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Retirement Planning > Saving for Retirement

Fixing 401(k)s

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A sagging economy and stock market have turned up the heat on 401(k) retirement plans across America. People have been losing money and they’re not happy.

U.S. lawmakers have been looking into ways to shore up America’s retirement system through new legislation that could come as early as this year.

The Congressional Budget Office estimated during the fourth quarter of last year that workers had lost $2 trillion in a span of 15 months from falling stock markets. Because some 55 million people participate in defined-contribution plans where they’re responsible for managing their own retirement funds, the implications are huge. The U.S. can’t afford the risk of having millions of people without adequate retirement income.

What are some of the main problems plaguing 401(k) retirement plans? What can be done to improve 401(k)s? And finally, what role with ETFs play in the future of 401(k) plans?

Darwin Abrahamson, CEO of Portland-based Invest n Retire, shared his views with Research about the state of the 401(k) market and where it’s headed.

In late February, George Miller, chairman of the House Education and Labor Committee said, “For too many Americans, 401(k) plans have become little more than a high-stakes crap shoot.” Do you share that same view of 401(k) retirement plans?

I agree with Rep. Miller that 401(k) plans need work. But, I disagree that 401(k) plans are a crap shoot. The biggest problem is that most Americans do not have sufficient savings in their 401(k) plan to provide an adequate retirement income.

Retirees have a median balance of $54,000 — which gives a larger weight to higher-income participants who are close to retirement with an average balance of $112,000. Clearly no one can retire on this small amount of savings. The solution to the retirement crisis is simple and only requires that employers get rid of the poor investment choices, which carry high costs, and provide employees with asset allocation models which are managed by independent fiduciaries.

This approach will move employees to the best practices of institutional investors superior investment options, asset allocation, diversification, and management of fees and costs.

Employers should also identify any potential conflicts of interest in order to protect employees from adverse consequences. If a conflict is identified, the employer should take action, such as changing service providers or investment options.

Are these the only issues impacting 401(k) plans?

No. Another problem is low contribution rates. The Pension Protection Act of 2006 (PPA) attempts to solve this problem by incorporating automatic enrollment, which allows a plan to automatically enroll employees when they become eligible to join the plan.

In general, most plans start the initial minimum automatic deferral percent at 3 percent. If the plan includes the provision for automatically increasing the contribution rate by 1 percent each year under the Qualified Automatic Contribution Arrangement (QACA), the contribution rate will accelerate up to a maximum of 6 percent.

More legislation needs to be passed to offer more incentives for plan sponsors to adopt QACA. The alternative is that employees who do not save enough will become a financial burden of the government or taxpayers.

Over the past decade, target-dated funds have become a popular default choice in 401(k) plans. Yet, it’s not uncommon for many target-dated retirement funds to have more than half of their funds allocated to stocks. That might be too much, especially for older 401(k) workers. What do you think?

Asset allocation is not the primary problem with target-date funds. Target-date funds have numerous problems. The more significant problem is that 401(k) providers offer target-date funds as an “additional investment option” like any other mutual fund. Most participants select an average of four target date funds as well as several other funds. The result is that participants end up with an even more expensive mix of funds and an incredibly poor asset allocation model, which cannot possibly address their retirement goals.

The Invest n Retire retirement platform uses ETFs. Why do you believe they’re a better choice than traditional mutual funds?

Most of the retirement plans on our platform use the services of an independent investment fiduciary. These investment managers efficiently use ETFs to manage risk and build better asset allocation models since ETFs offer more asset classes.

Also, ETFs are a lower-cost option, which means that investors are already ahead of the game by not having to increase return in order to recoup cost. Morningstar’s research illustrates that the average expense ratio for large-cap ETFs is about 0.35 percent as compared to 0.66 percent for a large-cap index fund and 1.1 percent for a traditional large-cap mutual fund.

What type of impact has selling in a down market had on 401(k) investors?

