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Can 401(k)s Get the Job Done?

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. Just about any discussion you'll have about how retirement has changed in the last 30 years will come around sooner or later to the 401(k) plan. As Corporate America had shifted from defined-benefit plans, or pensions, to defined-contribution plans, such as 401(k)s and 403(b)s, more of Americans' retirement security is now in their own hands.

Now we can discuss whether that's a good thing or a bad thing, and we will. But more importantly at least for the foreseeable future the 401(k) plan is going to be front and center in most Americans' retirements.

The practical issue is how do we make this work? Well joining me are three of Morningstar's finest: Morningstar's Christine Benz, our director of personal finance, David Blanchett, head of retirement research for Morningstar Investment Management, and John Rekenthaler, vice president of research for Morningstar and also columnist on who has written about 401(k) plans a lot in the last few months.

Thank you all for joining me and digging into this very important issue what we can do with these 401(k) plans and similar plans now that we have them as a big part of our retirement here in the U.S.

Let's start out very simply and just talk a little bit about the structure of these plans and how they work. There are a lot of folks involved in 401(k) plans. Of course they are administered through employers, so you get access to these plans based on where you work. But there are a few people involved in running them and managing them.

David, can you talk first of all about who's involved in the 401(k) plan, and who's making these decisions?

David Blanchett: The employer is what's called the plan sponsor; they chose to setup the 401(k) plan for their participants. 401(k)s are based upon on an Internal Revenue Service statute, but they are all very different. There are a few different ways you can actually build a 401(k) plan for participants. There are different features. Some plans have automatic enrollment features. Some plans do not. Every plan is a little bit different because every employer is a little bit different.

Stipp: There are different people who are potentially responsible for offering the plan, managing the plan. And there are also the fiduciaries who are responsible for what's actually in the plan and [determining whether it's] the best thing for fundholders. Who are some of the players?

John Rekenthaler: There are a lot of moving parts in this. You've got the plan administrator, a record-keeper, somebody who keeps the records. You've got the investment provider, which may be the same as the record-keeper or maybe largely the same. Often they are partially the same, but there'll be investment funds from other organizations. [There is the] record-keeper and the investment provider. There is often a consultant involved with a larger or a midsized company as well, or somebody settling in to an advisor role if it's a smaller company.

There are quite a few different participants along with the plan sponsor, which makes sense because after all, with the plan sponsor, unless it's a really large company, the company probably does not have somebody who is devoted to understanding ERISA Law and investment management issues.

That's a funny thing about the 401(k). The 401(k) is governed under ERISA Law. This is pretty specialized stuff, and to be a proper fiduciary requires quite a bit of investment knowledge. And small or medium-size companies have other things to do besides becoming investment experts.

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Stipp: They don't always have that…

Rekenthaler: It's not their business.

Stipp: At the end of the day, who is responsible for what's in my 401(k) plan? Who has picked that lineup of investments for me? Is it my employer?

Rekenthaler: The plan sponsor is the sign-off party and has responsibility for that. [But the sponsor] may have been assisted along the way, though.

Blanchett: They can delegate that authority to an investment manager under what's called section 3(38). But by and large it's the plan sponsor, the employer, who is responsible for that choice. They can choose to delegate someone else to make the decision, but at the end of the day, they are the fiduciary for the plan.

Stipp: And so is this potentially a problem for the structure that we may have people who aren't investment experts, who're ultimately responsible for the investments that I'm going to be putting money into my whole working career and eventually retiring on? Is that kind of a blind spot with this structure?

Rekenthaler: I'd say it used to be more of one. This has largely been resolved because over the 30 years or so that 401(k)s have been around--I'd say 20 years as being really mainstream--that's become body of knowledge. The providers that are coming to the plan sponsors are now coming with pretty standardized target-date funds and this, generally speaking, "Here is the cost structure for your size company," is fairly standardized to how much the funds cost and what kinds of funds are in there and so forth.

And it's been vetted. It's not the Wild West anymore where there were these huge differences between the providers. They've come together.

Christine Benz: I would argue that it is still a blind spot, though.

Rekenthaler: How about less of a blind spot?

Blanchett: It's less of a blind spot, I would say.

Benz: I was on the board of a rather large not-for-profit, and the person who was in charge of administering the 403(b) plan assured me that the plan costs were really low, the funds weren't charging any more than 1.5%. And she thought that was OK.

That's not OK. That's a very high price tag. I think that there still are plenty of people who are entrusted with managing these assets who really aren't clear on what their standards should be.

Rekenthaler: And I should clarify, probably on the costs there is still more work to be done. People are benchmarking costs and understanding what is normal for a company of a given size, I think, on the fund lineups. For one thing, what the mutual fund companies are offering, they have 75%, 80% market share with the three biggest Fidelity, Vanguard, and T. Rowe Price. There are some differences, but we are talking shades of differences among those.

Blanchett: To John's point my concern is that, is if you're that person who runs a company has 20 employees, how much time can you spend devoted to reviewing the 401(k) and understanding why this is better than that? So I think that while things have improved, there are still lots of ways that companies can get better if they have like a fiduciary or someone who is real true advisor to help them make the right choice.

Stipp: We've seen some dire statistics about the savings in 401(k) plans, and I guess part of me wonders these plans aren't necessarily as old as some people who have been out in the workforce so there might be some savings elsewhere. When you see the savings stats on 401(k)s is it alarming to you? Do you see alarm bells about what's been called the retirement crisis because there isn't enough money as there should be in these plans?

Blanchett: I think so. I mean if you look at the average 401(k) plan. The average participant is saving about 6%, and in most plans about two thirds of folks who are eligible actually are in the plan. So that means only about on average, the average employee is saving about 4% for retirement; 4% of your pay will not get you to retirement successfully. You need to save more than that and most people simply aren't saving enough.

Stipp: Here's the bigger question. Back when we had pensions, your company was doing that for you; it was happening behind the scenes. And now what we have is a much more voluntary system, and we'll talk about some things that maybe make it a lot more automatic in a moment. But essentially you can choose not to participate in your 401(k) plan. So if we are banking on the 401(k) to fund retirement in America, and its voluntary, is that a problem? Is this going to work? John?

Rekenthaler: It's a problem. You kind of answered your own question, right? If it's a voluntary system and the primary system, and we know that some people won't participate, then what are you going to do with those who just don't have money when they retire?

