Redefining 'Choice' in Retirement Plans

W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award.

---------------------------------------

As the summer winds down, I thought that I'd share some recent observations about fiduciary investment issues in this month's column.

Happy Birthday to ERISA
This isn't really an observation, more like a public service announcement: the Employee Retirement Income Security Act (ERISA) was signed into law by President Gerald R. Ford in a ceremony in the Rose Garden at the White House 40 years ago last Tuesday. One thing that has remained constant about ERISA through all those years: Plan participants (and their beneficiaries) sit at the center of the ERISA universe. 

At Least I Brought Some Great Zinfandel
Earlier this summer, I attended a dinner party hosted by some very good friends who I hadn't seen in some time. The master of the house, whom I've known since I was 13 years old, is an excellent chef. Although strictly an amateur, I know that he would have made it big in the restaurant business. He is that good.

By the third course, we had all entered culinary heaven--made all the easier with a little help from some fine wines--and we were enjoying the lazy talk characteristic among good friends over an intimate dinner. Suddenly, a guest fixed her gaze on me--and I do believe that it actually narrowed--and said: "You're an investment advisor, aren't you?" "Guilty as charged," I replied. When the dinner guests had established that the focus of my investment advisory business was retirement plans, it was off to the races.

One after another, they began to dump on their 401(k) plans. To a person, they complained that they couldn't understand the nature of the investment options offered to them. They were especially united in their condemnation of the undecipherable language used by plan service providers to describe the features of the plans and the ways in which they could invest. They even began to laugh at me: You mean to say that you actually work in that crazy business? How could anyone keep their sanity and do that stuff day in and day out? Talk about an instant focus group that makes you lose your appetite.

It's no secret that many participants in retirement plans just don't seem to be wired to understand the plan investment options available to them, the nature of investing, et al. In my own experience, I've often found that people are always very interested in what I do, but after a few minutes of explaining it to them, their eyes begin to glaze over, and they tune me out. There's always the possibility, no doubt, that the pontificating explanations I provide are particularly stultifying, but many other advisors I know get the same reaction.

In any event, it seems that providers of plan investments could marshal their vast resources and provide better investment education for plan participants. The objective decidedly should not be to turn participants into junior securities analysts. Rather, it should be to provide them with a basic understanding of the nature of investing as well as a minimal level of comfort about the plan investment options available to them.

One suggested improvement in this area: changing the definition of "choice" that's now favored by many plan providers. Such providers like to boast that they offer participants lots of choices in retirement plans. Having access to a greater number of choices in our daily lives is often seen as something positive, although it has also vastly complicated our lives if for no other reason than much more of our free time is now wasted deciding among all those choices.

Offering plan participants the choice of, say, five large-cap mutual funds, though, doesn't help them. Instead, it's often harmful, like when they end up investing in three or four of the funds, thinking that will yield them a diversified portfolio. In my own experience, many plan participants are not able to understand the distinction among five different large-cap funds, even when they're all clearly grouped under that particular heading.

So the definition of choice should not be based on selecting from among some multiple of the same kind of fund. Rather, it should be about selecting from different kinds of funds--say, a large-cap fund, an emerging-markets fund, a small-cap fund, et al., which will allow plan participants the ability to create a well-diversified portfolio. 

Choice in the context of a retirement plan means something quite different to providers that aren't fiduciaries to a plan than to fiduciary plan providers. Non-fiduciary plan providers care little about what any given participant invests in, because they just want to sell product--primarily theirs but if not theirs, then others. Which is why they give plan participants lots of choices. Defining choice in that way, however, means that plan participants have a much greater risk of investing in portfolios that are sub-optimal in diversification.

It should be a goal, then, to change the prevalent definition of choice in retirement plans--multiples of the same kinds of funds--to one that means providing different kinds of funds. This is made a lot easier when a knowledgeable discretionary fiduciary to a plan is in charge to do just that.

Two Simple Words: Disclosure and Understanding
I was asked recently to review the proposed services agreement between a K-12 school district and an insurance company. Section 5.12 of the agreement reads:

"[The school district] acknowledges that [the insurance company] has disclosed to [the school district] through the Services Agreement and related documents[, and] that [the school district] confirms it received and understands:

(a) the nature of [the insurance company's] business relationships with each issuer of a funding vehicle that may be used in the [the school district's] 401(a) plan;

(b) a description of [the insurance company's] receipt of compensation payable by each funding vehicle;

(c) a description of [the insurance company's] receipt of all other compensation payable in connection with the Services Agreement; and

(d) a description of the charges, fees, penalties or other adjustments that may be imposed under the funding vehicles."

This section of the services agreement is key to understanding why the K-12 retirement plan marketplace is rife with investment options that are riddled with hidden (and therefore high) costs and are sub-optimally diversified to boot. Here's why:

1. It is impossible to know and therefore fully understand the representations made in (a), (b), (c), and (d) simply because such information is not there. Some of it is contained within the four corners of the services agreement but not all of it. What's not contained there is not to be found in any of the other agreements referenced by the services agreement, including the mutual fund prospectuses and statements of additional information.

2. Because the representations made in (a), (b), (c), and (d) are not all there (nor elsewhere), how is it at all possible for the school district to acknowledge that the insurance company has fully disclosed to the school district the representations made in (a), (b), (c), and (d) and that the school district understands them? It's just not logically possible to do so.

3. Many K-12 school districts are signatories to such agreements. The non-fiduciary plan service providers (an insurance company in this case, as noted) use two simple words--disclosure and understanding--to contractually pin back the ears of K-12 plan fiduciaries. Retirement plans in the K-12 marketplace are usually not governed by ERISA, but many of them are governed either (1) by state law that often tracks verbatim the fiduciary language of ERISA or (2) by the language in the agreement between a K-12 school district and the plan provider. By hook or by crook, then, fiduciaries are in charge of many of the plans at K-12 schools.

4. But not one in a hundred school fiduciaries--or more likely one out of a much higher number--has a clue as to what constitutes disclosure and understanding in such situations. At best, plan providers provide incomplete disclosure--including the real costs involved and the identification of the entities that receive the revenues that flow to them as a result of those costs--which is why school fiduciaries have little understanding of them.

5. K-12 school district fiduciaries simply sign on the dotted line of a services agreement, thereby acknowledging that legally disclosure has been provided to them and that they understand the ramifications thereof. That's largely a fiction in many, many school districts in America, and it sentences millions of school employees to lousy 401(a), 403(b) and 457(b) plans.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.