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The (K)oncept Plan - 2004 Model

    
An Abridged Digest of Real World Solutions for Managing Defined Contribution Plans

By Stephen J. Lansing CIMC, CEBS, President and Founder of Sentinel Fiduciary Services, Inc. of Orlando, Florida. If you would like to discuss this issue further, you may contact Steve at stevel@sfs.cc or call him at 407.246.7221.

Yes, I answered you last night
No, this morning,Sir, I say
Colors seen by candle light
Do not look the same by day

Elizabeth Barrett Browning.

EXECUTIVE ABSTRACT

We have progressed well beyond the introductory premise of last year's article that defined contribution plans need to be managed differently. The art and science of managing retirement plans is irrevocably changing.

Sponsors need a Copernican experience, an epiphany, in the way they view their 401k/403(b) programs. Employers should see their role as being a partner with the employees to help them achieve financial security in retirement. In her book, Value Shift, Lynne Sharp Paine talks about corporate citizenship and "moral actors." She elaborates "In general, the linkage between values and employee engagement would lead us to also expect tie-ins between values and employee loyalty. Loyalty, in turn, translates into lower turnover and recruiting costs, as well as better knowledge retention because of greater employee continuity." Being deliberately indifferent by simply offering a plan to employees is no longer tenable. Accepting this new reality is mandatory because of overwhelming survey and empirical research from the new field of behavioral economics.

In the balance of this paper we will discuss numerous commitment devices that can be used to help people behave in a way that is conducive to their long-term financial security. There are many heuristic tools (short cuts) that can be employed to finesse participants into actions they acknowledge are desirable but seem unwilling to take. Accepting this premise is to understand that most people are not risk adverse investors (rational economic agents) but are loss adverse savers. Indeed, a recent EBRI study labels certain people as "strugglers, impulsives and deniers" when it comes to planning their financial future. The species Participans Lethargus8 will benefit from paternalistic libertarianism expressed in the form of a Syntheti(k) Pension.

A Syntheti(k) Pension is a term to describe how a 401k/403(b) plan can be designed and managed so to the typical participant it looks, tastes and feels more like a defined benefit plan rather than a defined contribution plan. For too many employees the 401k/403(b) resembles a simultaneous exercise in actuarial science, modern portfolio theory and behavioral psychology. It doesn't have to be that way.

Sounds a little over the top? Maybe, but read on because...

"Man's mind, stretched to a new idea, will never return to its original dimension."

Oliver Wendell Holmes

THE ACCUMULATION PHASE

Certain measures can improve both the chances that a person will invest for retirement and that accumulations will be large enough to assure financial security.

I. Automatic Enrollment: We touched on this device last year. Barring some states' obtuse wage and hour laws, what is the logic of presuming that your employees are either independently wealthy or have taken a vow of poverty? This is a little sarcastic, but what are the real reasons employers don't embrace automatic enrollment?

Is it to keep contribution expenses low? Is it to avoid some extra administration costs? Is it because of a fear of being different? These are reasons our firm has heard. Clearly this approach to getting people enrolled is not for every company. But it does work to increase participation. The simple act of beginning to save and invest is the crucial first step on the journey to financial security. Indecision and procrastination are human foibles that can be easily countered with automatic enrollment.

And this idea can be used more creatively than commonly adopted. What about re enrolling people after some fixed period when they have stopped deferring? Or at least enroll all non-participants once every three years, a "Jubilee" event. There is something magical about a birthday that has a zero in it, go for it every ten years!

II. Matching: This is the old standby. Everyone loves to get some extra company money. Why not increase the match as a reward for continued length of participation? Expand the information campaign beyond the common admonition like "don't you want to double your money" when you enroll people into a dollar for dollar match. Short-term participants could have their decision reinforced regularly with a "plan level" rate of return calculation that includes the effects of the match. A good match is still a substantial economic benefit after ten or more years of participation.

Or present the proposition in the form of an opportunity cost. Have non-participants sign a document acknowledging that they are giving up free money they can never get back. Who in their right mind will "sign" away the equivalent of a pay raise? While you are at it, make the match 100% vested (safe harbor status). It is cheaper to compensate people with retirement plan contributions than with salary or bonuses.