On the other hand, as I have often pointed out, under the old pension system there was nonparticipation of a different way. I mean my parents are not the only ones that just couldn't stay at the same place; they were restless. They didn't have pensions when they retired. Really it was basically off of meager savings and Social Security, because you had to be at a company long time to get that pension.

When we look back and we think about the old system, when we say we are in a crisis now, we were in a crisis then. We might not admit to it, but we were in a crisis then because people who weren't at large companies that had good defined-benefit plans and didn't stay at those companies for 20 years--and there were a whole lot of workers like that--they also were, they were out high and dry.

So, I'd say it's a new type of crisis as opposed to saying it was fine before. Now we are in a different place, but the old place wasn't all that great, either.

Stipp: Christine, what's your sense of people's rate of savings and the role of 401(k)s being so central now and also being a voluntary system essentially.

Benz: Well the most recent statistics I saw from Fidelity, which periodically put out average 401(k) balances, I think the average Fidelity 401(k) participant had something like $85,000 in the 401(k). People who had been in the plans for 10 years or more who are over age 55 were doing a lot better; they had $270,000 in their 401(k) plans. But it's still not enough.

Especially when you consider the fact that the length of retirement is extending so much, so that the typical retirement is now much longer than it was even two or three decades ago. I think it's a big problem. I tend to be a little bit more paternalistic on this issue and am in favor of possibly thinking about compulsory savings in 401(k)s or in some sort of retirement plan because the current system is just not serving a lot of participants well.

Rekenthaler: I will point out that depending on where you want to go with the answer, you can come up with a lot of different numbers. What's the average 401(k)? For one thing average versus median will give you a different number. How old the participants are and whether you're choosing from. Because if you just take the workforce overall, particularly if it's a company that's younger, 35-year-olds may not have a lot of savings and the number looks terrible. But on the other hand, they are 30 years away from retiring, too. It's not to deny that this is a major issue but also it's really tricky this whole what's the average or median?

Benz: Well, another issue is if you look at 401(k) balances--and they might average a certain amount--that doesn't take into account that people change jobs a lot and might have money in IRAs elsewhere.

Rekenthaler: So just understanding the nature of this crisis or how large it is.

Stipp: It's a tricky question.

Rekenthaler: It's a tricky item.

Blanchett: For me, I guess, 401(k)s are excellent in theory. The problem is that the people who use them don't do a very good job. People are not good at figuring how much they have to save, how to invest, and things like that. In the past that was the employer, the defined-benefit plan, but today it's individuals. And so you mentioned things like automatic features. I think that's a great way to kind of nudge people in the right direction when it comes preparing for retirement.

Stipp: What about the fact that if I want to withdraw money from my 401(k), I can do that before I am retired or I can use it as an asset and take out a loan which maybe isn't quite as bad. But should I have as much access to my 401(k) as I do have legally speaking?

Benz: I'd like to see some of that access removed even though there are steep penalties and taxes that you'll face for premature withdrawals. I would argue that the slippage is too great, that there are too many people who are yanking their money out prematurely. And a lot of that happens when someone leaves an employer, I think you should have two choices, not three at that point, it should be either, you do a rollover into an IRA or you can go into the new employer's plan, but you cannot take your money at that point. I think that is when a lot of money leaves the plans.

Blanchett: That's a plan-sponsor choice, either loans or hardship withdraws. I think that I agree with Christine. It's a good theory to have access to, but it's very costly. I think that most people don't understand that retirement really is 30 years. You have to wait to make that decision. So by giving them access today, they make poor choices.

Stipp: We've been talking about some of the negatives of 401(k) plans. There are also some pros to 401(k) plans that you wouldn't have with a pension, and one of them--as you were alluding to before, John--is with 401(k)s there's more portability. So you can roll over a 401(k) to another type of account. You can roll over into a new 401(k) account. But what would you say are some of the benefits of the 401(k) plan that you don't necessarily hear about as people are talking about this retirement crisis that we have going on.

Rekenthaler: I think the benefit is portability, portability and portability and everything else as much. The fact that you might control your investment option, most people don't want to do that. You can have a pension committee. But the portability you can't overstate the importance. Again it is my personal background with the family that moved around; defined-benefit meant nothing. I mean it was zero. And portability and being able to take your assets with you, the fact that it's yours. It's not a company obligation. It's yours.

Stipp: Well, that's right, is it more diversified if you've invested yourself in the securities versus a company which might have underfunded its pension?

Blanchett: Those are two different issues. One, was the employer making the right contribution to fully fund the plan? And in many cases they do and many cases they don't. But a separate issue is investing. I think that the average defined-benefit plan was better invested than the average 401(k) participant.

Now that's changing with the introduction and adoption of target-date funds. I think the worst idea was to make every single person a portfolio manager of his or her own account. Then you saw massive allocations to company stock, to single mutual funds. But now we're moving to a place where participant allocations are more diversified and better than they were five or 10 years ago.

Stipp: There was too much room for error, but we're starting to put up better guardrails so that we're getting better-diversified portfolios for that retirement need. What about some of the other things with 401(k)s, Christine, like that it's automatic and it's just coming out of my paycheck and I don't have to think about it.

Benz: That's a beautiful thing. When we look at investor behavior, one thing we see is that if the participant is making regular purchases, at regular intervals, that tends to lead to a pretty good outcome, versus the investor who is deciding when to deploy the money. So I think that 401(k)'s make investing painless and that's a really good thing in terms of investor outcomes. Another thing I would add is that especially for a very large plans, sometimes you have very low-cost investment choices that aren't available to you as an individual investor and you might also have fund types, like especially stable-value, that are not available outside of the 401(k) confines.

Rekenthaler: If I can simplify, which I like to do, when you look at defined-benefit versus defined-contribution plan, 401 (k), the big items on the 401 (k) are the portability, which is good for the investor and offloading the risk off the books from the company perspective. Those are really the two big items. That's where we started. Since then really what we've done is tried as an industry to say portability is great, but everything else about the defined-benefit plan, we want that back.

We don't want the investor becoming a portfolio manager; we don't want the investor making choices. We want this to be automatic and invisible and so the target-date fund is making this a little bit more like how a defined-benefit pension is run. The automatic-enrollment programs are making this more like a defined-benefit plan. So really it is trying to keep that portability which it was a massive advantage when we moved to the 401(k).

