With the spotlight increasingly on 401(k) plans as they grow and displace defined benefit plans, sponsors are outdoing themselves with new "bells and whistles" to add for employees. Likewise, 401(k) vendors are scrambling to offer still more new features to gain the edge on the competition. Institutional money managers, mutual funds, banks, consultants and administrators appear to merge, hold hands, spin around, separate and re-join again in a kind of Moroccan arabesque. The pace is brisk. You can't take your eyes off of the dancers or you'll miss a new twist.
Out of this dance, many new products and services have emerged: some useful, some useless, many ill-advised and one, absolutely wrong - daily trading.
Until recently plan participants were allowed to make exchanges in their accounts only once a month or once a quarter. Now, as sponsors overhaul their plans and add new investment options to allow further diversification, they also are permitting the participants to execute trades in their accounts on a daily basis. Some even broaden the experiment beyond a few mutual funds to include the universe of publicly traded stocks and bonds.
The broad acceptance of daily switching is both puzzling and shocking.
Puzzling because it isn't necessary. Pension plans have provided very good returns and they aren't managed on a daily basis. Quarterly reviews are considered almost too frequent. Daily switching is not required for 401(k) plans: The new 404(c) regulations don't even suggest this level of service as a way to reduce sponsor liability. Daily trading certainly isn't helpful if it causes people to think about and watch their long-term investments with a short-term mentality. And it costs a lot: it is a potentially dangerous and unnecessary service that carries a high cost to the plan.
It's shocking because smart, knowledgeable investors at "role model" companies are incorporating it into their plan structure; these are people who should be fully cognizant of its potential for major destruction of plan assets. It is a neutron bomb in the 401(k) plan.
Typically when I speak with plan sponsors who have implemented this service, they tell me almost unanimously that few of their employees, something like 3%, will take advantage of this new freedom. What's so shocking about this new development? The big deal is that not only 3% will take advantage of it; many more participants will. The sponsors' estimate is flawed. Before, employees had the opportunity to get low returns; now, they have the opportunity to get negative returns. This move to daily switching is definitely not a course we should continue to follow.
The 401(k) plan is a product of the 1980s. Most employees' experience with investments and investing for themselves were shaped by the 1980s, during one of the longest and strongest bull markets ever. It was a terrific time to be in bonds, as well. There hasn't been a bear stock market yet to test the 3% theory. We have had some corrections in a running bull market - October 1987, October 1990 and the rough patch of 1994 - but no bear markets. The declines have been relatively quick and of short duration, and the recoveries have been strong and steady. We have grown to expect a smart recovery with a runup to new highs in the indexes. Last year was a bear market for bonds, one of the worst ever. But people are more easily whipsawed by the volatility in the stock market.
But bear markets are different. They're ugly. They can drag on for long periods with no new highs to record. The Dow Jones Industrial Average from 1966 to 1980, that was indeed a bear market. Does anyone think that only 3% of the employees with a self-directed, daily trading account will have the nerves, the stomach, the experience to hold on to the wheel in that kind of sea? Anyone can hold the helm in a calm sea, maybe only 3% need to run to the side. But if the seas get rough like they did during the 1970s, my bet is more than 3% would run to the lee side.
What aspect of human nature has changed in the past decade? Probably none. So when many astute observers of the markets look for patterns in the behavior of the "little investor," it isn't to follow, it is to run in the opposite direction. The individual investor always has been a contrarian indicator to the institutional investor. That hasn't changed.
The damage will be done when another human instinct takes over - the herd instinct. When the rush to the exits begins, it will look like a fiesta morning in Pamplona. Think of the carnage to their accounts if employees could have traded the week of Oct. 19, 1987; and once out of the stock market, would they still be cowering in cash today?. Even knowledgeable and experienced investors find it difficult to follow wise and proven investment practice. The very human emotions of fear and greed are powerful influences.
If my conclusion is correct, the daily trading account for employees with self-directed retirement plans is a disaster waiting to happen. What can be done? Only one thing, better management.
The 401(k) plans need management. Defined benefit plans are managed: Policy statements articulate the overarching objectives and the guidelines; investment advisers are hired to implement the strategies and are measured against proper benchmarks; performance is monitored and evaluated and perceived weaknesses are identified and corrected. This is management.
Those responsible for administering their company's 401(k) plan should consider this model. Policies are implemented based on the evidence of sound investment theory and portfolio practices. Only those that are consistent with achieving long-term objectives are considered. Ask the employees not what they want; ask them what they know and then teach them what they don't understand. The leadership and direction should come from those with training and experience, not the other way around. If this trend toward total investment freedom for all becomes universal, then we have done irreparable damage. We will have put all employees in harm's way. We should know better.
People managing 401(k) plans aren't investment people. But many more financial people are starting to intervene in the management of the 401(k) plans. That's good. They might be helpful in voicing an air of caution.
Human resources departments are inclined to give employees what they want. But employees shouldn't tinker with their 401(k) allocations. They should put a good mix in place and keep it, rebalancing it when it gets out of proportion.
Education helps. It's amazing how it can allay a lot of concerns. Micromanaging 401(k) investments is a waste of time. But to naive investors, they think they should be tinkering with it. If sponsors give them daily switching, employees think management is trying to give them the tool to be more successful.
We spend a lot of time talking about educating employees. But the management that oversees these plans needs education. Employees have to become educated about investing, but it won't do them much good if they don't have a good plan to invest in.
Brian E. Schaefer is president of 401(k) Ventures, Palo Alto, Calif.