Companies are failing, American labor costs are too high relative to world markets, and employees are having their pension plans replaced with 401(k) plans, whose assets have plunged in value. As a result, calls are being made in academia and Congress for replacing 401(k) plans with a government-sponsored plan, claiming the government can give participants what the private sector and unstable investment market cannot. The government can promise more than the private sector, as we have seen with Medicare and Social Security. But given its track record, can it deliver? Replacing 401(k) plans with a “universal pension system” would very likely result in yet another empty promise.
Yet, any participant-directed retirement program that offers no guidelines to unsophisticated investors is a prescription for disaster. That is why Congress included the qualified default investment alternatives provision of the Pension Protection Act of 2006. We believe one of the QDIA options — the managed account option — provides the best hope for an actuarially sound retirement program that looks like a defined benefit plan at the participant level. Most importantly, participants need guidance on achieving their goals.
What should be the goal of a 401(k)? We believe the correct goal for 401(k) plans should be to replace an adequate level of preretirement income. The goal is not to beat the market or any other index. A 2007 GAO report on retirement adequacy noted that many economists and financial advisers only consider retirement income adequate if it replaces 65% to 85% of preretirement income. Andrew Rudd, co-founder of BARRA, has said, “What clients really want is to know that they are able to meet a range of financial goals given their current and future assets and liabilities.” We take a similar approach but measure risk and reward relative to a desired target return needed to achieve a desired retirement income.
How does this goal fit in with QDIA? There are three types of long-term QDIAs: Target-maturity funds, balanced or lifestyle funds and managed accounts. How well does each meet the goal of income replacement?
Target-date funds: The single determinant for selecting the optimal target-date fund is the participant’s age. Is that all that is needed to determine the future cash flow that is required? Doesn’t the participant need to know how much to contribute each month? Doesn’t the proper contribution schedule depend on the participant’s salary and how much money is currently invested? Target-date funds are a simplistic way of getting participants to invest for their future without regard to actuarial principals that would ensure adequacy. In short, target-date funds ignore anything to do with the replacement of preretirement income.
Lifestyle funds: Ask a participant how much risk they want to take and they will probably say, “as little as possible.” This is why so many participants defaulted into money market or stable value funds. They don’t realize that preservation of capital is not the goal. To have some chance of retiring with 75% of their preretirement salary they will have to take some loss of principal risk to reduce the true risk of failure to achieve the goal. How much risk they need to take depends on their financial profile not their risk profile. Lifestyle funds also ignore future cash flow needs.
Managed accounts: Many managed account services provide some type of financial planning tool that attempts to project future cash inflows to the 401(k) plan and subsequent cash outflows at retirement. On that basis alone, the managed account option holds the greatest promise of achieving a participant’s goal. It then behooves the plan sponsor to find that managed account service that best fulfills this goal of income replacement. The argument that this option is too expensive is not true. We know that collective investment funds can provide an actuarially sound product for a total cost as low as 60 basis points. That includes investment management fees of single account managers, trustee fees, consulting fees and portfolio construction fees.
Another area for consideration to improve 401(k)s is to provide a catch-up provision for participants who can show a funding projection of less than 65% at age 65. The way the law now reads, a participant 50 years old would be allowed to make catch-up contributions of $5,000 per year. Unfortunately, this is right at the time that the “glide path rule” encourages the QDIA to be reducing equity exposure resulting in lower and lower returns. If participants were aware of their current funding status and what it would take to get them back on a fully funded path, a new “catch-up provision” for them could allow the power of compound interest to work wonders in their behalf. If a defined benefit plan is required to increase contributions when underfunded, why shouldn’t a participant be allowed the same opportunity?
A better solution for participants than a government universal system has already been passed by Congress in the form of the QDIA provisions. Let’s give QDIA a reasonable chance before adding more trillions of dollars in a new system to the already immense budget deficit. The ability of the government to provide a universal pension system depends ultimately on the prosperity of American business. It is American business that provides the jobs that provide the taxes that would pay the benefits. Hiring professionals to invest in America for participants makes better sense to us than trusting to yet another government bureaucracy.
Frank Sortino is professor emeritus in finance from San Francisco State University and director of the Pension Research Institute in Menlo Park, Calif. David Hand is chief executive officer of Hand Benefits & Trust Co. and vice president of Benefit Plans Administrative Services Inc., Houston.