But then move the rest of this. All that great choice and freedom stuff about the 401(k)--you can get at the assets and you can invest them the way you want--most people don't find that to be an advantage, and it hasn't been an advantage for the public. So it's keeping the portability, but trying to get those other aspects of the defined-benefit plan back.

Stipp: A lot of you have hinted at some of these innovations we can call them in the 401(k) industry. Let's talk about some of them specifically. You mentioned more target-date funds are available in 401(k) plans, and these are funds that will change their allocations over time as the participant gets older and gets closer to retirement. There are some other features of 401(k) plans, though, that we've seen that have some behavioral hooks, specifically auto enrollment and auto escalation. How do those work, David, and why are they a good thing for 401(k)s?

Blanchett: It used to be in 401(k) plans, when you enrolled in a plan, you had to be proactive. You had to say, "I want to save 8%; I want to be in the plan." After the Pension Protection Act of 2006, there is a new rule where plans can automatically enroll you. So when you sign up, when you join the employer, you're automatically enrolled in the plan saving, say, 6% per year. Then it may increase by 1% per year. So all of a sudden, the default isn't, "I am not going to save anything." The default is "I'm going to save 6%." And if you've seen studies on this, it leads to a potential massive increase in the savings rates for plans. I think one early problem with plans that added this feature was they had the default at 3%. Well, if the default is at 3% you know that most new participants come in and they save 3%. Well, if you make the default 8%, it's kind of a huge spike or increase in your overall participants' savings rates.

Stipp: You were saying before a 3% default is probably not going to cut it for most people.

Blanchett: It will not get people to retirement. There is this endorsement effect. If your company is telling you that you should sign up for this and if you do, you save 3%, then those folks who don't know how much they have to save will just save 3%. So I think that that number is very important because it kind of sets that initial starting point for that person to think about how much they should be saving.

Stipp: Christine, beyond this, the auto enrollment and the auto escalation, there are caps on how much you can contribute to a 401(k) plan. So if I'm maxing out my plan, can I say, "I'm done with retirement. I'm set. I've maxed out my retirement plan?"

Benz: It really depends on your own individual situation. I think for some people that may be sufficient. For other people at very high income levels, that is not sufficient. They need not only the 401(k) but their IRA and possibly some taxable assets. It's very individual-specific. That's why I say either work with an advisor or use some sort of calculator to make sure that savings rate is in the right ballpark.

Rekenthaler: It also depends when you start. If you're maxing out starting at age 25, which is probably not going to be the case, that's very different than maxing out starting at age 50. So how long you're invested has just as much or more to do than the peak amount.

Blanchett: But that's a great point is, is how much do you have to save? How does the average person use that question effectively? People aren't actuaries; they aren't investment professionals. They don't know how much they have to save to achieve retirement success. So for some folks, maxing out could be great. For other folks, it's not nearly enough because they waited until they are 50 to start saving for retirement.

Rekenthaler: Or they have big dreams or something.

Blanchett: Yes.

Stipp: Given that we do have these auto-enrollment features kicking in, I think we've seen some of the effects of that with target-date funds and some of the assets under management increase that we've seen there. But, John, overall, when you look at the 401(k) industry, more people will be participating with this auto enrollment.

Are more people participating in a system as we were alluding to before, that is fundamentally better than it was before? Better investment options, better fees. How many people would you say are essentially covered by good plans versus how many people, if they're auto enrolled in their plan, that might not actually be the best thing for them?

Rekenthaler: Most people are covered by good plans because most people are in larger to midsize companies that are able to get very cost-competitive plans and usually from the major providers with all the modern features in there. So when you go and you look at Fidelity or T. Rowe or Vanguard, again with 75% of the assets in the industry and they talk about what they're doing to serve their customers and with all of them they have the new features in there.

But the issue is most of the plans, not most of the people or most of the assets, but most of the plans are smaller companies and that's more of a backwater business. That's really where the issues are in this, at least to my view. I don't think my panelists fully agree with me. They see maybe a little more of a crisis with 401(k) savings or so forth.

I happen to be more of an optimist there. I think we already have a very high level of participation, not 100%. And we can make it compulsory and go to 100%. But there is a very high level of participation at larger companies with these auto-enrolled, auto-savings plans. Many of these companies are dumping most people into target-date funds, and they're staying there. That's all fine. It gets funnier in the smaller companies. That's the biggest issue, and that's what I hear also. When I write my columns on the subject, people say, "OK, that's fine, but let me tell you about my [company's plan]." It's always a little company [that has issues, and after listing to these readers], I say, "OK, that's not a good plan; you're right."

Benz: I want to make a quick comment about auto enrollment because I think there's a lot to like about auto enrollment, especially into target-date plans. One thing that I've seen is that matching contributions tend to go down when companies institute auto enrollments. So, that's just something to watch if you are in a company that has suddenly added the auto-enrollment feature, watch what's happening there.

Rekenthaler: The company is little less enthusiastic about its money.

Benz: Well they know they're going to be spreading those contributions across a bigger base, yes.

Blanchett: And one thing with auto that I actually like is the idea of having reauto enrolling every year. It's a relatively new concept, but go in every single year and reenroll everyone in the plan. The idea being that some participants may opt out initially, and over time, we try to rescoop them up as much as you possibly can to get them to make the right choice.

Stipp: And what about auto rebalance? This is something that some plans will offer you. This could be a good thing for investors over long periods of time?

Benz: I think it could because it allows them to be even more hands off, and rebalancing over time does tend to take a little bit of volatility out of a portfolio, which will, I think, tend to make it even easier to live with. So, I like that feature.

Stipp: I had mentioned at the top a few different types of defined-contribution plans. 401(k)s are the big one, of course. There are few others. 403(b)s are ones you will often encounter in nonprofits. There are a lot of similarities. What are some of the differences though, Christine?

Benz: I think a key one is that you will often find annuities inside of 403(b) plans, and anecdotally, I think there is even less oversight. It's even more of Wild West atmosphere with 403(b)s. You tend to have multiple providers. So, I think that there are some key differences. Overall, I think that the costs can be higher with 403(b)s than is the case with 401(k)s.

Blanchett: There are different fiduciary rules for 401(k)s or 403(b)s. I think that's a big part of it. There is a lot more of a fiduciary focus in the 401(k) space that you don't see in the 403(b) space.

