Posted on 31 May 2011
By Mark Miller
Automation of workplace retirement plans has spread rapidly in recent years. But automation has its drawbacks.
The Pension Protection Act of 2006 (PPA) set the stage for retirement plan sponsors to step up automatic opt-in enrollment for new workers, and it’s resulted in much higher plan participation rates. Growing adoption of other automation features have helped to address the unfortunate reality that most workplace retirement savers don’t pay much attention to their contribution levels, rebalancing or mutual fund selection.
Yet plans often set default contribution rates too low. More than half of large plans set initial contribution rates for auto-enrolled workers at three percent, according to a survey of large defined contribution plans by the Defined Contribution Institutional Investment Association (DCIIA). This despite the fact that survey respondents acknowledge that the optimal rate is 10 percent or more.
If you’re only contributing three percent, consider boosting your contribution rate to a level that at least takes advantage of the maximum match offered by your employer.
Another shortfall in many plans is the lack of automatic contribution escalation. The DCIIA survey found that only one-third of companies with auto-enrollment have tied the opt-in default to an automatic increase feature, which bumps up your contribution rate annually — typically one percent — until the maximum is reached. If your current contribution rate is in the three percent range and your plan has an auto-escalation feature, consider adding it to your account if you can’t afford a big one-time bump.
Finally, the auto-enrollment trend has set off a boom in the use of target date funds (TDFs), which invest in a mix of assets and aim to reduce equity exposure as participants approach retirement. TDFs have become the most popular default investment option for plans with auto-enrollment features.
TDFs are a reasonable response to the problem of investor inattention to their portfolios. Numerous studies show retirement savers hurt themselves by trying to time the market, failing to rebalance and making poor fund selections.
But at the same time, many retirement investors don’t really understand how TDFs are allocated between equities and fixed income. Fees can be high, and some critics don’t think TDFs are structured to select the best-in-class funds for all asset groups.
If you’ve defaulted into a TDF, watch for these common problems:
Misunderstandings about risk: TDFs have come under fire for maintaining high equity allocations even in funds tailored for investors near retirement age. Many TDF investors near retirement age suffered dramatic losses in the 2008 market crash. Target funds labeled with dates between 2000 and 2010 lost 22.5 percent in 2008, and funds with target dates between 2011 and 2015 lost 28 percent, according to Morningstar. But those are broad averages; some funds with dates as early as 2010 lost as much as 50 percent of their value in 2008.
The industry notes — correctly — that the glide path for most TDFs isn’t the target year of retirement, but some point beyond. “More TDFs are designed to deliver investment strategies for life — not just for your working life,” says a spokesman for the Investment Company Institute (ICI). “Few, if any, serious financial planners would recommend a 100 percent cash (or cash-and-bond) portfolio for a 65-year-old facing the potential of 30-plus years in retirement.”
Fair enough — but that only points to the challenges of education and expectation-setting created by the way these funds are named. Disclosure and transparency also need to be improved; even Morningstar commented in a recent report that it has had trouble getting consistent information on basic glide-path allocations in TDFs. If Morningstar can’t figure it out, imagine the challenge facing the average investor.
High fees: Critics charge that fees often are too high due to the “fund of funds” construction of TDFs. Many TDFs charge fees for the underlying funds plus an overlay TDF management fee. The industry disputes this criticism; ICI notes that the asset-weighted average expense ratio for TDFs was 0.66 percent of assets as of May 2009, compared with 0.84 percent at year-end 2008 for comparable stock funds, and 0.63 percent for bond funds.
But a report from Brightscope, which measures and analyzes 401(k) fund performance, argues that asset weighting masks the true costs of most TDFs. Brightscope research indicates that the only two target date fund series with expense ratios below 0.66 percent are those of Vanguard, with a rock-bottom 0.19 percent and USAA (0.64). “The rest of the funds have fees over 0.66 percent,” Brightscope reports, “and over 50 percent of series have fees that are one percent or higher.”
Home cooking: TDFs usually are assembled from in-house, proprietary underlying funds run by the record-keeping companies hired by plan sponsors. The problem: No one company will have best-in-class funds in every asset class. “One company might excel at large cap funds,” says Adam Bold, CEO of The Mutual Fund Store, a fee-only investment advisory. “But when you blend the return of all the proprietary funds in the TDF and layer on fees, it dilutes the performance down to mediocre or worse.”