Help Improve 401(k) Participants'Investment Experience

Your firm likely has a 401(k), profit-sharing or other qualified “retirement” plan. It is also usually the case that your plan's participants make their own investment decisions. And it is likely they have done so with poor success over the years, usually trailing key market indexes.

That is not to say responsibility for investment choices, at least in the eyes of participants and plaintiffs' lawyers, ends with the participant. (See article on page 1.) There is the issue of the sponsor's duty. The sponsor, as a fiduciary, is responsible for more than the day-to-day administration of the plan. Responsibility includes plan governance, oversight, the selection and supervision of plan advisers (which themselves may or may not be fiduciaries), and offering investment options. Examination of the sponsor's and plan fiduciaries' actions thus extends beyond the scope of common administrative concepts, such as keeping good records, to an examination of how plans are governed, with performance measured against the very high standards of fiduciary duty. Maybe there is more your firm can or even should be doing to help participants achieve better investment results.

This article focuses on the offering of investment options and what plan sponsors can do to better serve plan participants by simplifying their choices and by engaging investment professionals to help in the investment decision-making process. The first step is to retain an investment adviser.

Third-Party Advisers

Depending on the mode of compensation and contractual commitments of an investment adviser, the third-party adviser may or may not be a fiduciary. It is a good idea for the sponsor to retain a third-party adviser that qualifies for co-fiduciary status ' a Registered Investment Adviser, well insured, with “deep pockets” to share the risk with the sponsor. Generally, a fee-based Registered Investment Adviser can qualify for fiduciary status. Brokers, agents and sales reps, which are compensated from the investments, normally will not be fiduciaries. In any event, the fiduciary investment adviser should agree to fiduciary status in the retention agreement.

The adviser will develop and recommend investment options for the plan. The investment adviser will in turn assist the plan sponsor in selecting a record-keeping company through which investment options (funds and other vehicles) can be obtained, which sometimes can include institutional funds not otherwise offered “to the public.” The record-keeper ideally will not offer its own proprietary investment vehicles. It will not be a fiduciary and can be compensated on a fixed fee or per-participant basis. The key element is to have absolute transparency as to all fees from funds, with the record-keeper and with the investment adviser. One of the key, indeed almost appalling, flaws of retail mutual funds is that the actual costs (management fees, internal brokerage costs, etc.) are extremely difficult to determine. For this reason, lower-cost institutional funds are often preferred and can only be obtained through qualified vendors.

Results of Common Investment Models

In the typical plan, sponsors offer a few investment alternatives (including index funds) and leave the decision-making as to where to allocate and invest up to the participants. Some sponsors have gone a step further by adding to the menu lifestyle funds keyed to risk and return-based decisions around which the funds are designed. Such lifestyle funds range from all equities, a high ratio of equities to income, to mostly bond, and finally income-based choices. Typically, plan sponsors have shied away from offering investment advice and adviser-managed alternatives other than allowing participants to elect to retain their own advisers outside the plan.

Any of these alternatives can fulfill the basic requirements of ERISA. However, the real concern is whether the choices are effectively used by participants. While in theory bad choices, if made, are made by the participant, the claim can be made that poor and inconsistent choices were offered by the sponsor. One way to approach the problem is by offering investment education. However, you are likely to find little success with even diligent attempts to educate participants as to what the choices are and how certain choices (such as an inconsistent mix of competing theory lifestyle funds) defeat the intent of the offered alternatives. Plan sponsors historically have been shy about appearing to give investment advice to or limiting the choices of plan participants, even regarding investment education of participants as a risky activity. The same fears led sponsors to avoid offering adviser-managed portfolios to plan participants. Even passage of the Pension Protection Act in 2006, designed among other things to permit the provision of certain types of investment advice to participants, has not been effective. Implementing regulations under the PPA have been stalled by investment industry lobbying efforts.

The Results of Various Decision Models

The effect of various traditional investment choice and investment decision models was illustrated in a study by Capital Directions, a Registered Investment Adviser located in Atlanta, of participants' records in two law firms (total of over 300 lawyers plus other participants) spanning the late 1990s through 2008. As a result of the study, according to Scott Pritchard of Capital Directions, these firms “bucked the conventional wisdom of good enough” and in an evolving process adapted plan choices “to serve the best interests of plan participants.”