III. Escalating Deferrals: Have you heard of the SMarT Plan? Professors Benartzi and Thaler introduced the concept several years ago. Inertia is a powerful force. So is assumed consent. Initiate the increases slowly, in one percent increments or less. Tie them to pay raises so the effect is minimized. What better time to increase savings than after a lo an is paid off (heaven forbid it is a plan loan, see step IX).

The most common point at which contribution increases cease is when the match limit is reached. But if you have a low matching formula, think again. Many studies indicate that most people need to save well over one month's income in order to obtain financial security in retirement. This benchmark is several times higher for baby boomers who got a late start. As we said last year, it is better to have money than not to have money. The driver behind most of these steps is that many employees interpret plan features and provisions to be de facto recommendations by their employer

IV. Professionally Managed Accounts (PMA): One of the realities that need stressing is that most people are either unwilling or unable to make sound investing decisions. What is being done with the common approach to self directed investing is the equivalent to sending a seven year old to the medicine cabinet by themselves when they complain of an illness.

In investment circles it is common knowledge that in the long run the typical participant in a self directed plan earns about two percent (2%) less than the vast majority of defined benefit plans. A broadly diversified allocation built around a 60/40 split between equities and bonds has served the pension community well for years. Take a page out of successful institutional investors' handbooks and make a "pension" like allocation a discrete choice that participants are defaulted into unless they make an affirmative election to control their own allocation. But make sure the option stays dynamic and is regularly re-balanced.

The construction of a PMA need not be limited to the funds that make up the menu. Certain asset classes that should not be offered as separate choices serve as good diversifiers to stabilize long-term returns and minimize volatility. If necessary, lifestyle funds could be used, but only as a last resort. These types of funds are interesting but are difficult to benchmark and hard to properly replace when they under perform. Note that "age based" allocations do not fit here. That concept is best reserved for advice solutions rather than straight forward trustee directed solutions.

V. Diversified Portfolios as Investment Guidelines: While the majority of people will be comfortable with the PMA, its return and risk profile will not suit everyone. The next best investment technique is to present other diversified portfolios that at least serve as guidelines for the allocation decision. They could represent a full spectrum of return and risk by bracketing the PMA, but limit the number of extra portfolios to no more than six. Too many options actually discourages participation. Portfolios should be constructed to target specific return and risk parameters. They can be made from the fund menu and automatically re-balanced if your record keeper has the modern technology to do so. While you are at it, make the portfolio exclusive from the other choices. The benefits of targeted diversification are nullified when other choices are naively mixed in.

Strange as it is, most people, when left to their own devices, pick less than four funds even when the menu offers many times more. One reason employees sabotage their investment plans is that they are betting instead of investing and don't even know it. To add insult to injury many never change their allocation, regardless of market performance.

VI. Investment Advice: Ok, some folks will be most comfortable with turning the entire process over to a professional firm by giving them full reign over their money. The need for this last step will be greatly mitigated if Steps IV and V are properly implemented. However, there is minimal cost to providing discretionary advice and only those people who use it pay for it, so why leave this base untouched.

An important reminder is in order. Selecting and keeping an advice provider is a serious and complex fiduciary decision. It should be managed in the same way you are charged with handling the investment choices. Don't let a vendor drag along their favored advice solution without prudently examining other worthy candidates.

VII. Core Investment Choices Should be Index Funds: Few quibble with the understanding that over the long run most actively managed funds in the major domestic asset classes will not outperform their indexes. Yes, some active funds give superior performance, but identifying them in advance is a gargantuan task. Many who lay claim to the skill have deluded themselves into thinking they are smart when they are actually lucky. Only Methuselah could statistically prove skill and not good fortune when it comes to picking managers (this goes for stock selection too). To blatantly claim so is akin to performing fraud on the investing public. The majority of the very few who actually know how to identify good managers won't work for you because they are busy sailing their yachts in the Mediterranean!

The point is that if thousands of educated, experienced professionals with all the modern resources can't identify the superior managers, why should the typical employee who is sleepwalking into retirement be forced to deal with the turmoil of sub-performing investments? Adverse performance can be a huge distraction that alienates the average participant. Landmark investing studies have demonstrated that most of a portfolio's returns are a function of allocating assets, not picking the best underlying investments. From a practical sense, far too many resources are devoted to trying to fix a problem that cannot reliably be solved.

