Low-Risk Choices for Retirement

There are many options to offer retirement plan participants who want to dial back their investment risks.

By Joanne Sammer Sep 1, 2010
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September coverStock market volatility has always been an unfortunate fact of life for investors. For those who forgot that truism, the recession and the meltdown in the financial markets in 2008 and 2009 became a harsh reminder.

“Everybody had ‘envelope shock’ when they opened the envelope and saw their statements,” says Christine Zirafi, a cardiologist and treasurer of Cardiovascular Clinic Inc. in Cleveland. “It destroyed the illusion that the stock market will automatically generate a 7 or 8 percent return.” Zirafi is one of nine physician owners and 30 employees participating in the clinic’s 401(k) plan.

Now, with 401(k) and other defined contribution retirement accounts generally on the rebound, will plan participants become risk-averse and flee to only the safest investments? And how can plan sponsors broaden investment options to accommodate employees who want to reduce their risks long term and steadily scale back their exposure to equities as they approach retirement? Such questions are coming to light as employees catch their breaths after their investment downturns, and as employers re-examine their defined contribution plan offerings.

The Big Inertia

If anyone was worried that 401(k) plan participants would panic in a steep stock market decline, recent findings on participant behavior throughout 2008-09 should put those concerns to rest. Perhaps the biggest news out of the market decline is how little 401(k) plan participants reacted. Instead of making large-scale movements to safer investments, most participants stayed put. Even when the market reached its lowest point, few participants made changes to their accounts or stopped participating in the plan, according to Robert Love, chief financial officer of Custom Air Products & Services Inc., a manufacturing services company with 180 employees, in Houston. Love attributes at least part of employees’ willingness to continue making plan contributions to the fact that the company did not suspend matching contributions during the height of the recession as some other companies did. “We continued the match, and people stayed the course,” he says. “There was no mass movement from fund to fund.”

This company was not alone in this experience. “At the bottom of the market, there was a spike in movement out of equities,” says David Tolve, Bostonbased retirement business leader for the Mercer global consulting firm. The bigger story: “The vast majority of participants really did not take any action.”

According to an analysis released in April of nearly 3 million employees in 120 large companies conducted by Hewitt Associates, even when the stock market was declining sharply, as it did in 2008 and 2009, the vast majority of those employees made no changes to their 401(k) plan investments or contributions; neither did they stop participating in their companies’ plans. In 2008, 19.6 percent of employees made any sort of fund transfer, and 16.2 percent did so in 2009. In addition, the study found that plan participation (about 74 percent) and contribution rates (7.3 percent) remained virtually unchanged from 2008 to 2009.

These findings mirror the 401(k) plan activity experienced at M.A. Mortenson, a Minneapolis-based construction company. Its plan saw a net decline in plan investments in equities of about 16 percent and an uptick in stable value funds designed to maintain a fixed net asset value and bond fund investments of about the same percentage, according to Annette Grabow, the company’s manager of retirement benefits.

Grabow attributes this “stay the course” approach to retirement education. “Every year, participants are making better decisions in their retirement plans,” she says. “Education does work if you do it the right way and if you make the effort.”

Others attribute the lack of movement to other reasons. “Participants tend to be quite inert as it relates to making changes or spending a lot of time in the oversight of their own investments,” says Sue Walton, a senior investment consultant with Towers Watson in Chicago. While there has been some impact as a result of the market decline, “I would not characterize it as an overwhelming majority of participants becoming risk-averse. Instead, they tend to ‘set it and forget it.’ ”

Perhaps most troubling to plan sponsors: Participants who did make changes to their investments did so at exactly the wrong time. If actively trading participants sell equities as the market is falling or nearing the bottom but waited to buy equities until the market resumed its rise, those individuals essentially locked in their losses while also missing the opportunity to partake in the rebound. “There were significant cash flows into stable value funds while the market was falling, and money is not going back into equities as quickly,” Tolve says.

DB(K) PLANS: THE FUTURE OR A FAD?