Rekenthaler: And an accent in history really, just coming out of these different regulatory codes. This wasn't done from top-down. People finding an angle from existing regulatory codes and building these. So, there is no reason that we should have a 401(k) and 403(b). I mean in an ideal world there'd be one retirement plan, but once you start having these multiple plans, it's hard to get agreement to get it all consolidated into one.

Stipp: A lot of other Morningstar readers we know are in the government TSP, thrift-savings plan. Generally it has some good options in it?

Benz: It does. It has very low-cost index options. I think that in a lot of ways it's a model for what 401(k) plans might be. It has all-index products as well as what's called the G Fund, which is kind of hybrid between cash and a government bond except that it's guaranteed. So, it's a great plan and has good target-date options, as well. I think that people who are in the TSP are very well-served by it.

Rekenthaler: Christine, should we just make that the national plan and go into that?

Stipp: I was going to say, she was saying it has good options and could be a model, should we maybe have more regulation about what's required to be in a 401(k) plan as far as we have caps on certain fees, we have to have an index option, or we need something that's highly diversified? Is that something that maybe should be on the table to enhance, again, the guardrails around these plans for people?

Rekenthaler: I think it should be. I'm on record as saying I don't think politicians should be regulating investment policies when asked about target-date funds. And after 2008 they were looking at rules that you could only put so many stocks in this kind of fund and limit the percentage, and that's getting into investment management details. But that's different than these issues of how a plan should be structured, what types of funds should be there, and what the costs are. And let's face it. This is kind of by default maybe because again it came up through the bottom-up, but it is national retirement policy de-facto.

Stipp: David, do you think that this is something that in the marketplace people will just begin to understand what does a good 401(k) plan look like and it's just going to be something where some of these more marginal plans that have really bad options just can't survive anymore?

Blanchett: I think, that if you mention the TSP, to me the TSP is like a really large 401(k) plan. If you look at like maybe the top 50 largest 401(k) plans you'd see very similar TSP-like features into them. And so, I think the key that the TSP has is economies of scale. And then if you're dealing with a plan that has 10 employees versus a plan of a million, you can make the costs much lower for the plan with a million participants.

Rekenthaler: And bargaining power. It's just not really that but the knowledge because you got the knowledge base now. You have got a company that big, you have got a segment that is an expert in this matter, and they know what's going on. They've done the benchmarking and they know how much things should cost and what thing should look like.

Blanchett: And you can subcontract each part of the planned administration, record-keeping, investment, and consulting work, whereas a smaller plan has to hire effectively one company for everything. It's obviously cheaper to buy in bulk than individually. And I think that's where the biggest problems are, is that difference in those large plans that have big dollars and the small plans that have fewer dollars.

Stipp: Can we say, though, generally to your point before, John, because some of the biggest players in the industry, the Vanguards have a lot of the assets under management in this area and they also tend to have very diversified low-cost funds that part of these market effects of what is a good fund is seeping into the 401(k) market and we are seeing that the leaders are leading because they do have the best products.

Rekenthaler: Yes, or among the best products. They certainly have a strong product lineup with not many duds in them. Average to below-average costs.

Stipp: We have talked a lot about with the 401(k) system broadly and some of the guardrails that have come and some of the improvements, some of the areas where we maybe could see some improvement still. But I'd like to get a little more hands-on and give people some practical tips on how they can assess their own 401(k) plans, whatever situation they're in, and make some good decisions about how to contribute, what to contribute, and where maybe they should look elsewhere.

I just want to start out by saying maybe you pick the top three things you would look for but imagine that for each of you, you started a new job. They've handed you the paperwork on the 401(k). You are going to go out being the investment experts that you are and figure out, is this a good plan? Does it have good options? What are the things the top things you're going to look for when you get those materials? Christine, I'll start with you.

Benz: I think costs would be at the top of the list. So, you're looking not just at what the investments are charging, although sometimes that maybe your total cost if there is no administrative layer of expenses. But you want to get your arms around what you are paying to own this plan, to own investments inside this plan. And that can help you decide whether you are better off just investing enough here to meet the match. If it's not such a good plan, then you can go outside of the plan with your other investment dollars, but that would be step one.

I would also do a little bit of due diligence using, researching the individual fund choices. Typically, they will be mutual funds. Sometimes not though, sometimes they will be collective trusts, which you may have to do a little bit more sleuthing on to find out who's managing them.

Those would be some of the key things. I think you'd also want to find out what the deal is on matching. If they are matching you, how much are they matching you? And also, when are those employer-matching contributions vesting? If you are someone who maybe isn't going to be in a job for such a long period of time, that's an important consideration, especially if it's a costly plan and your contributions aren't vesting until a period of years. You want to make sure that that's the right fit for you before putting some money there.

Blanchett: She took I think what I would call my top three. I'm now going to give you, number four. How about that? I want to know what kind of help is available because most participants, most employees need help to know how much they should be saving, where they should be saving. What tools do they have available, either an advisor or a consultant, or online guidance to help each individual figure out what they should be doing to actually get to retirement because let's be honest, most people aren't 401(k) experts. They don't know what they should be saving. I think utilizing the tools they have available is a great way to take advantage of the key features in the plan.

Stipp: John, what would you look for? What are your top things?

Rekenthaler: Not much to add to what they did. What I would look for if I didn't do this for a living, I'd invest in the target-date or the most or balanced fund or whatever they have because what do I know about picking funds as a typical person out there, particularly if you're starting off and you are younger. But don't wait to learn to get invested. Get invested. Just put it in the broadest offering. Then if I want to start to get clever and tricky and do my own investing over time, I can learn about it, and get some confidence and go do that.

I would get in there first and ask questions later. Maybe that's the right way.

Stipp: Let me put it to you this way. What might be a red flag or red flags if you were looking at a plan where you'd do a little bit more investigation or you would start to worry about the quality of the plan?

Rekenthaler: These days they're pretty diversified. So, again it gets back to where Christine started, which is costs. If it's a 1.5%, 2.0% kind of annual cost, that's a concern when you know that a lot of plans out there are charging 20 basis points or 10 basis points, literally a tenth of what I'm paying. And I can go on a retail market place and get funds for much lesser than that, too.

Outside of that, the nice thing is these are funds. So they're diversified. Even a bad fund is diversified. It's not like buying a single stock. Here and there you'll have a blow up where some fund will drop 20% or 30% a year, when the average fund in that category is break-even. But for the most part we're talking nuances. You'll lose 5% when you should have broken even if you had the average fund, or you'll make 10% when you could have made 15% or something like that.