VIII. Properly Educate Participants: Perhaps the most meaningful result of much of the research into participant behavior is the determination that conventional education campaigns do not work. They don't work because few people actually change their behavior in a positive way (try less than ten percent). This horse has been ridden into the ground and we are not even over the mountains yet!

Yet, sponsors should not give up on education completely. But it is time for a contemporary perspective on the issue. On a positive note, a primary benefit of the correct type of education is to reinforce the merits of the commitment devices being used to help the people. Let's finally dispense with the notion that we can turn people into apprentice CFAs. Educating is not training. Some other practical suggestions are to make the efforts short, sweet and explicit. The message should end with a simple directive as a call to action. Quick and easy facilitation should be emphasized immediately upon the completion of the session.

There is another approach to education that should be a prerequisite to any other information. People begin on the journey to retirement not knowing where they are really going. No one can plan effective investment strategies without knowing how much money they will need. Defined benefit plans will be disqualified if they don't actuarially determine their financial liability. Individuals should be no different. They need a realistic target to shoot for.

Therefore, at least once every three years useful information should be provided to employees about how much money they are likely to need in retirement. With today's technology this question can be answered in many dynamic ways. However, the end result needs to be a meaningful number a person can rely on and use to begin formulating their strategic plan. Think of this effort as being a tri-annual actuarial valuation of their personal pension liability.

THE DE-ACCUMULATION STAGE

IX. Limit or Eliminate Plan Loans: People need to accept that defined contribution plans are long term investment programs, not deferred spending plans. Broad availability of loans aids and abets self defeating behavior. Corporations cannot borrow money from their pensions without a prohibited transaction exemption. Why make it easy for naive investors to disrupt their fragile plans for financial security?

If loans must be available, make them hardship restricted with employee deferrals the only source of funds. It should go without saying that the limit be one to a customer. Sponsors should not expect their employees to comprehend the opportunity costs associated with plan loans.

X. Limit or Eliminate Hardship Withdrawals: Spending money dedicated for retirement with no mechanism to restore the account value is financial masochism. Defined contribution plans can be viewed as interest free loans from the government to fund a retirement plan. It is disastrous to voluntarily pay usurious "interest rates" (income and penalty taxes) unnecessarily. Frankly, some people need to make judicious use of the Credit Union before starting their retirement planning.

XI. Limit or Eliminate Distributions at Termination of Employment: The majority of pre-retirement distributions are spent, not saved. As with loans and hardships, most people need to be protected from themselves. While employers may not have a direct vested interest in preserving an ex-employee's retirement account, they are moral agents that hold a distinct position of influence in society. Desirable corporate citizenship should encompass facilitating the general good of the future retirement population. The overriding principle of fiduciary prudence can be extrapolated to many activities beyond just safekeeping the assets. Like it or not, sponsors are the last gatekeeper for employees exiting with their life savings.

So, what about keeping the company funded portion of the employees account until normal retirement age? Before current "modern sensibilities" came into play, this provision was frequently implemented. Or, how about requiring any distribution be made to another tax qualified plan or an IRA. Any impediment put between an employee and their money will help prevent the premature consumption of retirement assets that will likely be scarce later in life.

XII. Offer Annuities to Retirees: The most ignored financial risk is longevity. People routinely underestimate how much money they will need in retirement. And this miscalculation is made without comprehending the detriments of increasing life expectancy. What if we find a cure for cancer?! Immediate annuities (fixed or variable) have a legitimate place in many retirees' plans.

And no, you should not institute the dreaded "joint and survivor annuity rules" for you plan. Simply offering and explaining the attributes of an immediate annuity, with a specific product as a solution, is all that is necessary.

XIII. Monitor the program: As you adopt the principals of behavioral economics, make sure to regularly examine the results. Modern sponsor websites have the flexibility to compile almost any template necessary to study the success of each step. This kind of supervision should be part of the committee's quarterly meeting to monitor the assets. Fiduciary prudence relates to all the aspects of plan management, not just the investments.

A SOCIAL CONTRACT?

