Minding the 401k Gaps

By Michael Chamberlain CFP® AIF®. Mr. Chamberlain is a Principal with the firm Chamberlain Fiduciary Consultants, an independent advisory firm committed to enhancing employees' retirement income. For more information, visit their website at www.ChamberlainFC.com.

If you have been fortunate enough to have traveled to London and ridden the underground, you may recall the sign "Mind the Gap." This gap is the opening or pit between the door of the train and the station platform. Stepping in the gap could result in a broken leg or worse. "Mind the gap" also applies in the 401k world and there is more than one gap, any of which that will cause a broken future retirement income.

Brooks Hamilton the well-known ERISA attorney, as a result of his decades of work with pension plans, describes three types of gaps or what he calls "yield disparities." There are at least 5 other gaps, all of which hurt the opportunity for employees to have meaningful future retirement income.

The first gap is the difference in investment returns between plan participants who have great returns and those who have poor returns. Brookes found that generally; the plan participants with higher income had higher returns than those with smaller wages. This gap could be due to the "richer" participants having access to outside investment advisors or were more diligent in their investment education. Another factor is that those with less income and assets could not afford to take as much risk as those with greater financial capacity. This gap ranges from 2 to 21% per year depending on market conditions.

The second gap is the difference in the investment return of a particular 401k plan to the overall financial markets. This below-average performance of most 401k plans is often attributed to the high fees built into many 401k programs, the utilization of poorly selected or monitored actively managed funds and participant behavior. In a different study over several years in the late 90's of 5 well know financial institutions, including MorningStar and Citigroup, Brookes reports that 401k gap of 8%.

The third gap is the difference in the investment return of a 401k plan and the defined benefit pension plan (DBP) established by the same company. It is well known that traditional pension plans (DBP) are run by investment and actuary professionals who have a professional and fiduciary responsibility to do what is best on behalf of the plan participants. In one study and validated in subsequent studies, this gap was found to be 1.9%. This is very close to the 2% that is reported in other studies since.

A less visible gap is the difference between the ERISA required fiduciary duties of the plan sponsor (and other fiduciaries of the plan) and the performance of those duties. This gap is often inversely correlated to the size of the plan. Big plans can afford to hire ERISA attorneys, Investment Fiduciaries or have investment committees and tend to be more compliant with ERISA fiduciary duties. Better ERISA compliance results in lower plan costs, better quality service providers and better investment diversification and or selection, all of which lead to more retirement income.

Perhaps the most important gap is the difference between the participant's expected rates of return from the portfolio versus the required return in order for the participant to reach their retirement income goal. Lets say that a plan participant has a goal of $30,000 a year of 401k income. The expected rate of return may be 7% but the participant would need a rate of return of 19% a year to reach the income goal. There is no investment that will provide that consistent level of return-thus there is a gap. As a result, this participant either needs to cut back on their retirement income goals, work longer, work part-time in retirement, take more risk in their portfolio (seeking a higher average annual return) or contribute more to the plan. The sooner plan participants know about this gap, the more choices they have to reduce it.

The gap between the number of total company employees and the number of plan participants varies from one company to the next. Few have 100% participation. Those companies with opt out feature have higher participation rates than those with out-in enrollment. Obviously an employee that does not participate or delays enrollment will have less than an ideal retirement income.

A better-known gap is the investment knowledge gap between plans participants and an investment professional. No amount of onsite participant education will bring a plan participant up to the level of understanding of a full time investment professional. Attempts to provide investment education onsite have failed to improve portfolio performance.

A gap also exists between investment professionals. Insurance salesman and Broker Dealer representatives, contractually have a duty of loyalty to their employer. The responsibility to the plan and the plan participants comes second and leads to conflicts of interest. Whereas, a RIA or Investment Fiduciary is required by law to always keep the plan and plan participants interest foremost at all times.

So the question is, with all these 401k gaps that lead to decreased future retirement income, how is a plan sponsor or employee to "mind the gaps"? Perhaps the Department of Labor's recent proposed changes will help as would full fee disclosure but they will not be enough.

The best answer for minding all the gaps is for the plan to hire an Investment Fiduciary to act on behalf of the plan and it's participants. The fiduciary is not a part of the investment or insurance company, record keeper or custodian and has a result has no conflicts of interest.

A fiduciary will analyze the plan and make recommendations to increase the participant's opportunities for increased retirement income. These enhancements could be modifying the plan to increase participation and contributions, reviewing services providers to get the best in each field, designing model portfolios (based on Generally Accepted Investment Principles) that maximize the return for the risk taken, provide investment advice to the participants, help the participants chose the best model for their situation, monitor the portfolio investments and make changes if needed. The fiduciary also helps the employer meet its ERISA responsibilities and decrease plan costs in most cases at the same time.

The 401k status quo of "not minding gaps" will continue to greatly reduce plan participant's future retirement income. It is the responsibility for the plan sponsor to manage the plan and the gaps.

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