401(k) Blunders

According to a new paper, Americans commit a series of blunders with their retirement accounts. Jacob Hale Russell of Stanford Law School’s The Separation of Intelligence and Control: The Retirement Savings Crisis and the Limits of Soft Paternalism, says that the flubs are not entirely our fault. “Over the past four decades, the American retirement system has dramatically shifted risk onto the individual worker.” Whereas in the past, professional investment management committees were tasked with making complicated financial decisions, today the burden has shifted to individuals and the results have not been good. Retirement investors consistently make the following blunders:

• Not allocating retirement accounts and as a result, leaving money in cash or low-interest money-market funds, where it will decline relative to inflation
• Leaving a job, cashing out retirement plan assets and paying a tax penalty, instead of rolling over the funds into another retirement account
• Choosing high-fee funds despite overwhelming evidence that they offer lower returns than lower cost options
• Failing to diversify and over-investing in employer stock
• Not rebalancing on a periodic basis
• Overtrading individual securities
• Failing to take advantage of employer matching programs for contributions, which is tantamount to leaving cash on the table

With all of the literature that accompanies retirement plan enrollment, why do retirement savers continue to blow it? The author posits that people are simply overwhelmed by the decisions that they need to make. The policy response has been to use behavior economics to “nudge” retirement plan participants into making better decisions.

“Soft paternalism” or “libertarian paternalism” presents choices to individuals in a way that “encourages them to make better choices. The best example of the nudging was the 2006 enactment of the Pension Protection Act, which allowed companies to automatically enroll employees in 401(k) plans. Since then, participation has jumped for those companies who automatically enroll employees into their plans.

That’s the good news. However, other efforts to assist employees have not been as effective. In a recent interview, Russell said that nudging isn’t actually correcting investor mistakes, “It’s not educating people to make different choices, it’s not revealing to them their intrinsic errors.”

So what should be done? Russell encourages policymakers to take a big picture approach and ask: What purpose do we want 401(k)’s to serve? “Too often we assert abstract values—like autonomy, which animates much of the libertarian paternalist instinct—without reference to the higher-order purposes they do or don’t serve in a particular policy application.” Russell also notes that there are often conflicts of interest that can lead investors down the wrong path, which is why he advocates regulating the quality and fee structure of the funds that serve as default investment options. (This suggestion dovetails Yale Professor Ian Ayres' 2013 exhaustive analysis of company-sponsored 401 (k) plans, which found that many plans charge excessive fees.

Until a wholesale review and upgrade to retirement plans occurs, here are some tips which should help improve your retirement plan results:

Put your 401(k) plan on autopilot: Many plans offer the opportunity to automatically increase annual contributions. Have the plan add one or two percent each year in order to maximize your contributions over time. Additionally, plans also can be set to auto-rebalance your allocation on a periodic basis (quarterly, biannually or annually). Using this feature can help take emotions out of the investment process.

Diversify your holdings: You know that you shouldn’t put too many eggs in one basket. But some participants don’t realize how much overlap they may have among their retirement funds. It’s far more important to diversify among asset classes (stocks, bonds, commodities and cash) than in the total number of funds. If your company stock is an option in your plan, limit your exposure to 5 percent of your holdings.

Choose index funds, when possible: One way to increase your return without risk is to reduce the cost of investing. If your plan offers index funds, you may be able to save for retirement at a fraction of the cost of managed funds. If your plan is filled with expensive funds, gather your co-workers and lobby your boss to add low-cost index funds to your plan.

Beware pre-retirement withdrawals: During the recession, many were forced to take withdrawals from their retirement accounts to survive. But many workers still dip into retirement funds to fund everything from mortgages to credit cards and other bills. While the IRS does allow for hardship withdrawals in certain instances, pulling money from retirement accounts should be a last resort, due to potential fees and tax implications.

401(k) Fee-Asco

A Yale professor is providing a perfect follow up to this year’s PBS episode of Frontline called "The Retirement Gamble." That program detailed America's retirement crisis and the financial services industry’s feasting on high fees inside of many employer-sponsored plans. Professor Ian Ayres has recently completed an exhaustive analysis of company-sponsored 401 (k) plans and found that many charge excessive fees. But Ayres has taken the research to a new level by sending about 6,000 letters to companies, saying he would disseminate the results of his study next spring and would specifically identify and expose those companies with high-cost plans.

The concept of reeling in retirement plan fees gained a bit more momentum last year, when the Department of Labor put new rules into effect, which required 401 (k) sponsors to disclose fees and performance data to plan participants. The first round of the more detailed information was sent in November 2012 and, despite all of the media hype, those disclosures did not make much of an impact.

According to the EBRI 2013 Retirement Confidence Survey, about half (53 percent) of defined contribution plan participants reported having noticed these new disclosures, and only 14 percent of those who noticed (7 percent of all plan participants) said they made changes to their investments as a result.

This data gibes with findings from consulting firm LIMRA, which found that half of plan participants do not know how much they pay in plan fees and expenses. In fact, about a fifth of all participants think they pay nothing for their retirement plans.

To review, there are a bunch of fees that participants pay, including administrative, trustee and investment fees. The average plan costs about 1.5 percent, with larger company plans coming in at closer to 1 percent and small to medium sized ones sometimes costing in excess of 2 percent.

You may think that a half of a percent does not seem like a big difference, but that fraction could cost you hundreds of thousands of dollars over time. As a baseline, if you were to start with $100,000 and invest it over 50 years at a 7 percent return (compounded monthly) with no fees, you would end up with approximately $3.2 million.

If you apply the average plan fee of 1.5 percent, the future amount is more than halved to just over $1.5 million. But if you are in an expensive plan and the fee is 2 percent, your future value drops to $1.2 million at the end. That’s $300,000 that could be falling to your bottom line! 

What should you do if your retirement plan is more expensive than the average? One benefit to the disclosure rules is that plan participants can be empowered to effect change. The first step is to review the disclosure that was sent. If your plan costs more than the average of 1.5 percent, gather as many co-workers as possible and lobby your boss for a cheaper plan. It may surprise the boss to learn that he or she could find cheaper alternatives. But it is notoriously difficult for smaller companies to get the best plans. The reason is that the financial services industry likes scale. It takes a lot of money to provide all of the services necessary to operate a retirement plan, so financial companies like to land the big fish.

If you hit a brick wall on a new plan, then at the very least, try to have cheaper investment options added to the current plan. Index funds, which carry much lower fees, can make a big difference. I recently helped a radio caller navigate her 401 (k) plan investment options. By shifting from costlier actively managed funds to index funds, her cost of investing dropped from over 1 percent to just 0.25 percent.

It can feel burdensome to stay on top of all of these issues, but hopefully the long-term benefit outweighs the short-term work involved.

© 2013 TRIBUNE MEDIA SERVICES, INC.