The 401(k) plan, at only 20 years old, could be over the hill.
Consider these nagging questions:
* Suffering through what is the first real down market for many, will participants have enough money to live on in retirement, and should plan sponsors or service providers care?
* With 401(k) assets expected to stagnate or decline, how many service providers will remain in what has turned out to be a low-margin business?
* As baby boomers retire and take their large account balances with them, will participants, and not plan sponsors, become providers' primary customer? Will this shift cause the 401(k) plan to evolve into a retail product?
Despite the questions, many observers still think the 401(k) was a good idea. With the economy and down stock market forcing many plan sponsors to contribute anew to their defined benefit plans, corporations relying primarily on 401(k) plans have come out winners. Moreover, 401(k) plans remain more visible, more portable and less expensive than defined benefit plans.
"In some regard, the 401(k) has been at the center of the revolution in employee benefits in the last quarter of the 20th century," said Sylvester Schieber, vice president of research and information at Watson Wyatt Worldwide, Bethesda, Md.
Before 401(k)s, defined benefit plans were the predominant type of plan, Mr. Schieber said. But soon, more money was going into defined contribution plans and more people were covered by defined contribution plans than defined benefit plans, he said.
Since the late 1970s, more than 75% of all new tax-qualified plans have been defined contribution plans, according to a 1997 report by Towers Perrin, Philadelphia. Moreover, the percentage of the work force covered by defined contribution plans has grown at an annualized rate of 7% per year since 1975, while defined benefit coverage has shrunk by 0.8% per year, according to The Vanguard Group's 2000 How America Saves study.
Between 1.5% to 8% of participants' pay is going into 401(k) plans, and employee contributions make up two thirds of 401(k) money, Mr. Schieber explained. "The 401(k) gives people more flexibility to go from job to job; and from the employers' perspective, it's a relative sharing of costs," he said.
Almost half of U.S.employees, 49%, report that employers contributed money to their retirement accounts in 2000, and 66% of employees said their employers offer a retirement savings plan such as a 401(k), 403(b) or 457 plan, according to surveys by The Employee Benefit Research Institute, Washington.
"It (the DC plan) is more significant than the world of defined benefit plans. But I don't think it will be a full substitute for defined benefit plans," Mr. Schieber said.
Mr. Schieber said he "absolutely" believes 401(k) plans are here to stay. "There's more of a sense that people need to take care of themselves than (there was) 20 years ago, when 401(k) got started," he said.
"What a beautiful and wonderful thing the 401(k) has been," said Don Jones, national sales manager for Nationwide Financial Services Inc., Columbus, Ohio. It has allowed employers to offer qualified retirement plans on an affordable basis, he said. More people are able to participate in plans than ever before, and employees have access to investments they wouldn't have had before the 401(k) was born, he said.
"Before, you needed $5,000 to $20,000 to get into (mutual) funds. Who would have dreamed a secretary would be able to put in $20 a pay period?" Mr. Jones said. "401(k)s allowed, for the first time, small business owners and employees to have the same benefits as the larger companies."
That may be so, but some observers wonder whether the 401(k) plan is fulfilling its promise. More workers than ever before were covered by employer-sponsored pension plans in 1999, the last year for which data is available, 60.8%, up from 60.1% in 1994. However, fewer younger workers participated in retirement plans in general,in 1999: 32.5%, vs. 71.6% or workers aged 45 to 54, according to EBRI data.
A rapidly growing public policy concern is whether future generations will have adequate retirement incomes, according to a recent study by EBRI. This is due a projected long-term financial economic downturn, which may result in lower benefits. Baby boomers are particularly at risk, partially because many will be retiring with defined contribution plans, as opposed to defined benefit plans, which historically had been the predominant source of employer-provided retirement income, the report noted.
"I think from the plan sponsor standpoint, the 401(k) gives participants a higher degree of flexibility and a way to manage their costs," said Laura Bartlett, director of 401(k) plans for record-keeping firm ABD Insurance Financial Services, Redwood City, Calif. "It remains to be seen whether defined contribution plans really do the job of fulfilling employees retirement goals."
This is a difficult question because the 401(k) fits within other accumulation plans, Ms. Bartlett said. People who retire today should be in good shape because they have both a defined benefit and a defined contribution plan, she said.
"It'll be interesting to see in 10 or 20 years from now whether income replacement goals have been met by defined contribution plans (alone)", Ms. Bartlett said.
The 401(k) plan is attractive to younger workers because they can take their balances with them from job to job, she said. However, the 401(k) plan also puts the onus on the participant to manage his or her own retirement nest egg, she added.
"There are larger companies that do feel it is part of the employment equation to help people accumulate money for retirement," Ms. Bartlett said.
