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November 12, 2001 12:00 AM

PARTIAL AUTOMATION MIGHT FIX IT: Poor plan design cited as key reason for employees' bad investment decisions

Arleen Jacobius
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    SAN FRANCISCO - Two new studies of defined contribution plan sponsors and participants show a wide disparity between plan sponsor plan design and education efforts, and participant investment behavior. The answer, according to both studies, is to make some part of the investment decision-making process automatic.

    One study, released Nov. 12 by San Francisco-based money manager Barclays Global Investors, looks at the excessive amount of investment risk incurred by defined contribution plan participants. The other, released the week of Nov. 5 by Hewitt Associates LLC, Lincolnshire, Ill., concludes participants' investment behavior does not reflect plan sponsors' education and plan design efforts.

    The typical defined contribution plan participant incurs a cost and a level of risk that would be unthinkable to an institutional money manager, according to BGI.

    "The participants' troubles are largely a consequence of plan sponsors and their investment managers presenting them with plan designs that do little to discourage risk-taking and that in some ways actively promote it," the study stated. "Like parents who have handed the car keys to their child only to be left wondering what their children are doing, employers and plan sponsors must now ask: It's 11 p.m. - do you know where your employees' assets are?"

    Almost no plans are designed explicitly to help investors achieve optimal diversification across and within asset classes while also keeping down risk and cost, said M. Barton Waring, managing director and head of BGI's client advisory group.

    Wrong time

    In the 1980s, plan sponsors tried to get participants to increase their allocations to equities. In 1990, 45% of total plan assets were in equities, the study reported. By 1999, 72.2% of plan assets were in equities, Mr. Waring said in an interview. It's ironic that investors responded to the bull market of the late 1990s by boosting their equity allocations: When they finally acted, it was at the wrong time.

    By contrast, defined benefit plans' traditional target equity allocation is 60%, he said.

    "DC plan investors, having been burned once by underallocating to equities before the market boomed, set themselves up to be burned again by overallocating to them as markets neared a top," the study stated.

    To make matters worse, many plan sponsors aggressively encouraged their employees to load up on company stock, Mr. Waring noted in the interview.

    Then, the technology bubble tempted participants to concentrate assets in a single industry or type of stock, which the study dubbed "damn fool risk."

    Today, there is a danger of a "triple cross" if participants respond to the down markets by cutting their equity allocations, he said.

    "Participants are not well-diversified and, by definition, not optimally diversified," Mr. Waring said.

    He cited data from the Employee Benefit Research Institute and the Investment Company Institute, both in Washington, that showed 28.5% of participants have more than 80% of their account balances invested in equity funds, and 29% hold no equity funds.

    Age, however, isn't the reason for the extremes. Indeed, 27% of participants in their 20s have no equities, and 2% have less than 20% in stocks - at an age when they could tolerate the most risk. Among participants in their 60s, 47% had less than 20% equities, and 22% had more than 80% in stocks, Mr. Waring noted.

    "The vast majority of participants simply do not have the time and energy, and in some cases, the skill, to build and manage an investment portfolio," Mr. Waring wrote in the study. "We professionals should just do it for them."

    BGI's solution

    BGI's "solution" is a set of pre-mixed asset allocation funds, which automatically rebalances based on market conditions and participant's age, he said. BGI also recommends plan sponsors reduce active risk by including passively managed funds. Mr. Waring's idea is not unique - other providers offer asset allocation portfolios - and some offer such portfolios with age-related adjustments. But Mr. Waring thinks adding a set of these portfolios is a way to solve participant mistakes through plan design.

    Moreover, defined contribution plan participants are paying too much in fees, according to the study Many plan sponsors use bundled providers that divert some of the profits made on investing the money to subsidize administrative and record-keeping expenses, Mr. Waring said. This practice, he said, raises conflict-of-interests fiduciary issues.

    "The little guy on the street is suffering," Mr. Waring said. "We're trying to make the defined contribution plan more strategy-orientated and less fund-orientated."

    Hewitt's new study, meanwhile, concurs that one of participants' biggest mistakes is inadequate diversification. The other problems Hewitt cited are participants' delaying participation and not contributing enough. Plan sponsors are accurately identifying that these are some of participants' biggest 401(k) investing mistakes, but the solutions chosen by plan sponsors have not always solved the problems, said Lori Lucas, defined contribution consultant at Hewitt.

    For example, lifestyle funds have been used as a way of enabling an employee to participate in the plan and be automatically diversified. However, Hewitt's participant survey indicates participants who use lifestyle funds use them as just another investment option, rather than the sole, diversified option they were intended to be.

    "They do not look at the whole asset allocation picture," Ms. Lucas said.

    Plan sponsors cannot solve participant mistakes through plan design alone, Ms. Lucas said. It takes a significant amount of targeted communication and education, she said.

    Like BGI, Hewitt's study concludes that part of the answer to the issue of participants' not saving enough is to automatically step up participants' contribution rates each year.

    Hewitt reached these findings by comparing the results of its 2001 Trends and Experience in 401(k) Plans survey, which covered more than 400 employers, with its 2000 Hewitt Universe Benchmarks study, which examined the investment behavior of more than 730,000 eligible employees and 500,000 active participants.

    Some 45% of plan sponsors surveyed indicated that "increasing plan participation" was the most important goal of their education efforts. Although 20% said the most common employee investment mistake is "failure to participate early enough," another 22% said this is the area where employees have made the most progress.

    However, Hewitt found that employees with tenures of two years or less participate at a rate of 45.8%, below the average participation rate of 74%.

    The second most common employee investment mistake, cited by 24% of employers, is participants' not contributing enough. Hewitt's Benchmarks report shows active 401(k) participants contribute an average 7.7% of pay, more than the common employer match of 6% of pay. However, lower salaried employees and younger employees are contributing at a much lower rate than the average.

    Inadequate diversification is the third most common mistake, according to employers surveyed. At the same time, the average number of investment options offered in 401(k) plans is up to 12 from 11 in 1999, and the median is up to 10 from nine. However, 46%of participants invest in only one or two funds. The average number of funds held by 401(k) participants is 3.3.

    3 asset classes

    Meanwhile, 84% of 401(k) participants' account balances are in three asset classes: employer stock (30%); large U.S. equity (36%); and stable value investments (18%). Assets in lifestyle funds rose to 5% in 2001 from 2% in 1999.

    Moreover, Hewitt concludes plan sponsors are at least tacitly encouraging participant investment in company stock - 55% of plans offered the option in 2001, up from 52% in 1997 and 1999, the other years Hewitt conducted its trends survey. And 45% of plans require that matching contributions be invested exclusively in company stock.

    Among plans that have employer stock, 83% allow participants to invest their contributions in that investment option, and 14% place no limit on the percentage of employee contributions that may be invested in company stock.

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