So, you are not talking disastrous; you are talking milder regret from being in a bad plan. But high-expense funds, especially if you have been there for a while, that just eats away.

Stipp: Beyond expenses, Christine, from a fund lineup perspective, would anything give you pause about what was available on a plan?

Benz: Well, I think sometimes people get a little too hung up on omissions within their 401(k) plan lineups. I think some of our power users on might say, "Oh, you know, I really wish we had a quality small-cap fund." And the fact is that I think if you're using a 401(k) plan, you have to plan to augment it with assets elsewhere. So, you have to plan to maybe fill in some of those holes.

Anecdotally, I find that one place where some plans fall short is in the fixed income lineup. I was reviewing a friend's plan and this person was in her mid-50s, and there really was very little in terms of good fixed-income exposure. The sole bond fund was some sort of a government-bond fund. That doesn't seem like enough. That seems like a pretty big omission, but not one that, couldn't be solved by investing in a target-date fund within the plan.

I think that investors shouldn't get themselves into fits if they find that their plan has a couple of holes here or there.

Stipp: Several of you have mentioned target-date, and we do know that there are more target-date funds in these plans. When should I really think about that target-date fund, David, and why might I look at putting the pieces together on my own? What are some of the swing factors?

Blanchett: I'm really convinced that most people belong in a target-date fund. When anyone even asks me, "How should I invest my 401(k) plan?" I always just say invest in a target-date fund because that's an easier ride than trying to go out and pick this fund and that fund every year. I'd say that if you're really a hands-on investor, and you're convinced you could beat the market, then maybe think about it. But again, it's a smoother ride to just buy the target-date fund and kind of ride it out versus trying to kind of time the market in and out every few weeks or so.

Stipp: Are there any situations, Christine, when the target-date fund might not be the right allocation for my particular financial situation?

Benz: Well, possibly there might be, and this would really be probably David's area of expertise, but if someone is coming into a 401(k) and maybe has a big pension, for example, that would probably call for a more aggressive asset allocation than you typically find in the right target-date fund for your age band. So, there might be situations like that where the target-date fund may be too aggressive or too conservative for the person's needs.

Rekenthaler: I'll point out, from my view and I think from David and Christine's view as well, that the most attractive part of the target-date fund is not that it changes its asset allocation over time. That's nice. But that it's really the most diversified offering out there. It's not just stocks and bonds, but increasingly you get international exposure, Treasury Inflation-Protected Securities, so-called alternative investments, and some commodities in there. And it is the closest thing to an old-style pension fund, where it's all-in-one in one place, and that's the nice thing.

I look at it as I've got 401(k) assets and non-401(k) assets. Non-401(k) assets is where I think I'm smart and I do my thing. 401(k) assets is where maybe if I'm not so smart, those are those assets, and I just have them in target-date fund. Now, I've got this managed by Morningstar program; that's like a managed account that ends up being sort of like another version of the target-date fund. But either way, I have got someone else doing that, and it's pretty main stream stuff.

Blanchett: I would say that, I am by no means in love with target-date funds. I'm more scared of people making poor choices than I'm in love with target-date funds. So, I actually call target-date funds a temporary solution to a permanent problem because they are temporary fix to self-directed investing, but they aren't ideal because it's one-size-fits-all. And it's impossible to think that that one single glide path or one allocation by age is right for everyone. But then again it does give somewhat of a diversified portfolio. It removes their need to pick these funds themselves.

Benz: It sort of telegraphs: "Mitts off this thing." And I think that's where investors really shoot themselves in the foot that they make some of these trades.

Rekenthaler: It not only telegraphs, it has been mitts off, right?

Benz: Yes. Absolutely.

Rekenthaler: When you look at the stickiest monies in 401(k) plans, they are in target-date when you look at the amount of transactions that have occurred. And this really helped target-date investors following the 2008 downturn when we were at the time as you remember headlines about how terrible these things were in congressional hearings and so forth. But most target-date investors weren't involved, and the passivity really benefited them because they rode the market rebound unlike people some people who took action.

Blanchett: That's the benefit of professional advice. I mean, there are also managed accounts as a solution, as well. But as long as they've delegated that decision of investing to someone else, I think that it's better for the long run for the vast majority of defined-contribution investors.

Rekenthaler: Because we've been there before the target-date funds were around or before the idea of solutions were around. And in 1999 and 2000, I was actually quite involved and quite close to the retirement industry at that time. And I could tell you, plans were adding large-growth funds. They were adding technology funds, and the push was came from investors. It came from investors through to the plan sponsors that our plans are not aggressive enough.

At the top people wanted to buy more and wanted to take on more risk. That's what they want to do. In retail accounts, we know that. We were always writing articles on and other places you see about buying at the top after success and they get out after. It doesn't benefit anybody for 401(k) plans to be on that roller coaster.

Stipp: Christine, if I go with the target-date option, should that be the only thing that I invest in, in that plan? If I invest in other funds is that going to screw up the target-date fund allocation?

Benz: Possibly. I think you want to do your homework about the composition of that target-date fund, make sure that you're comfortable with its asset allocation. Make sure that if you have other assets elsewhere that the whole thing syncs up and comes out with a semisensible asset-allocation mix relative to where you are in your life.

I think you do need to do your homework. But generally speaking they are set up to be kind of one and done, that you shouldn't augment them with other holdings.

Blanchett: It's very nonintuitive. If you just hold a target-date fund, you've a very diversified portfolio. But I think the average person might say, "Hey, I'll hold that target-date fund and maybe two other funds to increase the diversification." You've actually gone backwards. Target-date funds are great one-size-fits-all options. When you add other investments, you're kind of reducing the benefit of being a hands-off, diversified easy investor in the 401(k) plan.

Stipp: Because you've made a lopsided bet on investments.

Blanchett: Exactly. What if you go 50-50 and the other fund only holds 20 stocks? The target-date fund could maybe hold 1,000 securities and then you add this other investment. And so you haven't kind of helped yourself, but you actually hurt yourself.

Stipp: David, you have already answered this, and I know that the answer is: It depends. But I'm hoping you can give me some swing factors so people can figure it out. You've just been auto enrolled at 3%, how do you know if that's enough or not? You pretty much said it's probably not.

Blanchett:  It's not.