Believe it or not, you have an implicit contract with the employees. If you doubt it, consider the proposition of the "prisoners dilemma" as defined by another field of contemporary economic thought, Game Theory (remember a Beautiful Mind). This idea is the modern derivation of psychological reciprocity. Consider two people who stand to benefit from cooperation with each other. The conundrum occurs when one decides they can gain by not cooperating, "defecting", while the other is performing. The reality is that if both follow a course of self-centeredness, both end up worse off then if they helped each other. Looked at in this way, life is a zero sum game.

You may now be concluding that the person who most often gets away with taking advantage of the other will be the winner. Research demonstrates that the violator who is persistently self centered in this way will likely do less well than if they cooperated with the other party. Have you ever heard the term "passive aggressive behavior"? This activity can be implicit, even subliminal, and still be harmful.

So, a policy of "tit-for-tat" is the best way of assuring both players optimize their mutual well-being. Demonstrating legitimate concern for the employee's long-term financial security is a great way to signal you really are a team player, indeed, a partner. Most will respond favorably!

A CALL TO ACTION

A few quotes come to mind as admonitions for changing the way you are managing your defined contribution plan.

For the financially orientated: "When the facts change, sir, I change my mind-what do you do?" Sir John Maynard Keynes

For the psychologically orientated: "Progress means getting nearer to the place where you want to be. And if you have taken a wrong turning, then to go forward does not get you any nearer. If you are on the wrong road, progress means doing an about-turn and walking back to the right road; and in that case the man who turns back the soonest is the most progressive man." C.S. Lewis, Mere Christianity

For the rest of you: "If at first you don't succeed, then try, try again. Then if you don't succeed, quit. No sense being a damn fool about it." W.C. Fields

On a more serious note, give the people the choice not to choose. Given all the emerging evidence to the contrary, why lead people down a path that many do not want to follow? Most of you work for companies that would never think of bringing a product or service to market by pursuing a marketing plan so one dimensional. Many railroads went broke by seeing themselves just operating trains instead of being in the transportation business. The participant is your customer!

Or, look at the Syntheti(k) Pension like a twelve step program. Take what you like and leave the rest. Progress should be measured in increments. Working the program means progressing through the steps at your pace. You and the participants are on the journey to retirement. IT is the dream!

"We shall not cease from exploration
And at the end of all our exploring
Will be to arrive where we started
And know the place for the first time

T. S. Eliot

Bibliography

Never in the annals of ERISA has so many owed so much to so few.

  1. Susan J. Erickson, "Paternalism's Turn? Plan Design vs. Participant Education", Letter to the Editor, Journal of Pension Benefits, Summer 2002, p. 89-92.
  2. Lori Lucas, "Meeting the Financial Planning Needs of a Diverse and Paradoxical 401k Population", Benefits Quarterly, Fourth Quarter 2002, p. 15-21.
  3. Brooks Hamilton and Scott Burns, "Reinventing Retirement Income in America", NCPA Policy Report No. 248, December 2001.
  4. James J. Choi, David Laibson, Brigitte Madrian, Andrew Metrick, "Defined Contribution Pensions: Plan Rules, Participant Decisions, and the Path of Least Resistance", Pension Research Council Working Paper, November 2001.
  5. Donna M. MacFarland, Carolyn D. Marconi, Stephen P. Utkus, "'Money Attitudes' and Retirement Plan Design: One Size Does Not Fit All", Pension Research Council Working Paper, November 2003.
  6. Robert L. Clark, Madeleine B. d'Ambrosio, "Ignorance is Not Bliss: The Importance of Financial Education", TIAA-CREF Institute Research Dialogue, December 2003.
  7. Susan J. Stabile, "The Behavior of Defined Contribution Plan Participants", New York University Law Review, April 2002.
  8. Susan J. Erickson, "The 401k Makeover: What's New, What's Tried and True", Journal of Pension Benefits, Autumn 2003.
  9. Brigitte C. Madrian and Dennis F. Shea, "The Power of Suggestion: Inertia in 401k Participation and Savings Behavior", The Quarterly Journal of Economics, November 2001.
  10. Olivia Mitchell and Stephen Utkus, "Lessons from Behavioral Finance for Retirement Plan Design", Pension Research Council Working Paper, June 2003.

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