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 between the floor of the train and the station platform. Stepping in the gap could result in a broken leg or worse.
“Mind the gap” also applies to the 401(k) world and there are many pitfalls, any of which can cause a broken retirement income.
Brooks Hamilton a well-known ERISA attorney describes three gaps or what he calls “yield disparities”. There are other gaps, all of which hurt the opportunity for employees to have meaningful future retirement income.
Gap 1 – Difference in investment returns amongst participants
Some plan participants have great returns and others have poor returns. Brookes found that generally; the plan participants with higher incomes had higher returns than those with smaller wages. This gap could be due to the “richer” participants having access to outside investment advisors or perhaps 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 has been stated to range from 2% to 21% per year depending on market conditions
Gap 2 – 401k-plan investment returns lag market returns
The below-average performance of most 401k plans is often attributed to the high fees built into programs by the financial services industry as well as the utilization of poorly selected or monitored funds. Participant’s inexperienced investment behavior is also a factor. In another multi-year study in the late 90’s with 5 well know financial institutions, including Morningstar and Citigroup, Brookes reports that the gap between market returns and 401K returns was 8% per year.
Gap 3 – 401k investment returns lag Defined Benefit Pension plan (DBP) of 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, this gap between 401k and DBP’s was found to be 1.9% per year. This is very close to the 2% that is reported in other studies since. A 1% reduction of return per year over time can lead to a reduction in funds at retirement of 28%. That would be the difference of $1,000,000 and $720,000. Which would you prefer?
Gap 4 – Big plans usually have higher returns than smaller plans
Economy of scale is part of the reason. With a larger plan, costs can be spread over more accounts, so the costs as a percentage are smaller. There are changes that small plans can make to improve their returns.
Gap 5 – Difference between the ERISA required fiduciary duties of the plan sponsor 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 can lead to more retirement income.
Gap 6 – Participant’s actual rate of portfolio return rate vs. the required rate of return for meaningful retirement income
Most participants do not know what the expected rate of return is for their portfolio so there is no way to calculate the expected retirement income. As a result, these participants either need 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.
Gap 7 – The gap between the number of total company employees and the number of plan participants
Few employers have 100% participation in their company 401k. The whole purpose of the 401k is to provide retirement income. If a participant does not participate they lose. There are features that can be put into a plan to increase participation. Those companies with “opt-out” feature have higher participation rates than those with “opt-in” enrollment. Obviously an employee that does not participate or delays enrollment will have less than an ideal retirement income.
Gap 8 – 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 to any great extent. The DOL has recently issued new regulations that could limit education in the future.
Gap 9 – The performance gap between Bundled and Unbundled plan providers
The service providers include, Third Party Administer, Record Keeper, Custodian, and Investment professional. Many times these are all in one and the fees are very difficult to understand. In other cases a plan can hire the best of class in each area and have better control of costs and the quality of service. If one provider is lacking, retain the others and replace the poor performer.
Gap 10 – Legal protection gap between plan salesmen and Fiduciaries
Broker Dealer or Insurance company representatives have a contractual responsibility to their employer not to the plan sponsor of the participants. Whereas, a RIA or Investment Fiduciary is required by law to always keep the plan and plan participants interest foremost at all times. The sales people from the financial services industry have negatively impacted participants for too long. In part due to the plan sponsors not having the experience or time to complete the proper due diligence when working with a plan salesman.
When working with an Investment fiduciary the plan sponsor has a much higher chance to operate the plan and produce higher retirement income for the participants since the Fiduciary standard of care is the highest legal.
All these 401k gaps will lead to reduced retirement income. The question is how does a plan sponsor or employee “mind the 401(k) gaps” and obtain meaningful retirement income?
The best answer is for the plan to hire an Investment Fiduciary to act on behalf of the plan and it’s participants.
This answer is actually contained in the Department of Labor guidelines, which says that if the plan sponsor does not have the experience or knowledge of an expert in running the plan, than the plan sponsor must hire one. The big problem is that most plan sponsors hire a “salesman” who is subject to conflict of interest rather then a unbiased Fiduciary expert acting as a 3(38) Investment Manager or a 3(21) Co-Investment Fiduciary.
The Fiduciary is not a part of an investment or insurance company, record keeper or custodian and as a result has no conflicts of interest. These professionals will provide insights based on their training and experience solely for the benefit of the plan and the participants.
An investment fiduciary will analyze the plan and make recommendations to increase the participant’s opportunities for increased retirement income. These enhancements could include:
- Modifying the plan to increase participation and contributions
- Reviewing service providers to get the best in each field
- Writing an Investment policy Statement
- Designing model portfolios (based on Generally Accepted Investment Principles) that maximize the return for the risk taken
- Providing investment advice to the participants
- Helping the participants chose the best model for their situation
- Monitoring the portfolio investments and making changes if needed
- Helping the employer meet its ERISA responsibilities and decreasing 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 ERISA responsibility of the plan sponsor according to the DOL to manage the plan and “mind the gaps.”