Stipp: Let's say you auto enrolled 6% or 7%. How do you know if it's enough?

Blanchett: Even 6% is probably not enough, right. One question you have to ask is: What does the employer match your contribution? Some companies will give you 12%. It's rare, but it happens. And so I think that each person should be saving total at least 10% or 12% on average. That's a high-level number. And so if your company is matching let's say 50% of my first 6%, and you're saving 6%, that's only 9% total. That's probably not enough. I mean, I would say that you should look to have at least 10% a year going toward retirement, and if you're a late saver, more like 12% or 15%.

Stipp: Christine, the 401(k) plan that's offered to you has a Roth option. Should you take that?

Benz: Again, I think it depends, but generally speaking we work with a lot of young people here at Morningstar, I say go for it because I think it's a good bet that tax rates right now are near the low point of what they will be in the future. And I think for most people, a good answer is probably to just diversify to spread your contributions across Roth and traditional, especially for people who've been working for many years. They probably already have a lot of assets that will be taxed upon withdrawal in retirement. For them, it's important to diversify their tax treatment, get some money over into the Roth camp.

Blanchett: It's actually a really, really complex decision that most people aren't going to waste some of their time to know about. But to Christine's point, tax diversification is a big thing. And it's nice to know that you have one bucket of money that's pretax and one that's posttax because all employer contributions are pretax.

And if your employer is contributing a third of your total contributions, then only one third would be in Roth; that's half of your total contributions. And so I think that it really helps people to have a more diversified tax portfolio of account types that they have of both Roth and traditional monies.

Stipp: And at the end of the day you get to retirement and you've a pool of assets where you don't have any tax liability. That could be a very useful tool depending on what your other liabilities or income might be in any given year?

Blanchett: If in one year you have a huge hit that could put you in a higher tax bracket, you pull from your Roth versus your traditional. That's the right on.

Stipp: John, you mentioned that you have money in Morningstar's 401(k) and then you have money somewhere else. How should investors think about how much in my 401(k), how much might I put somewhere else, and should they even invest for retirement outside the 401(k)? What are some ways to think about that?

Rekenthaler: I'll tell you what I did. I'm more of an investment junkie person than a financial-planning person. That's where my training has been and my outlook. I've always saved in the 401(k) to the max as much as I could. And then when I started to have some money that I was able to save outside of the 401(k). Then I did that. So it's really not complicated thinking there.

So, 401(k) first that's what I did all the way. I went many years saving only in the 401(k), but I was saving as much as I could, at a high level.

Stipp: Christine, when does it make sense to look beyond the 401(k) and do something in addition to or instead of a 401(k).

Benz: Certainly if you've done your homework on the 401(k) plan, and it doesn't measure up--so it's maybe a very high-cost plan or you are not getting much in the way of the match--then by all means, it makes sense to look outside the confines of a 401(k). Certainly some sort of an IRA vehicle will be the right choice for lot of people. Then for people who are in a position to, say, max out the 401(k) and max out their IRA contribution, then building taxable assets [is ideal].

Rekenthaler: So, Christine, what would you do in a situation where it is a good plan and you are saving at 6%. You've got a 50% company match. So if you can do it, you continue to push up and max out the 401(k) before you go into the IRA, if it's a good 401(k) plan.

Benz: Well, certainly ease of use with a 401(k) plan is something that we shouldn't understate. I think that is something that a lot of investors should take advantage of, if they can max out their contribution. It's so easy to do and painless to do within a 401(k). That probably would be the right thing to do.

Rekenthaler: Perhaps you are likely to stick with it just because you have to check the box once and you don't have reinvest into the IRA or set something up.

Blanchett: You say you are going to save that $2,000 late in the year. And then you need a new television, or something happened. And so you know the money is gone in the 401(k).

Stipp: Christine what about a 401(k) from an old employer. What should I do with that? Should I keep it there, should I roll it over to my new 401(k)? Should I put that into an IRA? What are some of the questions I should ask myself in making that decision?

Benz: Generally speaking, I think the rollover is a better idea, especially if your plan does carry some level of expenses above and beyond what the individual funds are charging. I think the rollover is the right answer.

Stipp: To an IRA.

Benz: To an IRA. But again you have to do your homework on the old employer's plan and the new employer's plan. If neither of them look especially compelling, then the rollover, I think, is the better idea. But recognize that there will be potentially some reasons to keep money within the company retirement plan confines. Sometimes you get better legal protections, and this depends on the state where you live, within a 401(k). If you're someone who is maybe later in your accumulation years and you really value that stable-value option, you are not going to find that outside of the confines of a 401(k).

Highly appreciated employer stock is another reason to sometimes stick with the 401(k), but check with an accountant about that, as well.

Stipp: David, let's say instead of 401(k) from prior job, you have a pension from a prior job. And now I am coming in, and I have a 401(k). How might that affect how I would allocate that 401(k).

Blanchett: Pensions are like Social Security. It's guaranteed income for life, and so I am a believer that when you build a portfolio for someone, you take a holistic perspective. Let's look at my assets and see how risky they are, and if you have a really big pension or a big Social Security benefit, then you can probably take a little bit more risk in your 401(k) than you could if you didn't because you have effectively this bondlike asset that will give you guaranteed rates of return.

Stipp: Let's shift since we are starting to talk about income and move into retirement. Which I think is another interesting area when it comes to 401(k)s because again with a defined-benefit plan, or a pension, there wasn't a whole lot to worry about as you went into retirement because that was going to turn into some kind of an income stream or a lump sum that you would probably annuitize somehow. It would be income and more or less automatic.

Now with the 401(k) my last day of work, I retire, now I'm on my own, and I have this 401(k) with these investments. First of all before we talk about what you should do if you're an investor in this situation, is this a problem with 401(k)s in general, that now I'm retired, and I don't have an income stream; I've got to make one? John, let's start with you.

Rekenthaler: Yes. The issue of 401(k)s is do-it-yourself, and do-it-yourself we found ways to make it easier during the accumulation phase, where I'd say, we're largely there. Do-it-yourself gets pretty hard, harder when you're in retirement.

Stipp: It gets a lot more complicated.

Rekenthaler: Turning this into an income stream is a lot more complicated than checking the box and saying take some from my paycheck and put it in to some diversified funds. Yes, it is a problem. It's an issue for people to deal with as they have pools of money rather than an income stream that's promised to them under the old system.