Our present market climate has caused forced selling by mutual fund managers in order to generate cash for investors who are bailing out of the market. In other words, fund managers are selling in a down market to create cash to pay redemptions. This trading activity increases trading costs within the funds and decreases returns. Clearly, this is a no-win situation for mutual fund investors who choose to stay put. According to Morningstar, equity mutual funds had outflows of $208 billion in 2008, while ETFs had cash inflows of $158 billion.

Data from the Center for Retirement Research at Boston College shows funds of a 401(k) plan are pooled with the funds of other investors and therefore the plan’s participants are paying a share of the trading costs incurred by investors who do not belong to the plan. In contrast, investors who sell ETF shares pay the trading commissions at the time of the sell; therefore, anyone else who may own the same shares does not incur any trading costs just because an ETF investor initiated a sell transaction.

Critics of ETFs inside 401(k) plans argue that ETFs are not suitable investments for long-term retirement plans because they encourage people to day-trade their retirement accounts. What do you say to that?

That is the most absurd argument, which I hear all the time. In my experience, investors who purchase ETFs are no more likely to actively trade than an investor who buys mutual funds.

Regarding your question about day-trading ETFs, the definition of day-trading refers to the practice of buying and selling financial instruments — within the same trading day — such that all positions are usually closed before the market close of the trading day.

In a 401(k) plan, employees are not sitting at a computer executing buy and sell orders during the day. Instead, the record-keeper for the plan is the service provider who executes transactions on behalf of employees (buys and sells).

Therefore, the employee has absolutely no ability to day-trade, no matter what investment options the employee holds, ETFs or mutual funds.

What about the 2006 Pension Protection Act (PPA)? Has it made people’s retirement more secure or less secure?

Quite frankly, the PPA has no ability to make individuals’ retirement more or less secure. The purpose of the PPA is to address poor investment options as the default investment, lack of participation by removing obstacles for automatic enrollment, and attempts to promote higher contribution rates.

One of the most positive provisions implemented by the PPA is a shift from money market and stable value funds as the default investment option. Before the PPA, most plans used extremely conservative investments as the default option (equivalent to cash), which unfortunately most participants never bother to change. It’s pretty hard to save enough when you are invested in cash, which lags behind inflation.

How should older workers respond to the major drop in the value of their 401(k) plans? Do they abandon ship?

The question should not be: Do they abandon ship? The question should be: Do they need the money to start flowing the minute they retire? One initiative which President Obama is proposing is to stop forcing individuals who reach age 70 1/2 to take mandatory distributions.

I firmly believe that no one should be forced to sell in a down market.

If an individual does need to turn on the spigot at retirement, he or she should consider delaying retirement a few years in order to increase savings. The net result is the individual will have more years to save with fewer years of payout.

What should financial professionals do to help their clients that may be sitting on large 401(k) losses?

I hear people say all the time that I’ve lost my retirement savings. However, most of these individuals haven’t sold anything.

For some perplexing reason, a number of investors believe they have losses, even though they haven’t sold anything. On the other hand, if an investor panics and sells in a down market, the investor will realize actual losses.

Investors are constantly being told by their financial advisors that they should invest for the long-term. That adage should not be abandoned just because we’re in a cyclical down market.

The House/Labor Committee recently held a hearing about the failure of the 401(k) system as we know it. This is nothing new. They’ve been talking a tough 401(k) game for years and it seems nothing gets done. Do you think any meaningful or positive changes are coming to people’s 401(k) plans?

I hope so, but unfortunately, Congress likes to discuss the failure of the 401(k) system without taking action.

In fact, the Office of Management and Budget (OMB) has failed to approve the Department of Labor proposed regulation under ERISA section 408(b)(2) related to the disclosure of service providers’ compensation and conflicts of interest. The OMB position is that the proposed 408(b)(2) disclosure regulation imposes too large a cost burden on service providers. o

Ron DeLegge is the San Diego-based editor of


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