Earlier this year, defined benefit 401(k) plans—dubbed DB(k) plans—became another retirement plan option for employers with up to 500 employees, as a result of a provision in the Pension Protection Act of 2006. However, the plans are off to a rough start. One observer referred to these plans as “a gimmick” unlikely to make much of a splash in the retirement plan market—at least at the outset.

Although the Internal Revenue Service requested comments last year on its proposed guidance for these plans, no final guidance or pre-approved plan document has been forthcoming. Without that, it is unlikely that any employer will take the plunge with these plans.

The plans are being pushed as a lower-cost alternative to a traditional defined benefit plan, but they require a significant financial commitment that many employers may not be willing to make in the current economic climate.

First, the defined benefit portion of the plan must pay out a retirement benefit equal to 20 percent of an employee’s final average pay or 1 percent of final average pay multiplied by years of service, whichever is less.

In addition, the plan sponsor must maintain a safe harbor design 401(k) plan with an annual contribution to each participant’s account equal to 4 percent of pay. Any participant contributions must be matched at a rate of 50 percent, with a maximum required match equal to 2 percent of pay.

However, once the regulatory details are ironed out and the economy improves, the DB(k) plan will be another option for employers to consider.


The Risk/Return Trade-Off

To the extent that risk tolerance among plan participants has waned, plan sponsors can accommodate participants’ needs by offering new types of investment options or more lower-risk options. Although such investments may help participants sleep at night, they may not offer sufficiently robust returns to fund a lengthy retirement. As a result, any decline in portfolio risk may need to be offset by larger contributions. Long term, the real danger is that low-risk assets “are not likely to provide the necessary returns that participants need for retirement and the chance of financial independence,” says John Burns of Burns Advisory Group in Oklahoma City. Many money market funds are yielding only 1 percent or less, and stable value funds 3 percent or 4 percent. For plan participants heavily invested in low-risk funds, Burns says, “Retirement will be fueled by how much they set aside and how well they maximize company matches.” Still, even with a greater array of low-risk investments, participants face some risk. There are even suggestions that stable value funds may carry more risk than many plan sponsors and plan participants realize. “With a stable value option, it is important to understand the credit risks, particularly if there is an insurance contract involved,” says Mike Swallow, vice president and senior retirement plan consultant with consulting firm CBIZ in Cleveland.

Plan sponsors that want to offer new types of investment options can consider the following:

Add more index funds. For plan sponsors concerned about the impact of investment fees on participant returns, “index funds can become a lower-fee alternative in some of the asset classes that are part of an overall investment structure,” says Alan Vorchheimer, a principal with Buck Consultants in Secaucus, N.J. Index funds tend to have significantly lower investment fees than actively managed funds.

Expand the bond fund lineup. Plan sponsors looking to expand lower-risk choices can include some of the more conservative bond funds, such as those that invest in short- or intermediateterm bonds. As individuals approach retirement age, they are likely to look for those types of investments.

TIPS. Another investment option might be funds that invest in Treasury Inflation-Protected Securities (TIPS). Because the principal increases with inflation as measured by the Consumer Price Index, this investment option can help plan participants to manage inflation risks. In 2009, TIPS funds were the most common investment option that plan sponsors added to defined contribution plans, and are likely to be so again in 2010, according to Callan Associates’ 2010 Defined Contribution Trends Survey.

Annuities. When it comes to adding an annuity purchase option to 401(k) plans, there has been a lot of discussion but not a lot of implementation. Issues concerning portability, fees, regulations and the role of insurance companies all weigh on plan sponsors. One of the biggest challenges: “Figuring out how to deal with their severe lack of portability,” says Gerald Wernette, director of retirement plan services at accounting and consulting firm Rehmann in Troy, Mich. If an employee leaves a company and wants to roll over his 401(k) plan account balance, that would be very difficult if the new plan uses another provider for its annuities or doesn’t offer an annuity option.

Target Date Funds

One important realization that came out of the stock market volatility is the large amount of 401(k) plan assets now invested in target date funds. These funds are structured so that their investment mix automatically becomes more conservative as retirement approaches. The Hewitt study found that 51.2 percent of employees invest in premixed portfolios when available, including target date funds and target risk funds that mix investments to maintain a level degree of risk.

