Tuesday, November 8, 2011

401(k) Advice, Good but only if Used

There was an article in the Wall Street Journal yesterday titled 'Thanks but No Thanks on 401(k) Advice' found here.

The gist of this article is that more and more 401(k) plans are offering outside help in the form of participant level investment advice, but that uptake on this advice is generally low.

The fact that more plans are giving participants access to advice, in one form or another, is a very good thing or at least it should be. Many surveys show that formal advice leads participants to better decision making and that leads to better outcomes in the form of income replacement rates. However, if only 25% of the people who have access to advice through their retirement plans actually take advantage of it, then this is an issue. My feeling is that many if not most of the advice programs out there are good, very good or great. So why aren't the participants using these services? I have my thoughts.

Firstly, from a behavioral perspective, it has been my experience that many participants would be better described as speculators rather than investors. The key differnce is in expectations. Investors have an expected return on investment (ROI).

Ex.) I invest $10,000 in a 4% bond, I have an expected outcome of 4% interest for the term of the bond and a return of my $10,000 when the bond matures.

Most participants in 401(k) plans do not have an expectation of ROI, rather what they have is hope. I think, in part, this stems from the experience level of most participants as it pertains to investing. The great majority of investment professionals set minimum requirements on who they will look to as potential clients, such as net worth, or minimum investment amounts, e.g. $250,000. Many 401(k) participants would never qualify to work with investment professionals and are ill-equipped to understand the basics of investing, what the experience will be like, what market volatility is and how that will translate to emotional bias' and poor decision-making. Subsequently, the first and perhaps only investing experience they have is with their 401(k) plan and the only reason they get this access is from the aggregation of the asset of the plan.

Next, behaviorally, we've observed that for most participants that savings is a low priority. Most have a set-it forget-it mentality when it comes to decisions they make. For example, they decide to join the plan at a deferral rate of 4%, when we look back at them 3-4 years from now, they are still deferring just 4%. Asset Allocation is a best guess. The simple act of rebalancing, which is additive, doesn't happen in the aggregate. These and other issues lead to the poor income replacement statistics that we've all been seeing.

So, again, how do we take a valuable service like participant advice and get the uptake on it to be higher than the 25% figure in the article?

1.) Remove the price barriers. Not saying that advice should be free, far from it, what I am saying is that if the participant feels they will pay more for advice, they are likely to not take it. Instead, have the fee for advice be a plan-level fee. I.E. 25 basis points to the Plan Sponsor. If the Plan Sponsor chooses to pass along fees to the plan, then everyone pays for it. It becomes a fee neutral decision for the participant to use it or not.

2.) Make advice the default. Like other automatic provisions, usage goes up SUBSTANTIALLY if you make it a plan default. Our experience is that when we make advice programs a plan default we see a usage rate north of 85%.....that's right, 85% or 60% HIGHER than what the Wall Street Journal article says is the industry norm right now.

3.) Change the conversation at the participant level. Give them information in a way that they truly can understand. Most participants are return-centric, not benefit-centric. They look at what the investments did last quarter. In general, as mentioned, most are ill equipped to do anything with performance information, positive or negative. However, if we communicate to them at what age they will be able to afford to retire, give them the REAL number on what that is for a variety of ages, 66, 67, 68, etc. then they will truly know if they are on target to retire with enough income or not. If they are on a shortfall, we can communicate to them the earliest age that they can afford to retire or show them the impact of saving more.....what a novel concept, use the 401(k) Savings Plan as just that, a SAVINGS PLAN!

4.) Use the advantages offered in the Pension Protection Act of 2006. Automate savings, automate escalation, default people to Qualified Default Investment Alternatives, and automate rebalancing.

Those are real, practical solutions that can be implemented easily for many plans and will change the dialogue with Plan Sponsors and participants from investments and fees to something that really matters more which is income replacement rates.

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