At the studied firms, plan participants were initially offered a selected investment menu of choices considered state-of-the art in the late 1990s. These ranged from asset-class exposure to a choice of income funds. Later, when participant results from the offered list were found to be disappointing due to poor and inconsistent investment selections, the menus were expanded to include lifestyle funds (growth, moderate growth, conservative growth, income, etc.). Lifestyle funds are designed to be alternatives to traditional “balanced portfolio” investing (i.e., choosing from a list of offered funds). The idea is that one, not two or more, lifestyle funds be chosen, and thus the burden of making investment choices is lifted from the participant. The study revealed, however, notwithstanding the then “state-of-the art” nature of these fund menus, that participants did not use the lifestyle funds correctly, often using one or more in combination with a number of individual funds. Further inquiry also showed evidence of return-chasing (a fundamental mistake as a rule), over-concentration in cash, and poor diversification. Some participants were found to have allocated investments to all available lifestyle funds, negating the benefits of all in the process. Participants' returns lagged behind market benchmarks. This all occurred in spite of extensive efforts to educate participants about proper asset allocation and investment behavior and in the proper use of lifestyle funds. According to Pritchard, “The participants' thinking appeared to be that if one lifestyle fund was good, then four would be even better”.

Wrong Use of Lifestyle Funds

The study showed that 75% of the participants in one of the studied firms were using lifestyle funds incorrectly. When the firms' investment advisers suggested to the record-keepers that administered the funds the notion of limiting any participant's choice of a lifestyle fund to one, the company balked for fear of potential liability for limiting participants' choices.

Meanwhile, some attorneys had chosen to self-direct their investments outside the plans, and had engaged the same investment adviser to manage their assets. They were consistently achieving better results than their peers inside the plans. Their investment decisions were being made not by themselves, but by the investment adviser. There was no return-chasing; there was no misuse of lifestyle funds; and there was regular rebalancing and maintenance of diversification. The obvious difference was in who made the investment decisions.

Use of Adviser-Managed Portfolios

Though the performance of the masses was poor, the plans' investment choices did meet the minimum requirements of ERISA. However, both firms then sought a means to allow all participants to have a shot at the results shown with adviser-managed investments. The result was a proposal from Capital Directions to offer adviser-managed portfolios. This was to be a step beyond lifestyle funds. The first difference was that only one adviser-managed portfolio could be selected. According to Pritchard, “In essence, we wanted to save participants from themselves by preventing them from undoing the do-it-yourself intent of the managed portfolios.” And it had to be simple. Other studies have shown that participation rates decline as more choices are offered. ERISA Section 404(c) requires a minimum of three choices. Five adviser-managed portfolios were decided upon with the participants' only decision being based on a spectrum of risk: All equity (10% stocks); growth (80-20 stocks and bonds); moderate growth (60-40 stocks and bonds); conservative (40-60 stocks and bonds); and defensive (20-80 stocks and bonds).

In turn, the adviser designed the adviser-managed portfolios so that each had broad exposure to nine different equity asset classes and three fixed-income asset classes. Each fund is in turn re-balanced at least quarterly by the investment adviser without further action or election by participants other than that participants can elect not to have automatic rebalancing. The funds are not placed in traditional index funds, but are customized per the targeted asset classes. This is done through the use of asset class funds of Dimensional Fund Advisers (DFA), which are available only through approved fee-only advisers. They are passively managed but as noted, are not traditional index funds. DFA's funds do hold all available stocks in a given sector and the costs are very reasonable, according to Capital Directions.

Participants were also offered the alternative, besides choosing one of the offered adviser-managed portfolios, to build a custom allocation from the same underlying available funds such as, for example, 70% equities and 30% bonds, an allocation not available on the list. Participants can also engage in selecting funds from the traditional menu or opt to engage an outside adviser through a self-directed brokerage window.

Over 80% of the lawyers in the combined firms selected one of the five offered adviser-managed portfolios. Solicited feedback from participants can best be summarized as “What a relief.”

Conclusion

The limited study reported here shows at least that what Capital Directions calls the “tyranny of choice” can be mitigated by plan sponsors that are willing to go to the trouble of introducing adviser-managed options to 401(k) plan participants.

As a plan sponsor, your firm can certainly get by with meeting minimum ERISA requirements when it comes to investment choices offered, but you will not be immune from criticism or claims that poor and inconsistent choices were offered, and you may not be adequately serving your plan's participants. You can be more proactive by helping participants obtain third-party, professional assistance, which can lead to better results. The case studies above, as the usual caveat goes, are not of course indicative of future success. Also, don't run with scissors.

Bruce Jackson, a member of this newsletter's Board of Editors, is a partner with Arnall Golden Gregory LLP, Atlanta, where he is a member of the firm's Benefits Committee. Jackson can be reached at 404-521-3985 or at [email protected].