The down market is exposing the weaknesses in participants' investment savvy.
Saving for retirement will be no mean feat in the current economy. The 401(k) market lost $72 billion in assets in 2000, its first negative year, according to a recent report by Cerulli Associates Inc., Boston. With equity markets dropping, 401(k) plan assets closed 2000 at $1.8 trillion, down 3.9% since year-end 1999.
"For the first time in 401(k) history, participants opened their year-end 401(k) statements to find they had lost money," the Cerulli report noted.
For at least the last five years, the lion's share of 401(k) asset increases has been tied to the stock market. Nearly 80% of the increase in 401(k) assets over the last five years was due to market appreciation, according to the Cerulli report. Between 1995 and 2000, 401(k) assets had a net increase of $1.1 trillion; and Cerulli estimated that $846 billion of that was due to market appreciation. Some $832 billion in participant contributions during this same five-year period was offset by $638 billion in distributions.
Meanwhile, company contributions to 401(k) plans dropped to 2.5% of participants' annual pay in 2000 from 3.3% in 1999, according to the Profit Sharing/401(k) Council of America's 2001 survey.
Participation in 401(k) plans dipped to 80.2% in 2000 from 82.5% the year before, and pretax participant deferral for low-paid employees dipped to 5.3% from 5.4% of salary, while pretax deferrals for highly paid employees remained at 6.4% of pay, the survey revealed.
Eighteen percent of 401(k) plans have more than half of plan assets invested in company stock, the PSCA survey showed. Another 48% of 401(k)s have between 10% and 50% of assets in company stock. Company stock was the second most popular investment vehicle within 401(k) plans in 2000, just behind retail mutual funds, according to Cerulli.
Shrinking returns due to large investments in company stock are "just starting to become an issue ... 18 months ago, everyone had been happy as clams," said Joe Horlings, first vice president of consulting firm McDonald Investments Inc., Grand Rapids, Mich. "Employers and employees are stepping back and saying, 'Wow, did I make a mistake.'
Nearly two years of market volatility have opened fiduciaries' eyes to the issues involved with company stock, Mr. Horlings said. A few plan sponsors have been discussing the possibility of limiting new investments to in company stock, he said (Pensions & Investments, Sept. 30).
Other executives at big plans would rather allow participants to move their money out of company stock earlier than the traditional retirement age, said Ellen Roxby, director, investment operations, at Verizon Communications, New York, which is expected to have $21 billion in 401(K) asets when it merges next year (see story on page one). The idea is to allow participants to invest company stock matches in other investment options before age 50. (Verizon's match is in company stock, and half of plan assets are invested in company stock, she said.)
Company stock lawsuit
There have been at least two lawsuits involving company stock in 401(k) plans.
One, brought by employees of First Union Corp., Charlotte, N.C., alleged, in part, that First Union added company stock as an investment option for its own benefit and had not conducted the due diligence necessary when adding an investment option to a defined contribution plan. That suit was settled earlier this year with the participants getting some money and the 401(k) plan being made to hire an outside consultant to review its investment options.
Another case, still pending, is a $1.15 billion class-action suit against SBC Communications Inc., San Antonio, Texas. The plaintiffs claim SBC sold off more than $600 million in employee holdings in AirTouch Communications Inc. - now Vodafone AirTouch Inc. - whose stock had doubled in value before SBC took control, and reinvested the proceeds in SBC stock, which remained flat.
Currently, the company match in SBC's $17.9 billion defined contribution plan is in company stock, said Judith J. Brown, executive director, benefit plan investment administration.
"The company is looking at how the company match fits into its long-term objectives," said Ms. Brown, who added that she could not speak further on the issue due to the lawsuit.
"My personal feeling is I'm very leery of company stock in a plan," said Ira Hoffman, operations manager, portfolio investments, at The Dow Chemical Co., Midland, Mich. "If I had to face what Lucent is facing, I'm not sure what I would do."
On July 25, Lucent plan participants filed a class action suit against the company in U.S. District Court in Newark, N.J., alleging that Lucent employees breached their fiduciary responsibility by continuing to offer Lucent stock as an option in the company's defined contribution plans even after they were aware of numerous, serious business problems that likely would negatively impact the stock price. The suit seeks unspecified monetary relief, injunctive and equitable relief, interest and attorneys' fees and expenses. (Pensions & Investments, Sept. 20)
At Dow Chemical, 1% of the match is in company stock and the remaining 3% is in cash, Mr. Hoffman said. If a participant contributes 6% of salary, he receives 1% stock and 50 cents on the dollar on the next 6%, he said.
However, plan sponsors with company stock as part of their plans may have few practical choices when stock prices decline.
