June 1, 2010

The 401(k) Destination: If you don't know where you are going...

The print media are full of articles about lawsuits on 401(k) expenses, fees, and revenue sharing; large investment losses on target-date funds and, more generally, in participant 401(k) accounts; and out-and-out theft by investment managers. However, the real story—and the big problem—for 401(k) plans is that employees are not deferring enough. Even if all of the headline problems are solved, the core problem remains: Most employees cannot comfortably retire at 65 if they continue to defer at current levels. A big part of the problem is that employees do not know how much income they will need in retirement and do not know how much they need to defer to provide that income.

So, the real issue is, why aren’t employees being given that information?

Ask yourself, why doesn’t your plan communicate, at least annually, with each of your employees about probable retirement needs, the annual income that the current account balance and deferral rate will probably produce, and the increase in deferrals needed to have a secure retirement? I suspect that it is because your provider does not offer that service. In other words, I would bet that the problem lies with the 401(k) industry, and not with plan sponsors. (Having said that, I want to acknowledge that some providers do offer that service and, in many cases, plan sponsors don’t use it. That needs to change.)

When I talk to the 401(k) providers that don’t offer the service, they tell me that they use their budget for new products and services primarily to meet the demands and requests of plan sponsors (and, of course, for satisfying the compliance requirements imposed by the government). So, we come full circle. Plan sponsors aren’t giving a high priority to providing participants with information about benefit adequacy and needed deferrals. Instead, they are asking providers for other services, which I suspect are valuable, but which can have nowhere near the impact of information about the amounts employees need to defer to live comfortably in retirement.

As I have pointed out in prior articles, the level of deferrals is the primary determinant of the adequacy of benefits. Putnam has done excellent analysis of that subject, showing that deferrals are more important than participants selecting the best mutual funds or even having good asset allocation. Russell also has done interesting research on the power of deferrals—showing that, for every dollar deferred, the typical participant will earn $9 in pre- and post-retirement investments. However, based on research by Vanguard, it appears that the typical employee needs to be adding at least 15% of pay per year to his account—considering both deferrals and company contributions—to accumulate enough for retirement at age 65.

If participants don’t know how much they need at retirement, or how much they need to defer to get to that point, what are their chances of success? Probably not great.

So, how do we turn this vicious cycle into a virtuous circle? The first step is for plan sponsors to ask their providers for a service that tells new participants the amount of deferrals needed to have a reasonable chance of accumulating enough at retirement to have adequate income for life. Most of the studies conclude that people need 70% to 85% of their pre-retirement income. The second step is to make sure the providers update that information at least annually so the participants know if they are on course or, if not, what adjustments they need to make.

There is an old saying: “If you don’t know where you are going, any road will do.” For 401(k) plans, we need to establish clearly the destination—adequate retirement benefits; and then we need to give good directions—the amount that needs to be deferred today; and, finally, we need to make sure participants stay on the right road—periodic updates about whether they are on course to reach the right destination.

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