Imagine a 401(k) plan that does not allow participants to direct the investment of their accounts, a plan where trustees make investment decisions on behalf of the plan as a whole. Some might consider that blasphemy. Participants want – no, they have a right – to direct the investment of their retirement accounts.
As radical as it sounds, it was not that long ago when participant investment direction was rare. Technology has been the single biggest factor in enabling plans to permit participant directed investments. Throw in a threat of fiduciary liability, some marketing, and we have a train that cannot be stopped. I am not suggesting that this train needs to be stopped. I do, however, think it is time to step back and take a look at where this train is headed.
Over the years I have asked attendees at retirement industry conferences whether they think participant directed investments are beneficial for participants. In most cases, the answer is NO. There are a small number of individuals who have independent investment advisors who need the ability to direct their investments and manage their entire portfolio. But, for the vast majority of participants and plan sponsors, it is difficult to determine the benefit/cost analysis.
The most touted benefit of participant investment direction is control: each participant is able to make an investment decision that is best for his or her individual circumstances. I think there is also a social benefit that cannot be overstated. Financial literacy is a national concern, and the retirement plan industry has not only highlighted the problems we face, but also made progress in solving the problems.
We know that the retirement plan is the single biggest savings for many participants. Retirement plan providers are able to give participants access to extensive educational materials and tools, including more cost effective access to investment advisors. This is a benefit that extends beyond just retirement plans. Some providers also believe that participants will not make deferrals to their plan if they are not able to control the investment of these deferrals. This is debatable, as some providers believe participants are paralyzed when confronted with investment decisions, and this may inhibit, not enhance, participation. Lastly, from a plan sponsor perspective, there is concern about fiduciary liability. The Employee Retirement Income Security Act (ERISA) provides protection to fiduciaries where investment losses are due to a participant’s own investment decisions. Thus, some believe that allowing participants to direct their investments helps minimize fiduciary liability.
The costs of participant investment direction are equally as difficult to quantify. Providers spend countless dollars to create all of the tools and materials that are needed to educate and enable participants to direct their investments. This may be wasted money if it is true that the majority of participants just do not care. Hence, default investment options are needed when no investment decisions are made, leading to the proliferation of target date funds. Rather than educate participants on portfolio management, providers create the “easy button.”
Another cost is the risk of participants making poor investment choices. Unfortunately, the cost of poor investment decisions can be devastating if it results in individuals not having sufficient assets for retirement. While ERISA may protect the plan fiduciaries from liability for these poor investment decisions, permitting participant investment direction might also increase liability. There are more investment transactions that can go wrong (e.g., I instructed the plan to invest in Fund A, and due to a processing error, the trade did not take place, and I missed a market uptick). In that case the loss was caused by the plan, not by a poor investment decision.
One final cost that is particularly acute this year is the implementation of new Department of Labor fee and investment disclosure requirements. All of the new disclosure requirements for participants (as distinguished from disclosure to plan sponsors) apply only to plans that permit participant investment direction. This will increase costs in the short-term, but the hope is it will increase financial literacy and enable participants to make more informed investment decisions.
I recently came across a 401(k) plan using a plan design that I have been thinking about for quite some time. Participant investment direction is not permitted until an individual nears retirement (e.g., is age 55 or older). This is similar to Employee Stock Ownership Plans where certain older participants have the right to diversify their investment out of company stock. The theory is that as one nears retirement, he or she may want to invest in less risky investments, and he or she may actually be willing to take on investment decisions because money management will be critical in post-retirement years.
There is no right or wrong answer when it comes to participant investment direction. I welcome your thoughts.