The Target 401k - An Idea Whose Time Has Come

By Matthew D. Hutcheson, an independent fiduciary and a nationally recognized authority on qualified plans and fiduciary responsibility. He is a Certified Pension Consultant and an Accredited Investment Fiduciary Auditor™. He may be contacted at matt@erisa-fiduciary.com.

It is easy enough to say how much someone will need - but it is far more difficult to make it actually happen! Before I explain the concept of the Target 401(k), let me provide some background and history.

In the early 1990's, the race to capture market share was nearly as intense as the race to send a man to the moon. Many 401(k) providers left the "participant" in the dust. As almost an afterthought, some of these same providers began to say, "oh yeah…them. I guess we had better start informing them about investments so they can make educated decisions."

In my opinion, this practice, although well intended, is vain in many cases. Why? Because investing is extremely dynamic and complicated by itself. Analysts spend months looking at various investments before constructing a portfolio, but we demand participants to choose and construct their portfolio after a morning enrollment session. Yes, it is true that their fund choices have been pre-screened in most cases, but by placing these decisions in the lap of the person who has the most to lose, an emotional component is introduced that may not ordinarily be part of an intelligent investment strategy. Emotion and a lack of information create less than optimal environment to develop sound and successful financial decisions. Many, if not the majority of, participants just don't get it (investment education/advice) but we should not expect them to. Why demand the most from those who understand investments the least? Herein lies the fallacy of our current 401(k) system.

Query: What is the real purpose of a retirement plan? To get rich? No, its purpose is to replace pre-retirement income. This being the case, what the 401(k) market should be focusing on is how to ensure participant accounts are on track verifying they (the account) will be able to replace a specified amount of pre-retirement income. Income and security is something all participants can understand. Let's focus our efforts there.

Enter the Target 401(k). The Target 401(k) is not a plan "type" but rather an ongoing "approach" to managing the 401(k) plan - with income replacement as its goal. It has all of the same components of a normal 401(k) except for three fundamental differences:

1. Elective deferrals, employer matching and profit sharing are optimally determined and re-determined year-to-year to zero in on, or "target" a specific level of income needed at retirement.

2. The participant is no longer burdened with having to select funds themselves. Worries, anxiety and frustration of fiduciaries and participants alike are no more. A professional investment manager is hired to develop a portfolio to accomplish a specific objective. The written investment policy statement becomes more functional and relevant.

3. The plan sponsor agrees to use profit sharing and matching as a tool to increase funding to the plan if it appears that the target for participants will not be satisfied. For example, if trust investment performance is poor, profit sharing contributions can be increased to "shore-up" the accounts to keep them on target. This must be an iterative process each year to ensure these minor adjustments are continually made.

Here's how it works:

Let's say that the goal is to replace 80% of the participant's pre-retirement income. By using simple actuarial techniques, numbers are computed to assist in achieving this goal. Certain assumptions must be made, such as:

• A normal retirement age of 65 is used for this example.
• An investment return of 9.5% per year is the goal in this example.
• An investment expert who understands this goal manages the portfolio.
• The written investment policy statement reflects the investment goal.
• An employer match equal to 25% of elective deferrals is given in this example.
• An employer non-elective contribution equal to 3% of pay given in this example.

Based on the above assumptions, take a look at the data below and how the numbers would look. (YTR = "Years to Retirement")

In the table above, you see each participant's age and their "years to retirement." You also see their wages and how much income will need to be replaced at age 65. For purposes of this article, the income replacement numbers do not factor in inflation.

Replacing income means accumulating sufficient assets to provide an annual annuity equal to the desired goal. In this case, how much would each participant need to have accumulated by age 65 to ensure they will be able to draw 80% of their pre-retirement wages, each year, for their entire life expectancy?

The amount needed to retire on for each participant is individually computed in the table below. Again, using some simple actuarial techniques and assumptions, we determine that each participant needs the following amounts:

Participant 1 needs: 1,322,640
Participant 2 needs: 621,720
Participant 3 needs: 594,000

And so on...

From these accumulated assets, we determine how much needs to be contributed - from all sources - to ensure the goal is met. Any contributions over the minimal amount would provide accumulated assets over and above the "target." As you can see, the contributions needed and the contributions made are nearly identical except for a couple younger employees who end up receiving more than they need - given this example - through profit sharing contributions alone.

Who wouldn't want to know they are "on target?"

Participant "1" should try to contribute $10,417 in 401(k) deferrals. Participant 2 should try to contribute $4,225 and so forth. Obviously a plan sponsor cannot force someone to defer a specific amount, other wise 401(k) deferrals would no longer be elective. However, who wouldn't want to know what they should be contributing? The targeted 401(k) deferrals plus the targeted employer contributions are the fundamental basis of a successful plan. So much time is spent on which investments to choose that those things than can be controlled aren't. A participant can control how much they contribute - and if the plan carefully determines the amount needed to stay on target each year - a participant no longer has to worry about whether they can retire. The participants do their part, the investment experts do theirs and the goal is attained.

Each year thereafter, the contribution amount is adjusted, generally upward in small, calculated increments, to ensure success. If a participant meets or exceeds the target, the plan has been a success.

For participants, there is peace of mind in knowing they are contributing the right amount, and that investment and consulting experts are consistently working toward a stated goal. For what does it profit a person if they gain control over their investment choices, yet lose control over their retirement?

New Conceptual Participant Education Begins

Educating participants about investments is a good idea, because it will benefit the participant in other ways in addition to the plan itself. However, it is my opinion that if we truly want to help participants internalize meaningful data and concepts, we need to consider the basics and fundamentals. Consider the following:

• Participants should be educated about income replacement concepts first.
• Financial education is very good - but requiring participants to make the own investment decisions is not statistically helpful to them.
• Stick with investment strategies that work - delegate investment management duties to Registered Investment Management/Advisory companies and let them do what they do best.
• Can we really argue that a fiduciary has less risk by passing investment selection responsibilities to participants? Do statistics prove that participants are greatly benefited by it? Are participants more knowledgeable than professional investment analysts? Who are we supposed to be taking care of anyway?
• It seems to me that the lower the return (statistically the participant directed account) carries with it far more fiduciary risk than a scientifically and professionally managed portfolio, handled by an independent fiduciary and manager.

This concept obviously will not work for all plans, nor should one try. It is only a strategy that should be considered as an alternative to the conventional approach. I suppose that this dialog could be expanded upon significantly, but to summarize, professionals and plan sponsors should consider focusing more on income replacement, not fund returns. Consider hiring professionals who can do what they do best on each individual plan component, i.e. managing the portfolio and actuarially determining needed contribution adjustments. By allowing a concerted effort of highly trained experts - along with the Target 401(k) concept - we can alleviate much of the speculation of whether Americans will enjoy future retirement security. ~ MDH

Need More Information?

Matt would be glad to discuss this issue with you further. You may email him at matt@erisa-fiduiary.com. Matthew D. Hutcheson, President of MDH Consulting, Inc., is a Certified Pension Consultant and an Independent Fiduciary located in Portland Oregon.