From the October 2006 issue of Investment Advisor • Subscribe!

ETFs for 401(k)s Are OK

May be the best perch for default 401(k) money

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Now that the Pension Protection Act has become law, plan sponsors should refrain from using money market and stable value funds as default options in 401(k) plans because they jeopardize investors' likelihood of having enough money to retire. Plan sponsors should instead offer plan participants a default investment option that provides long-term growth, like Seligman's TargETFund Core, which is a mutual fund that invests in ETFs, says Charles Kadlec, president of Seligman Advisors Inc.

Selecting a default fund is crucial because 20% of participants who enroll in a defined contribution or 401(k) plan fail to select a default option on their own. This percentage is only going to increase, Kadlec predicts, since the new pension law--the Pension Protection Act of 2006--makes it easier for employers to increase participation by adding automatic enrollment. Kadlec also cites a recent study by Mercer Consulting which found that for those plans that implement automatic enrollment, 85% of automatically enrolled participants keep their accounts invested in the default option.

Seligman's TargETFund Core seeks capital appreciation and preservation of capital with current income by investing in a mix of asset classes including U.S. large- and mid-cap equities, bonds, equity REITs, and dividend-paying stocks. "We have tremendous diversification in traditional mutual funds that are easy to plug into anyone's 401(k)," Kadlec says. The TargETFund Core's portfolio allocations generally look like this: 35% fixed income (including 10% allocation to TIPs), 35% U.S. large-cap stocks, 10% U.S. mid-cap stocks, 10% international large-cap stocks, and 10% equity REITs.

The Seligman funds are a form of lifecycle or target date funds, Kadlec notes, and offer a great alternative to money market or stable value funds because they are multi-asset class balanced funds. Moreover, the funds reduce active manager risk because they invest in ETFs. "We know we'll deliver investment results that are very near the indexes that those ETFs track," he says. "In fact, the mutual funds have reliably tracked the index returns that they're invested in." Don Dedeski, an advisor with Wachovia, says the advantage of using Seligman's ETF portfolios "is that if someone chooses to do nothing, [their plan is] being run in the most efficient manner."

Kadlec also points out that Seligman's allocations are based on good research. "We have done an extraordinary amount of work and assembled a database that goes back to 1950 and uses Monte Carlo analysis to get at the right balance between the prudent allocation that takes into account short-term volatility, but that also provides for longer-term growth."

The Pension Act provides plan sponsors with an opportunity to improve their retirement plans by rethinking the default option, Kadlec says, and the new law also revises a plan sponsor's fiduciary duties. As it stands now, plan sponsors are the fiduciary for the employees in the default option. But under the new law, "that changes in that the plan sponsor, or employer, provides the participant notice what the default option is," Kadlec explains. Then, under the Act, "if the individual stays in the default option they will be deemed to have made an affirmative decision--once you have an affirmative decision, you have a safe harbor from fiduciary risk."

Advisors, too, should be assessing their existing clients' defined contribution plans to

ensure the default option has been updated to something beyond a stable value or money market fund, Kadlec says, and "that the correct language is inserted into the investment policy statement."

Washington Bureau Chief Melanie Waddell can be reached at mwaddell@investmentadvisor.com.

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