In terms of overall assets, premixed portfolios now hold 24.7 percent of employees’ asset allocations, the largest portion when compared with any other type of asset. By comparison, Guaranteed Investment Contract/stable value funds hold 17.1 percent of assets and large U.S. equity funds hold 15.3 percent. And when participants Hewitt analyzed did move assets, 25.2 percent moved them into a premixed portfolio.

Finally, 26.6 percent of new contributions were directed to these funds.

High concentrations in premixed funds can also be attributed to increases in the number of employers using target date funds as the investment default under automatic enrollment. Hewitt research shows that among the 58 percent of employers that automatically enrolled their employees into their 401(k) plan, 69 percent use a target date fund as the default investment option.

The key issue with target date funds is that many employees do not know what holdings a target date fund has, particularly its exposure to equities. “Exposure to equity at the retirement age of a target date fund can be anywhere from 20 percent to 60 percent,” says Walton. Therefore, it is important for plan sponsors and participants to understand each fund’s glide path and level of exposure. “The appropriateness of equity exposure depends on a number of factors, including what other retirement benefits are available,” Walton notes. “Higher equity exposure might be OK if participants will get retirement benefits from a defined benefit pension plan.”

With target date funds playing such an important role in 401(k) plans, it is up to plan sponsors to make sure participants know what they are getting from these funds. In fact, part of the problem stems from lack of communication about the role of target date funds in retirement planning. “The mutual fund industry did a horrible job explaining the difference between managing money for retirement or through retirement,” says Vorchheimer. If you invest in a 2010 fund, the fund manager “assumes that you are going to live another 20 years and continue investing, not that you will be taking all of that money out and be done. And that means that these funds have a pretty heavy equity concentration.”

Proposed rules from the U.S. Securities and Exchange Commission will help to address this by, among other things, requiring target date funds to disclose their asset allocations.

Continuous Contributions

Perhaps the most effective tool that plan sponsors can use to help participants rebound from the market downturn is the company match along with other strategies that encourage plan participation and maximize contributions. Although the meltdown had a significant impact on all employees, younger employees have more time to let their contributions aid their recovery. According to Mercer’s Tolve, only 64 percent of people older than 55 saw their account balances return to the pre-correction levels, while 83 percent of participants under 30 saw their balances recover because a higher percentage of the overall account balance consists of contributions.

Ongoing participant contributions and company matches have been important tools to help the employees of Custom Air Products & Services rebound from the downturn. The company’s 401(k) plan was established just a few years ago, and because it is relatively new, its asset growth is driven mostly by new money coming in rather than investment returns. Moreover, the company has a safe harbor plan with a company match of 4 percent of salary for every 5 percent of salary employees contribute, in addition to a discretionary contribution by the company each year.

“Because it’s a new plan, dollar-cost averaging works in participants’ favor, and they can take advantage of recovery by continuing to contribute,” says CFO Love. Dollar-cost averaging is an investment strategy based on investing consistently at specific time intervals to smooth the impact of market fluctuations and to avoid investing a large sum of money at one time. Investments made to 401(k) plans through payroll deductions are a perfect example of this.

One of the biggest advantages of 401(k) plan participation is the ongoing, regular investing that enables participants to buy more shares at lower costs, enhancing their long-term return.

You’ve Got Their Attention

The stock market meltdown caused employees to become engaged with their 401(k) plans. “It was a positive thing because it got employees paying attention to what was in their funds, whereas before they may have enrolled” without doing much beyond that, reflects Joanne Townsend, vice president of human resources for Lincolnshire, Ill.-based Zebra Technologies. “Yet, most of them were willing to ride out the storm.”

For example, fully half of Zebra’s participants in the 401(k) plans logged in to check their 401(k) accounts in 2009, compared to the usual 35 percent. In addition, more employees signed up for webinars and contacted the call center with questions.

If plan sponsors can take advantage of the attention participants have been paying to their plans, the meltdown and all of its accompanying angst might still create a positive result for long-term retirement security.

The author is a New Jersey-based business and financial writer.

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