"For a plan sponsor to knowingly say company stock is a bad investment option is suicide and a self-fulfilling prophecy, if they pull company stock as an option," said Verizon's Ms. Roxby.
Once the market hears a plan sponsor has eliminated company stock as an investment option, it is sure to cause the stock's price to drop, she said.
Still, most of participants' 401(k) plan assets, 75%, are in equities, the PSCA survey indicated. Another 1.2% is in stable value funds, and 3.4% is in cash equivalents. Some 39.2% of plan assets are in company stock, down from 43% in 1999; and 18% of plans have more than 50% of plan assets invested in company stock, down from 20% in 1999, according to the survey.
"Plan sponsors should re-examine their investment menus in light of the last 18 months," said Gregory D. Upah, managing director of Merrill Lynch Investment Managers, Plainsboro, N.J. "Participants are short-term oriented."
Many participants want choice, and they want funds that did well two months ago, he said. They fail to make investment decisions that are in their long-term interests because they feel that it is an impossible task, Mr. Upah said. It's time to pare back investment options and refocus on asset allocation, he said. And, if sponsors want to keep their extensive investment menus, they should restructure their plans into three tiers, he said. One tier would have a set of lifestyle funds for participants who want the most help with their investment options; a second tier would be a set of mutual funds for participants who prefer to create their own asset allocations; and the third tier would be a self-directed or mutual fund window for participants who want a wide variety of investment choices.
"In light of the current market, people are trying to get their arms around asset allocation. There could be some advances in asset allocation and how to stop people from chasing last year's performance," said Michelle L. Rappa, senior vice president with Seligman Advisors Inc., New York.
"A lot of participants choose an asset allocation they think is right for them and do not look at it again. They put it on auto pilot," she said.
This is problematic, Ms. Rappa said. Even if participants stick with a long-term strategy instead of chasing hot returns, they need to change their asset allocations as their time horizons shorten.
Gerry Mullane, principal with The Vanguard Group Inc., Valley Forge, Pa., believes participants may change their investment behavior. "People will be less inclined to invest in risky investment options and more inclined to invest in more conservative options, which is what we've seen."
But even with the current down market, Watson Wyatt's Mr. Schieber said he was unconcerned about the tendency of participants to figure out one asset allocation and then leave their accounts alone.
"There has not been a lot of rebalancing as markets go up and down," he acknowledged. Instead, people rebalance over their life cycles - and because this is a long-term investment, people should not be switching their 401(k) money around frequently, he added.
Another effect of the 401(k) has been to empower participants, Ms. Roxby said.
"At a certain point, a participant has to say, 'I blew it,'" she said. "At some point, if participants want the power to make decisions, they have to take the responsibility and the opportunity to do better or do worse. We are moving from a paternalistic society."
In line with concerns over how participants will handle the down market long term, vendors and plan sponsors continue to struggle with the issue of investment advice.
"I think what has happened is we have started off saying 'How will we provide investment education?' and tried many different ways of doing that, but you just can't go far enough," said Michael Falivena, vice president of North East Retirement Services Inc., Woburn, Mass. "You can only go so far in getting the rank and file to understand what a corporate bond is. The goal is leap-frogging over education to advice, instead of educating participants (about) what a stock, what a bond and what risk is."
Investment advice could help participants with asset allocation, Seligman's Ms. Rappa said. "They need as much help as they possibly can get."
Ed Ferrigno, vice president in Washington for the Profit Sharing/401(k) Council of America, disagrees.
"Education may be enough. All participants need to know is what a stock is, what a bond is and how to asset allocate. That's all education," Mr. Ferrigno said. "It doesn't matter which stock or bond they choose, as long as they have the right asset allocation."
The market is still deciding if advice will survive and, if so, how it will be given. So far, no online advice giver has been profitable, said Scott Lummer, an independent consultant who was chief investment officer at mPower Inc., a San Francisco-based online advice provider.
Crunch on service providers
Meanwhile, the down market and the slowdown in 401(k) plan asset growth are expected to make it harder for service providers to stay in business. More than half, 52.3%, of 401(k) assets are held in plans with more than 5,000 participants, according to Cerulli's 2001 study. The medium-sized, small- and micro-plan markets comprise 98% of 401(k) plans, but only 32% of 401(k) assets, Cerulli reported.
The large and very large plan markets are "virtually owned" by the top five players, according to the Cerulli study. These are: Fidelity Investments Inc., Boston; Hewitt Associates LLC, Lincolnshire, Ill.; CitiStreet, Quincy, Mass.; Vanguard; and Merrill Lynch.
Not only is competition among these service providers stiff, but they have begun expanding their reach down market to support continued growth.
