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Leading the Way

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The biggest issue these days for investment advisors and financial planners is retirement planning. If you ask retirement planning professionals what the biggest retirement issues are this year for advisors, plan sponsors, and plan administrators, they’ll collectively nod that adhering to provisions of the Pension Protection Act (PPA) will monopolize a great deal of their time. If you ask them which PPA provisions concern them most, they’ll likely say automatic enrollment, fee disclosures, providing investment advice to plan participants, and selection of default investment options in 401(k) plans.

Let’s not forget, however, that there are other retirement issues that will consume a significant portion of advisors’ time in 2007, namely the ever-increasing need for advisors to find income for retiree clients, particularly Baby Boomers. The debate on whether annuities are the superior income-generating vehicles of choice for advisors will likely rage on. Some advisors argue in favor of annuities, saying it’s really the only option, while others prefer alternative methods of generating income for clients. Still other advisors believe that getting up to speed on helping their retiree clients tackle healthcare-related issues will be a pressing task this year.

Passage of the PPA last August was a watershed event that confirmed what retirement officials say is the sea change that’s occurring in the retirement planning industry: defined benefit plans are falling by the wayside as defined contribution plans, including 401(k) plans, become the dominant retirement savings vehicles. The findings of Cerulli & Associates in its “State of the 401(k) Marketplace,” released in January, bear out this shift. Total assets in retirement plans at year-end 2005 (the most recent numbers available) totaled $13.3 trillion, Cerulli says, with IRAs holding $3.9 trillion and defined contribution plans holding $3.8 trillion. Defined benefit plans, meanwhile, make up the remaining $5.61 trillion. However, $2.8 trillion of the DB total is in state and local government DB plans, while only $1.9 trillion is in private DB plans, which continue to shrink. The remaining $0.91 trillion is in federal DB plans. In 2005, there were almost 55 million participants in DC plans, an increase of more than one million from the previous year, Cerulli says. The Boston-based research firm predicts that the PPA’s support of automatic enrollments and the retirement industry’s movement toward auto enrollments will continue to boost the number of 401(k) participants in the next five years.

Enrolling Automatically

Indeed, the impetus for auto enrollment, says Steve Utkus, principal at the Vanguard Center for Retirement Research, has come from “large companies who’ve been concerned about specific fiduciary issues like how to choose the default [investment option] and how to avoid state anti-garnishment rules.” It will be the medium- and large-sized firms that “find it hard to promote their plans,” Utkus says, and that will be quick to adopt auto enrollment in the near term, as opposed to smaller companies. “Smaller companies tend to have higher participation rates” in their retirement plans, he says. However, those advisors who service small company plans will need to be savvy about the auto enrollment rules–both the safe harbor as well as the traditional auto enrollment rules–he warns, as some small firms will jump on auto enrollment. “There will be an increasing emphasis on auto enrollment [from large companies], and eventually it will trickle down but I don’t think there’s an immediate sense of urgency where advisors need to be out talking to clients about shifting from a voluntary plan to an automatic enrollment plan,” Utkus says.

A group of attorneys at the law firm of Reish Luftman Reicher & Cohen in Los Angeles agree, in their recent bulletin on automatic enrollment, that large and mid-sized plan sponsors are likely to be quicker in embracing this option. They go on to note that approximately 20% of the largest 401(k) plans already automatically enroll participants.

On a related note, The Retirement Security Project is urging Congress to establish a payroll-based automatic IRA program as lawmakers review the Bush administration’s 2008 budget proposal. The group says the automatic IRA, which it proposed last year, “could bring millions of people into the retirement saving system and increase net national saving by an estimated $8 billion annually.”

Defining Default

You can’t talk about auto enrollment unless you also discuss default investment options. The PPA requires that the Department of Labor (DOL) create new rules within six months of the Act’s passage which will detail exactly what constitutes an appropriate default option within a 401(k) plan–the so-called Qualifying Default Investment Alterna-tives (QDIAs). At press time, DOL said that it would not issue final rules on QDIAs by its February 17 deadline. However, DOL’s proposed rules indicate that the QDIA must be a target date fund (lifecycle fund), balanced fund (lifestyle fund), or a managed account. Louis Campagna, chief of the Division of Fiduciary Interpretations and Regulations at DOL, said in late January at the ALI-ABA investment advisor regulation conference in Washington that DOL is now reviewing the more than 1,000 comments it received on the QDIA proposal.

Matt Smith, managing director of Russell Retirement Services, says if DOL sticks with the three investment choices, he thinks the majority of plan sponsors will “go the target date route,” because the funds offer a “simple, sensible, elegant way to default your participants.”

Target Funds Can Take Away Participant Worries

Why do target date funds make the most sense? Smith offers this simple explanation. When 401(k) plans first hit the scene a few decades ago, employers were solely responsible for investing all of a participants’ money, leaving participants with basically no say in the matter. Then the pendulum swung in the other direction to the point where employees have been given too much choice, Smith says, and participants have been bombarded with too many investment selections. Now, with PPA, “we’re kind of swinging back to this equilibrium where it’s the responsibility of both employer and employee to invest properly,” he says.

Given the fact a number of behavioral finance studies have shown that retirement plan participants are either “uninterested or ill-equipped to make sensible investment decisions,” Smith says, it stands to reason that target date funds are becoming popular because they require “no work on the part of the participant.” With target date funds, “participants know how long they have until they retire, they’re choosing a target date fund that matches up to that retirement date, or they are being defaulted into it by their employer by making no decision–at that point, within the fund, the asset allocation decisions are made for them, and they are managed over time and supervised.”