Stipp: Is this something that companies should be helping with, or is this something that the financial advisory business should be helping with, or something that fund companies should be helping with? Who is best to solve this problem for investors.

Blanchett: Yes.

Benz: Everyone's trying, that's for sure. But I would see this as the next big evolution in the 401(k) industry. There is this effort to give participants that helping hand when they do retire. And the issue is not so much figuring out your plan when you're 65 because I think a lot of retirees are really into it at that point, and they have all their mental faculties and are in a position to make very good decisions about what to do.

I think the issue is about as someone progresses in retirement and possibly we do see some diminishment of mental faculties that they are making very important decisions about their money and not necessarily having a helping hand to do so.

Blanchett: I think that's the problem. You retire when you're 65-ish. When are you going to pass away? I don't know. Should we have millions of 90-year-old portfolio managers? And most of those individuals are probably spouses whose husbands passed away or something. So I think that the crisis problem of having to figure out how much you can take out of your portfolio every year, but also how to invest and what to do, to me, it's this kind of scary thing about everyone who's 85 years old, figuring out how to invest their portfolio, how to pull money out. It's just not, I think, a great kind of social program to have everyone figuring out for themselves.

Stipp: We talked about some of the solutions on the accumulation side: Target-date funds have helped, auto enroll, auto escalate, auto rebalance, better, more diversified funds and plans. What are some of the possible solutions or tools that we might start to look to in retirement to help us with this transition to income and sustainability?

Rekenthaler: Before I get there, one thing to point out is the employer is very much, the plan sponsor very much there with all those issues with accumulation because the employee is working for them and they are required under ERISA Law, if they setup the 401(k) plan, they have a fiduciary responsibility.

The employer is right in there and has an interest in solving these problems. For somebody who has been retired or left the company five or 10 years ago, it's different, and I don't think it's realistic to expect the employer to be involved.

So now there's a gap because the employer is the main advisor in a way, you could say, to the American public. During the accumulation phase, wealthier investors have financial advisors but most people don't have financial advisors to the extent they have one. It's the guidance offered through the employer and through the company system, and that just disappears in retirement.

Stipp: Well, part of the reason that employers like the 401(k) is that they did want to have that handoff, right? They didn't want to have to be responsible.

Rekenthaler: Right. But they are still there to an extent, and they are not going to be there when you are not working at the company any more. They are not going to step in and take that responsibility.

Blanchett: Some are. We've seen newer employers coming in and wanting to play that role and willing to help there.

Rekenthaler: At the handoff time though, right? Not for a 75- or 80-year old.

Blanchett: No, they see it as their role to that person who worked there for 30 years. [The company doesn't] want to abandon them for their last 20 or 30, as well. They want to actually create solutions. It's very complex from a fiduciary perspective because when you use guaranteed-income products like annuities, it introduces a whole host of factors. But I think there are definitely a lot of plan sponsors that want to say, "I'm done with you when you leave." But there are a growing set that say, "I have this huge buying power to make your retirement much better and much cheaper, and so I'm going to help you get there."

Stipp: Christine, logistically speaking when you retire, what happens with that 401(k)? What should happen with that 401(k) from the investor's perspective?

Benz: It depends on the 401(k) plan. In some cases, they may tell you need to take your money and leave, but you may be able to leave it within the plan, as well. So it depends on the plan. One comment I wanted to make, we have talked a lot about how we like target-date funds, I think they really fall short as vehicles for retirement mainly because as you do become retired, one of the key things you want is some flexibility to decide where you are going to draw that income from.

In 2008 for example, if I have some sort of a target-date vehicle, I don't want my company to hand me back pro rata shares of stocks and bonds. I don't want to sell stocks at that point. I want maybe just to take some of my bonds because they've held steady or maybe even gone up. I think that target-date funds as currently construed fall short as retirement income vehicles.

Stipp: David, I'm retired; I have this 401(k). One option would be to annuitize that money to create an income stream. What are the pros and cons of that decision?

Blanchett: I think that first off the largest asset of most Americans is Social Security. So, that is an annuity. And so, looking at my pension wealth, my Social Security, what else do I have, and how do I create income from that? Well, there is this thing called the 4% rule. And this for when you first retire, take out 4% of the balance and create income.

I think it's a very viable approach. But I like the idea of annuitizing over time perhaps where you look at your portfolio and say, "The older I get, the more I'm going to purchase of an annuity because I don't want to make these decisions myself." Obviously, it's very personalized, but it's difficult to plan for a 30- or 40-year retirement period.

I think that as you transition and move through it, you need to kind of change your perspective on what you should be doing. And that's where a fee-only financial advisor can really help out, figuring out what is best for your unique situation because, to Christine's point, target-date funds, I think, they are OK for accumulation. They do not do the job for distribution.

Stipp: And if I were going to do an annuity, but specifically there are few cons as far as, my money gets tied up and interest rates are very low right now. So I might not be buying one at the most opportune time.

Blanchett: So Social Security benefits are not price-based upon market interest rates, but annuities are. If you want to buy guaranteed income, the right claim is Social Security benefits. That is your best option today to get more guaranteed income. Now if you delayed to age 70, that's when you should really think about what else you can do. But right now, if you want guaranteed income, it's Social Security.

Rekenthaler: One thing worth mentioning about annuities is that anybody who studies annuities knows you can model annuities and say, from an investment math stance, here is the right answer. But to cross this psychological hurdle and getting people to do that is different. Annuities are pretty strange. If you think about the beloved defined-benefit plan, they take money from you on an ongoing basis. You don't know it, but the company pays you less because they are putting money into the defined-benefit plan.

They are taking money from you, and effectively you are investing. On an ongoing basis you get to the age of retirement, you get promised an annual income stream. If you do that in a 401(k), you put the money into 401(k), then at the time of retirement, you buy an annuity, you get an annual income stream.

You can duplicate what you used to get from the defined-benefit plan, but what you got from the defined-benefit plan was great. And that was cool, and that was the golden age of, "Oh, no, I don't want to give up my money and buy an annuity." Because now once you think you own these assets, I mean you do own these assets, but economically the underline is the same. You are getting less out of your paycheck, it was going away to somewhere, and you can get a guaranteed income stream at the time of retirement. But people who liked that old defined-benefit system are generally not going out and buying annuities where they can duplicate.

Stipp: There are some reasons why annuities have a bad reputation. So, I'm not saying that they are bad in concept necessarily, but some of them have high fees and riders.