Among the challenges to asset-based revenues that could cause further consolidation of service provider companies: increasing use of outside managers; plan sponsor demand for institutionally priced investment options; continued popularity of index funds; and the rise of self-directed brokerage accounts, according to the Cerulli report. For example, in 2000, only 77% of the managed assets in bundled 401(k) platforms was held in proprietary funds, down from 95% in 1992. Cerulli projects this portion will decline to 65% by 2006.
"No record keeper has ever appeared on 'Lifestyles of the Rich and Famous,'" quipped Tom Kmak, chief executive officer of J.P. Morgan/American Century Retirement Plan Services, at Pensions & Investments' October Defined Contribution/401(k) Plan Conference in Monterey, Calif. "How are vendors doing? They are jumping ship."
If they haven't left the business altogether, they've formed partnerships and alliances seeking scale. In the last two weeks of October alone, J.P. Morgan/American Century and Towers Perrin formed a partnership to provide defined contribution and defined benefit plan record-keeping and administration services. Hewitt Associates and Frank Russell Co., Tacoma, Wash., announced they were joining forces to offer a bundled defined contribution plan service. MetLife Inc., New York, stopped providing record-keeping services to large defined contribution plans, giving Hewitt the business (See story on page 3). And Fidelity Investments and Morgan Stanley Investment Management joined forces to provide a bundled defined contribution service for the small plan market.
The future of 401(k)s
Half the work force does not have access to 401(k) plans, Watson Wyatt's Mr. Schieber said. Rather than moving past 401(k) plans, the new challenge will be giving every American worker the opportunity to invest in them, he said.
One solution is to invest 2% of Social Security contributions into 401(k)-types of plans while retaining the fixed Social Security benefit for the rest, he said. Under Mr. Schieber's solution, this privatized 2% of pay would be matched dollar for dollar using Social Security money, and the federal government would set up a bookkeeping agency for the self-directed portion. This hybrid Social Security system would give workers a range of investment choices, mainly bond and stock index accounts with varying degrees of risk, he said. The investments would be provided by private money managers chosen by the federal government, Mr. Schieber said.
Non-discrimination testing would ensure that rank-and-file workers participated, he said.
Ted Benna, president of the 401(k) Association, Cross Forks, Pa., and founder of the 401(k), has said that in the next decade 401(k) plans will be a retail product for which employees pick their providers. (Pensions & Investments, February 7, 2000) At the same time, participants will want the same array of investment options they can get outside of their 401(k) plans. Under Mr. Benna's scenario, participants will be able to choose from the entire universe of investment options guided by an investment advice provider. Plan sponsors will have little fiduciary responsibility because they will no longer be involved with designing 401(k) plans or choosing investment options.
Mr. Benna has since revised his idea to include, not just unlimited choice, but also structured portfolios that consider participants' time horizons and risk tolerance, or their opportunity to select their own investments from a mutual fund brokerage window. Participants choose only one portfolio, which would be rebalanced as their time horizons shortened or the need arose, Mr. Benna said. Participants who stayed with the structured portfolio for 20 years would receive a 7% guaranteed minimum average annual return. The Internal Revenue Service would allow participants to retain the portfolio even if they change employers, Mr. Benna explained. And in exchange for providing such a "safe harbor" plan, plan sponsors would be free of fiduciary responsibility, he added.
The next challenge
The industry agrees that the big issue facing the 401(k) world is how the next big wave of retirees will manage their money in retirement.
"We're moving away from annuitization and insuring the risk of outliving our money," Mr. Schieber said. "People are walking out the door with these big lump sums and have to figure out a rate of spending that can support them over an uncertain lifespan."
Some will be too conservative and deny themselves things they deserve after a lifetime of toil, and others will run out of money, he said.
"It's a predictable surprise that will jump up and bite us," Mr. Schieber said.
"The big issue over the next five years is having a 401(k) system that is going into distribution mode, and required distribution (of assets at age 701/2) will come to the forefront," agreed Mr. Ferrigno from the Profit Sharing/401(k) Council. "There'll be a move to keep money in the plan for retirees.
"After all, 401(k)s have only been around 15 years. Some say 20, but it took five years to gather any steam," Mr. Ferrigno said. "No one has accumulated defined contribution assets for 40 years. There'll be mammoth issues with people with tons of money who need to manage it over their retirement."
And the tax laws make the situation worse, said Mr. Ferrigno. "Despite improvements (in the new tax law), minimum distributions is bad retirement policy," he said.
Still, the 401(k) has come a long, long way, said Seligman's Ms. Rappa. "Twenty years ago there was one woman at the end of the hall who knew something about 401(k)s, but nobody else had any idea," she said.