Without going into the evolution of the 401(k) plan, I can say with confidence that the defined contribution plan design in large part has failed many hard working people. This failure creates an atmosphere of fear and confusion that can subject employees to ruin in their golden years. The reasons for our situation are many but our educational system and complicated 401(k) plan rules are major contributing factors.
The current interest rate environment, potential for large profits and sales techniques using sophisticated statistical analysis are making matters more difficult for plan participants nearing retirement. Many small to mid-sized companies do not have the in-house expertise or resources to obtain an expert evaluation as required by the law. As a result, decisions are often made by the owner, CEO and sometimes a committee comprised of employees. These committees are normally formed and chaired by the company’s HR department, and in many cases, the members of these committees are unknowingly putting their personal assets at risk by accepting a fiduciary responsibility. (For more, see: 6 Problems with 401(k) Plans.)
A Client Example
Recently, a client came to me for advice concerning investment options in her new 401(k) plan which was selected by a well meaning committee comprised of employees. For reasons unknown to my client, the company decided to move their plan from a well-known 401(k) plan provider to a relatively unknown money manager who designed a better mouse trap. It is a better mouse trap. Unfortunately, my client is the mouse.
It’s a trap because the committee set in motion processes that are not easily changed in a company that employs approximately 70 people. The enrollment material presented to me was not professionally produced. Considering the size of the 401(k) plan, I thought it a bit strange. However, knowing that one should not judge a book by its cover, I tried not to let that issue cloud my opinion of the overall 401(k) plan.
As I paged through the material, I found a line up of 21 actively-managed funds and seven exchange-traded funds. An employee has the option of using these financial products to build their own portfolios or they could choose from six model portfolios managed by asset allocators. The plan seems to be an imitation of a Morningstar open architecture 401(k) plan that can be found on my web site. Two major differences in the Morningstar 401(k) plan are the sophistication and resources of its money managers and the amount of investment options in the plan.
Large institutions can afford to pay for some of the best investment talent in the industry and when it comes to investment options they are experienced enough not to clutter the plan making it more difficult for employees who wish to manage their own portfolios. Whether or not you agree with their investment philosophy, professional money managers employed by large institutions are well trained and focused entirely on managing money. Asset allocators are a mixed bag and sometimes can be dangerous to the financial wellbeing of the retail investor. (For more, see: Is Your 401(k) Administrator Competent?)
The greatest danger in the new 401(k) plan is the model portfolios, which are substitutes for the target-date retirement funds offered in the old plan. These model portfolios have approximately three years of historical performance. They involve market timing and each model has a substantial allocation to alternative investments. Worse yet, the plan is so cluttered, employees may choose these models in an effort to simplify their lives.
In Service Distributions
I advised a 61-year-old client to inquire whether or not the plan allows for in service distributions. An in service distribution would allow my client to reap the normal 401(k) benefits of tax deferral and the employer match and at the same time not subject the majority of their nest egg to the speculation of these asset allocators. As luck would have it, my client was able to roll over a large portion of her retirement assets into an IRA before the new plan shut the door on any future in service distributions.
In service distributions for plan participants 55 year or older should be available in most if not all 401(k) plans. Keeping retirement funds trapped in a 401(k) plan primarily benefits the money managers and the 401(k) trust provider. This is because their compensation is based on a percentage of the 401(k) plan assets. A 401(k) plan is supposed to be run for the benefit of the plan participants. If you feel this is not the case with your 401(k) plan, an in service distribution may be your emergency exit. (For related reading see: 401(k) Fees You Need to Know.)