A number of critics have argued that one of the problems with target date funds is that they lump all types of investors together, regardless of their risk tolerance and financial situation. But Smith, for one, says that most participants either don’t have the time or are anxious about choosing an asset allocation for their retirement accounts, so by choosing a default option, they’re consciously asking someone to do it for them. “When we’re talking about a default, it’s for participants who have chosen to not [choose an allocation] for some reason,” Smith says. “If that’s the case, I don’t think it’s a fair criticism to say we’re lumping all these people together. They are actually lumping themselves into that do-it-for-me category.”

Utkus of Vanguard adds that “the default is only powerful if people are automatically enrolled into it.” Unless the client adopts auto enrollment, he says, “you can put in these new [target date] funds but they’re not going to be a focal point.” For advisors, “there’s a planning opportunity to work with clients to make sure they have a good default fund.”

Evaluating Options

As employers start evaluating their plan’s default options and potentially choose target date funds, Smith says the next crucial step is deciphering the differences between them. This process requires a different methodology than choosing a single asset class fund, he notes, because a target date fund, by its nature, manages the asset allocation over time. Unlike a single asset class fund, the target date fund’s asset allocation “changes over time–it’s not a static 60/40 fund.” So a plan sponsor will have to evaluate the fund’s “glide path,” which means the percent of equities versus bonds in the allocation at any given point in time.

While these glide paths generally look the same, Smith says it’s important to realize that there are differences. “The plan sponsors are going to have to determine what’s good or bad about these different glide paths.” Russell, for instance, diversifies “across certain asset classes that others may not be using,” he says, and also “diversifies our style risk and our manager risk in a certain way that we feel is a competitive advantage.” Advisors, too, will be required to get up to speed on how to evaluate target date funds if they expect to be in a position to give plan sponsors sound advice.

Smith adds that advisors can use this as an opportunity to expand their traditional role of selecting funds and evaluating investment options for plan sponsor clients. With target date funds, advisors will be evaluating the monthly asset allocation and the target date options, as opposed to whether the plan has the best large-cap or small-cap fund, he says. Advisors will now have an opportunity to change the dialogue with the plan sponsor, he maintains. “The advisor can go back to the [plan sponsor] client and say, ‘We should look at the objective of this plan in terms of an outcome.’ In other words, ‘What kind of income replacement ratio do you want to accomplish with this plan for your employees?’”

Providing Advice

Another important provision of PPA opens the door for advisors to provide investment advice to plan participants. But advisors have to tread carefully in how they go about offering that advice. How an advisor approaches advice will depend on whether they’re a wirehouse broker or an independent, says Utkus. Under the DOL’s new Field Assistance Bulletin (FAB) 2007-01, issued February 2, the fiduciary advisor must have level fees, whereas the fund company is allowed to have variable fees, Utkus explains.

Under the new FAB, “if you’re getting variable compensation, depending on which funds you talk to people about, that would violate the PPA.” Wirehouse brokers “will have to take a wait-and-see approach” as their legal departments structure the safest ways for them to give advice to 401(k) participants. For independent advisors, he says, “It gets tricky, too.” Independents have to make sure they’re not getting compensation that’s variable according to the funds offered, so they’ll have to get some legal advice on how to offer 401(k) advice. “From a compliance point of view, you have to do a bit more work, if you’re an independent advisor, with your lawyers to make sure you’re PPA compliant.”


While the fees of advisors and affiliates may vary if the advice given is based solely on a computer model, under the level fee scenario, questions remain as to who is actually the fiduciary advisor. More specifically, ask the lawyers at Reish Luftman Reicher & Cohen in their recent bulletin on the PPA’s investment advice rules, “Does the level fee requirement extend to affiliates of the advisor, such as a mutual fund family or insurance company, and, if so, to what extent?”

The real question, the lawyers say, is “who is actually providing the advice?” They also ask: “What if the advisor is told explicitly by an affiliate what advice he must give or what software to use? What about the situation where a fund company requires that its proprietary funds be included in the asset allocation?” The lawyers want the DOL to address the situation “in which an entity exercises actual, affirmative control over the advice being given and clarify that the entity’s compensation must meet the level fee requirement.” Campagna of DOL said in January that DOL will indeed be addressing “the scope” of the fee leveling requirement.

Generating Income

Beyond complying with the various provisions of the PPA, advisors will continue to grapple this year with finding the best income-generating vehicles for their retiree clients. Some advisors believe annuities are a crucial component of a retirement portfolio, while the majority of advisors use systematic withdrawal strategies, dividend paying investments, and mutual funds to generate cash for clients (see sidebar, “What are your peers doing to prepare?”) Utkus of Vanguard says the new generation of annuities, the so-called guaranteed minimum withdrawal annuities, which allow individuals to have annuity streams of monthly income as well as access to their money, will become increasingly popular in the next few years.


When devising an income strategy, “some advisors stick to the old 4.5% [withdrawal rate] rule, which is ‘I’m just going to spend down in some structured way’” a client’s portfolio, Utkus says. Other advisors generate income from the portfolio and pay it out monthly, which is the most traditional way, he says. Still other advisors integrate some of the newer annuity payout products into their strategy. The key, Utkus says, is that “advisors have to structure an income sources portfolio for individuals, and obviously there’s Social Security, but you can use inflation-indexed annuities for a portion of it, variable payout annuities, income coming off the portfolio from investments, as well as some sort of withdrawal strategy. The planner’s job is to optimize that choice for each of their clients.”

This year is shaping up into one in which advisors will have to stay compliant with a plethora of retirement planning rules and regs if they expect to stay firmly rooted in the retirement planning arena–and doing what’s best for their clients.


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