Tips on Managing a 401(k) Plan in the Post-recession Economy

Given the severity of the current recession, it is clear the light at the end of the tunnel will not provide a clear vision of what lies ahead for 401(k) plan administrators.

The article, "Black Swan, Red Flags," posted on this Web site, notes that some financial events which have been considered statistically remote have happened with increasing frequency over the last few years. This may mean the financial markets will be facing a new version of normalcy.

There are a few reasons for these impending changes. One is that financial markets have become even more increasingly interconnected. The rapid flow of smart money quickly invested via sovereign wealth funds and hedge funds have replaced central banks as being the largest source of capital. Unlike central banks, sovereign funds also have a trading orientation. The hedge funds are also short-term and they all look try to recognize mis-pricings, so they can take advantage of any arbitrage.

All of this means more volatility, more efficient markets, and lower returns, especially for the retail, 401(k)-end of the market. This is the theme of the "Black Swan, Red Flag" article.

The Future of the 401(k) Market
The future of the 401(k) market should force plan administrators to become more diligent in supervising costs, expenses, and the fund offerings themselves.

For example, it's clear that the faddish target-date funds failed to perform during their first market stress test. These funds are great from the mutual fund company perspective because they often bundle mediocre funds into a target date program with a "glide path," or asset allocation exposure, which is very flexible and untested.

When I asked the manager of a target-date fund what happens in 2010 or 2015, (when many of the first target-date funds will reach their maturity date), there was a silence on the other end of the phone. He then basically said there was no plan for that event; he would face that issue when the time arrived.

Other target-date funds said that as maturities arrived, they would do one of the following: go to cash, stay fixed in the last asset allocation exposure, or gradually move into a new fixed income exposure which was an unspecified post-glide path scenario.

Plus, none of the fund managers I spoke with had a specific date when they would make those changes after the target date was reached. Some said they would not make any changes for six, ten or one year after the target date was reached.

So while target dates have an appeal to investors, primarily because they are simple to explain, they did not work in the current recession. If they did, there is no reason for them to be down 25% to 30%. (There is a study, Looking Under the Hood which has more details on the target-date fund performance.)


The Re-Birth of Pensions?
While target-date funds have proved disappointing during the current recession, opinion polls show that many employees would prefer pensions over 401(k) if given the choice.

While this idea may be unpopular with employers and the mutual fund industry, the idea of abandoning pension plans, or some other form of lower-cost group annuitization, may be premature. Anecdotal evidence shows that one of the main reasons why many people are trying to gain government employment is because of pension benefits.

Many studies have found that people cannot manage their own investments themselves. This helps account for the lower returns, higher portfolio turnover. While 401(k)s are great for the mutual fund business, they are not making great strides towards helping to build a more secure financial future for too many individuals.

Another challenge for 401(k) administrators is to take a more inclusive look at their employees’ overall investment portfolio, including their housing wealth and medical costs. These are the building blocks of retirement security, yet many 401(k) administrators take an atomized view of retirement wealth, often because they are afraid of incurring legal liability.

While this is understandable, the fact is that housing wealth, Social Security, and portfolio assets are the only sources of retirement income for the vast majority of Americans.

In the white paper I wrote on the effects of housing wealth on retirement planning, the research found that many middle class people relied on housing wealth to supplement their retirement wealth. When house prices declined, it wiped out the major source of this wealth. The recent portfolio losses were the 1-2 punch. As a result, many people close to retirement now face a lost decade of investment returns. This means the first ten years of the new millennium have done little to produce long-lasting new wealth to allow a comfortable retirement.

Housing Glut
Another complicating factor is that there is a huge backlog of houses on the market which will depress prices for years to come. As a result, people who counted on significant sales prices should expect to get less for their houses, thus robbing them of one of the few sources of wealth which was once available to them. As an example, due to its dismal sales and overbuilding, Florida now faces is a six-year backlog of housing inventory.

What 401(k) Administrators Should Do
--Adopt a fiduciary standard approach to their 401(k) plan providers.
--Critically evaluate target-date funds and question why they should be a core holding versus lower cost ETFs.
--Be critical of insurance companies which offer mutual funds as an adjunct to their plan administration business. Often these are mediocre funds that are offered as loss leaders to get the business.
--Re-visit the idea of pension funds or group annuities as away of re-building employee-company loyalty.
--Challenge mutual funds to justify their active-management fees. One mutual fund manager told me his Treasury Inflation protection (TIPs) fund did not own any TIPs; he was invested in higher-yielding derivatives until those derivatives (and the entire fund) lost money.
--Create a poster-size schedule of all 401(k) fees and post it in the company cafeteria or locker room, alongside the other OSHA, minimum wage and other mandatory notices, so all can see the 401k expenses clearly.
--Focus on fund fees and lowering overall fund expenses in order to help employees recover their losses faster.