Rekenthaler: Yes. I think there is still more of a psychological and control issue. Though once, when you think you own those assets and you do own those assets, it's different. There is something about letting them go. You have $200,000, and you could see that. And now you have zero and instead just a promise to get income. Whereas with the defined-benefit plan. you didn't have those monies in an absolute sense.

Stipp: Does it have to be either/or? I mean I don't have to annuitize my entire fund?

Rekenthaler: No. And you shouldn't.

Blanchett: No. And you shouldn't. You should think, you should figure out what is best for you. But to your point, there is definitely a spectrum of quality when it comes to annuities. Look for low-cost options. I mean Vanguard has annuities you can purchase through them. There is other, there are other annuity products. Start there and then figure out what makes the most sense for you because there are very complex products. And let's say for most people, you don't need complexity, you want income for life. That doesn't have to be overly complex with eight different types of riders, for example.

Stipp: Christine, we could do a whole panel session on income and retirement, and you have, in fact. But what are some of the big mistakes that people make when they are trying to create an income stream from a portfolio of assets?

Benz: Well, I think David hit on one of the key ones which is just making sure that that withdrawal rate is within the realm of reasonableness. David has done some work on the 3% rule versus the 4% rule given how low bond yields are. Just make sure that whatever your starting point is, that it is within the realm of reasonableness.

And then also I think a best practice in terms of retirement income is updating that withdrawal rate. David you have done work here, as well, where you are staying sensitive to the market environment and perhaps adjusting downward or definitely adjusting downward if the market winds move against you. I think those are a couple of key things that people can do to stack the deck in their favor.

Rekenthaler: I think one of the things with the 401(k) plan that we've talked about that can stand to improve the retirement section, we have seen some product innovation or people trying to make this more defined-benefit-like. And what you could do--and some people put out a product--you get less from your paycheck because you are contributing to your 401(k) plan but rather than going into stock or bond it's going into some sort of purchase of a future annuity.

Effectively, you put it in each time, and you are getting a little bit more of a future payment. And there have been some people in that experiment. And that's something that I don't know if it's going succeed because there are reasons why it's still little a different than owning a defined-benefit plan. But there effectively it is. You just put your money in, and you are getting a promise to get a future annuity. Now how you value that, gets tricky within the defined-contribution system.

But again, I think that when we are talking about these issues of what people do in retirement and inadequacies of 401(k)s, we at least should continue to look back at the old defined-benefit structure that's succeeded very well aside from portability. And again figure out why did that work, how did that get inside people's heads, and why do they like it so much? And try to do that as much as possible.

Blanchett: I would make one important caveat there. I'd rarely ever recommend that someone buys an annuity more than 10 years out from retirement. I would think you maybe start phasing-in just beforehand but there are costs you are paying there.

Rekenthaler: I was assuming a very cheap annuity.

Blanchett: Yes, a very cheap annuity. But I mean by and large, within a 401(k) plan you do not need to buy an annuity when you are 25 years old or 35 years old. Wait until you are just for retirement because you are paying different types of administration and rider fees that aren't very beneficial with that young age. I know that there are products in a lot of 401(k)s that you can buy at any age. Look to those when you are close to or in retirement.

Stipp: Last question for each of you. I've heard people say the 401(k) was never actually designed to be the primary retirement-savings vehicle, but it's what we've got now. We've got the 401(k) and similar plans. So, final question, can we make this work, and if we can, what needs to happen with 401(k) plans? Kind of summarize some of the things we have been talking about. John, I will start with you.

Rekenthaler: Well, I'm the biggest optimist here. I'm not sure it's not working because it is early in the process as we've talked about, and you see a lot of these figures about balances and so forth. And these are people that have only had 401(k)s for half their working lives and such. The next generation will be different, and the plans are also improving. To the extent that it does not work, if you want to take the pessimistic view, it's probably because we are letting, per Christine, people get more control over their assets than they should.

I know it sounds paternalistic, and a large part of me pushes against this, but there is something to be said for a compulsory system. For example, Australia has a compulsory system. And I don't think we will call that anymore a penal colony or a place where people don't have freedoms because they have a compulsory system. It goes against the grain of, I think, American nature in many ways to have this being more compulsory. But that would, if people can get over that hurdle, that would solve a lot of things.

Stipp: David?

Blanchett: I'd say yes, and again, if you look at the 401(k) plan, there are kind of two main parts. There is investing and there is saving. I think that we've mostly cured the investing problems with things like target-date funds, but we haven't cured the savings problems. So, to John's point, it sounds odd to say it but mandatory savings, doing something to make sure people are saving in the 401(k) would dramatically improve retirement readiness hands down.

I know that it will be very difficult, I think, politically to make it happen, but if you have those two things--good investing and good savings--you get to retirement successfully. In the absence of that, it can work. The problem is we're all people, and we're all irrational creatures. And so this idea of retirement that is 30 years away, [many people think] "I don't want to save for it." So, mandatory savings could plug the gap; I think that's the biggest thing.

Stipp: Christine?

Benz: I would agree. [Behavioral-finance professor] Meir Statman has said maybe we turn some of these nudges that have worked so well into actual shoves, and it sounds like maybe we are talking about the same thing that that even though we all like the idea of auto enrollment, well maybe we auto enroll at higher rates and maybe we make the contributions mandatory.

Blanchett: And to put it in perspective, we are all saving now for retirement via a mandatory system called Social Security. This is just going to give you maybe a different basket of money to pull from when you retire that isn't necessarily government-controlled.

Rekenthaler: I think David put it well. The investing side has been where most of the attention has been, most of the change has been, and that has altered quite a bit over the last 15 years. Participation rates, though, have not much changed.

Blanchett: Savings rates have been going down after 2008. We aren't at a good spot today for saving. We are at a good spot for investing. So how do you plug that gap? We've been trying now for 20 or 30 years, and so I think there needs to be some new change to get that in the right direction.

Stipp: You can have the best investments in the world, but if you haven't saved enough, those investments are not going to get you very far.

Rekenthaler: Right.

Stipp: An excellent, very enlightening and interesting conversation about 401(k)s and investing. I want to thank you again for being here. Christine Benz, David Blanchett, John Rekenthaler, thanks so much for your insights today.

Rekenthaler: Thanks as always, Jason.

Blanchett: Thank you.

Benz: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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