Your firm likely has a 401(k), profit-sharing or other qualified “retirement” plan. It is also usually the case that your plan's participants make their own investment decisions. And it is likely they have done so with poor success over the years, usually trailing key market indexes.

That is not to say responsibility for investment choices, at least in the eyes of participants and plaintiffs' lawyers, ends with the participant. (See article on page 1.) There is the issue of the sponsor's duty. The sponsor, as a fiduciary, is responsible for more than the day-to-day administration of the plan. Responsibility includes plan governance, oversight, the selection and supervision of plan advisers (which themselves may or may not be fiduciaries), and offering investment options. Examination of the sponsor's and plan fiduciaries' actions thus extends beyond the scope of common administrative concepts, such as keeping good records, to an examination of how plans are governed, with performance measured against the very high standards of fiduciary duty. Maybe there is more your firm can or even should be doing to help participants achieve better investment results.

This article focuses on the offering of investment options and what plan sponsors can do to better serve plan participants by simplifying their choices and by engaging investment professionals to help in the investment decision-making process. The first step is to retain an investment adviser.

Third-Party Advisers

Depending on the mode of compensation and contractual commitments of an investment adviser, the third-party adviser may or may not be a fiduciary. It is a good idea for the sponsor to retain a third-party adviser that qualifies for co-fiduciary status ' a Registered Investment Adviser, well insured, with “deep pockets” to share the risk with the sponsor. Generally, a fee-based Registered Investment Adviser can qualify for fiduciary status. Brokers, agents and sales reps, which are compensated from the investments, normally will not be fiduciaries. In any event, the fiduciary investment adviser should agree to fiduciary status in the retention agreement.

The adviser will develop and recommend investment options for the plan. The investment adviser will in turn assist the plan sponsor in selecting a record-keeping company through which investment options (funds and other vehicles) can be obtained, which sometimes can include institutional funds not otherwise offered “to the public.” The record-keeper ideally will not offer its own proprietary investment vehicles. It will not be a fiduciary and can be compensated on a fixed fee or per-participant basis. The key element is to have absolute transparency as to all fees from funds, with the record-keeper and with the investment adviser. One of the key, indeed almost appalling, flaws of retail mutual funds is that the actual costs (management fees, internal brokerage costs, etc.) are extremely difficult to determine. For this reason, lower-cost institutional funds are often preferred and can only be obtained through qualified vendors.

Results of Common Investment Models

In the typical plan, sponsors offer a few investment alternatives (including index funds) and leave the decision-making as to where to allocate and invest up to the participants. Some sponsors have gone a step further by adding to the menu lifestyle funds keyed to risk and return-based decisions around which the funds are designed. Such lifestyle funds range from all equities, a high ratio of equities to income, to mostly bond, and finally income-based choices. Typically, plan sponsors have shied away from offering investment advice and adviser-managed alternatives other than allowing participants to elect to retain their own advisers outside the plan.

Any of these alternatives can fulfill the basic requirements of ERISA. However, the real concern is whether the choices are effectively used by participants. While in theory bad choices, if made, are made by the participant, the claim can be made that poor and inconsistent choices were offered by the sponsor. One way to approach the problem is by offering investment education. However, you are likely to find little success with even diligent attempts to educate participants as to what the choices are and how certain choices (such as an inconsistent mix of competing theory lifestyle funds) defeat the intent of the offered alternatives. Plan sponsors historically have been shy about appearing to give investment advice to or limiting the choices of plan participants, even regarding investment education of participants as a risky activity. The same fears led sponsors to avoid offering adviser-managed portfolios to plan participants. Even passage of the Pension Protection Act in 2006, designed among other things to permit the provision of certain types of investment advice to participants, has not been effective. Implementing regulations under the PPA have been stalled by investment industry lobbying efforts.

The Results of Various Decision Models

The effect of various traditional investment choice and investment decision models was illustrated in a study by Capital Directions, a Registered Investment Adviser located in Atlanta, of participants' records in two law firms (total of over 300 lawyers plus other participants) spanning the late 1990s through 2008. As a result of the study, according to Scott Pritchard of Capital Directions, these firms “bucked the conventional wisdom of good enough” and in an evolving process adapted plan choices “to serve the best interests of plan participants.”

