot of education about investing can choose that option,” Beaty says. Employees who prefer to choose on their own from among seven investment funds can still do so.

The system works well but not perfectly, Beaty admits. Turnover forces her to deal with a lot of small lump-sum distributions, constant explanations of why those distributions are taxed and small balances left by former workers who can’t be located. Safelite plans to hire an outside firm that will improve the plan’s operations and communications.

Can this experiment work elsewhere? Perhaps, but critics say it removes too much responsibility from employers and employees and, more important, does nothing to solve the long-term problem of financial illiteracy. “It’s a cop-out,” Rouse says.

Other industry observers have proposed minimizing employers’ role as “gatekeepers” of 401(k) plans and developing an “open architecture” in which employees could choose their own investment fund providers much as they now do with IRAs. The accounts would be more portable and provide participants more options, but there is debate over whether costs would increase or decrease. Such a system would be more like the 403(b) defined contribution plans now available to colleges and nonprofit organizations.

Charting the Future

As anyone in Washington, D.C., knows, there’s no shortage of ideas for 401(k) reform. Pension lobbyists are wary of too much regulation—which they say has choked defined benefit plans—and new rules that could backfire. There’s concern, for example, that if levels of company stock are limited, plan sponsors that use company stock for matching contributions might decide to eliminate their matches altogether.

To be sure, there are weaknesses in the defined-contribution system that have be.come clearer as the system has grown, experts say. Many small businesses can’t afford to offer plans, so only half of all private-sector workers are covered. Account balances are woefully low, especially for lower-income workers. Many employers don’t know how to best design their plans or track their costs. Often, plans have too many investment options. In fact, some say there are too many kinds of defined contribution plans with different features and regulations.

“There isn’t one magic bullet” to fix all these problems, says Erik Ristuben, director of Frank Russell Co.’s investment group based in Tacoma, Wash.

The one certainty, it seems, is that 401(k)s will play an increasing role in the nation’s retirement picture. “The power of payroll deductions and pretax contributions cannot be denied,” says Salisbury of EBRI. Nor can the steady decline of defined-benefit plans, which many experts believe will one day cease to exist. And how Social Security benefits will fare is anyone’s guess.

This situation means that all types of pension benefits, which now make up 19 percent of elderly Americans’ income, will likely provide a bigger share of future retirees’ incomes. To live well later, participants must invest now—and employers and government must develop systems that encourage and maximize their savings.

Carolyn Hirschman is a business writer based in Rockville, Md. She has written for a variety of business publications and has covered workplace issues since 1991.

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