At the studied firms, plan participants were initially offered a selected investment menu of choices considered state-of-the art in the late 1990s. These ranged from asset-class exposure to a choice of income funds. Later, when participant results from the offered list were found to be disappointing due to poor and inconsistent investment selections, the menus were expanded to include lifestyle funds (growth, moderate growth, conservative growth, income, etc.). Lifestyle funds are designed to be alternatives to traditional “balanced portfolio” investing (i.e., choosing from a list of offered funds). The idea is that one, not two or more, lifestyle funds be chosen, and thus the burden of making investment choices is lifted from the participant. The study revealed, however, notwithstanding the then “state-of-the art” nature of these fund menus, that participants did not use the lifestyle funds correctly, often using one or more in combination with a number of individual funds. Further inquiry also showed evidence of return-chasing (a fundamental mistake as a rule), over-concentration in cash, and poor diversification. Some participants were found to have allocated investments to all available lifestyle funds, negating the benefits of all in the process. Participants' returns lagged behind market benchmarks. This all occurred in spite of extensive efforts to educate participants about proper asset allocation and investment behavior and in the proper use of lifestyle funds. According to Pritchard, “The participants' thinking appeared to be that if one lifestyle fund was good, then four would be even better”.

Wrong Use of Lifestyle Funds

The study showed that 75% of the participants in one of the studied firms were using lifestyle funds incorrectly. When the firms' investment advisers suggested to the record-keepers that administered the funds the notion of limiting any participant's choice of a lifestyle fund to one, the company balked for fear of potential liability for limiting participants' choices.

Meanwhile, some attorneys had chosen to self-direct their investments outside the plans, and had engaged the same investment adviser to manage their assets. They were consistently achieving better results than their peers inside the plans. Their investment decisions were being made not by themselves, but by the investment adviser. There was no return-chasing; there was no misuse of lifestyle funds; and there was regular rebalancing and maintenance of diversification. The obvious difference was in who made the investment decisions.

Use of Adviser-Managed Portfolios

Though the performance of the masses was poor, the plans' investment choices did meet the minimum requirements of ERISA. However, both firms then sought a means to allow all participants to have a shot at the results shown with adviser-managed investments. The result was a proposal from Capital Directions to offer adviser-managed portfolios. This was to be a step beyond lifestyle funds. The first difference was that only one adviser-managed portfolio could be selected. According to Pritchard, “In essence, we wanted to save participants from themselves by preventing them from undoing the do-it-yourself intent of the managed portfolios.” And it had to be simple. Other studies have shown that participation rates decline as more choices are offered. ERISA Section 404(c) requires a minimum of three choices. Five adviser-managed portfolios were decided upon with the participants' only decision being based on a spectrum of risk: All equity (10% stocks); growth (80-20 stocks and bonds); moderate growth (60-40 stocks and bonds); conservative (40-60 stocks and bonds); and defensive (20-80 stocks and bonds).

In turn, the adviser designed the adviser-managed portfolios so that each had broad exposure to nine different equity asset classes and three fixed-income asset classes. Each fund is in turn re-balanced at least quarterly by the investment adviser without further action or election by participants other than that participants can elect not to have automatic rebalancing. The funds are not placed in traditional index funds, but are customized per the targeted asset classes. This is done through the use of asset class funds of Dimensional Fund Advisers (DFA), which are available only through approved fee-only advisers. They are passively managed but as noted, are not traditional index funds. DFA's funds do hold all available stocks in a given sector and the costs are very reasonable, according to Capital Directions.

Participants were also offered the alternative, besides choosing one of the offered adviser-managed portfolios, to build a custom allocation from the same underlying available funds such as, for example, 70% equities and 30% bonds, an allocation not available on the list. Participants can also engage in selecting funds from the traditional menu or opt to engage an outside adviser through a self-directed brokerage window.

Over 80% of the lawyers in the combined firms selected one of the five offered adviser-managed portfolios. Solicited feedback from participants can best be summarized as “What a relief.”

Conclusion

The limited study reported here shows at least that what Capital Directions calls the “tyranny of choice” can be mitigated by plan sponsors that are willing to go to the trouble of introducing adviser-managed options to 401(k) plan participants.

As a plan sponsor, your firm can certainly get by with meeting minimum ERISA requirements when it comes to investment choices offered, but you will not be immune from criticism or claims that poor and inconsistent choices were offered, and you may not be adequately serving your plan's participants. You can be more proactive by helping participants obtain third-party, professional assistance, which can lead to better results. The case studies above, as the usual caveat goes, are not of course indicative of future success. Also, don't run with scissors.

Bruce Jackson, a member of this newsletter's Board of Editors, is a partner with Arnall Golden Gregory LLP, Atlanta, where he is a member of the firm's Benefits Committee. Jackson can be reached at 404-521-3985 or at [email protected].