When people write about 401(k) plans, they usually discuss how the system treats existing workers. As have I. My 401(k) articles have addressed two aspects of 401(k) plans that apply to current employees, those being 1) availability and 2) portability. In the unlikely event that my suggestions for 401(k) reform are adopted, all incoming workers would automatically be enrolled into a 401(k) account, which would move seamlessly with them, whenever they changed jobs.
Those are the most important issues for the 401(k) system. If workers can't contribute to 401(k) plans, they won't have those assets when they retire. And if each company's plan is separate and distinct, they will collect several unrelated 401(k) accounts. (According to the U.S. Bureau of Labor Statistics, the typical worker has 12 employers during his career.) At best, those accounts will be annoying to administer; at worst, the employee will cash out of several of them.
Still, improving 401(k) plans for retirees is also a worthwhile goal. Currently, the system is messy. To start, plan sponsors view their responsibilities divergently. According to a survey from Pimco, 36% of sponsors actively encourage their company's retirees to remain in the 401(k) plan, 38% prefer that they do so but do not solicit such behavior, 19% are indifferent, and 7% hope that their retirees will leave. The trend, however, is toward greater involvement. Over time, attempting to retain retiree accounts will likely become the corporate standard.
Investing by Chance
Another concern is that the funds that serve 401(k) retirees are highly diverse. Among target-date retirement funds, the highest stock allocation is 46% and the lowest is 12%. Bond positions range from 85% to 45%, while 12-month yields range between 5.6% and 0.7%. Thus, while two investors who are randomly assigned 2050 target-date funds will likely hold similar investments, because the industry has reached a consensus of how to manage long-dated funds, the same precept does not hold for target-date retirement funds. They vary greatly.
Such inconsistency creates problems. One is that retirees at different companies may have very different portfolios, leading to very different results. It's one thing to make an active investment decision that backfires; it's quite another to lose by accident, by being dropped into a notably unsuccessful fund. Also, even if the participant anticipates a target-date retirement fund's potential struggles and wishes to avoid that fund, he will lack other options. Within each 401(k) plan, there is only a single target-date retirement fund.
A New Hope
Given this backdrop, change seems inevitable. Not for workers. After 40 years of experimentation, the 401(k) system has settled on its service for employees: an automatic-enrollment program, probably into a series of target-date funds, supplemented by several low-cost funds for those who wish to make their own investment decisions. (This structure is ubiquitous for large plans and is moving down the ladder to midsize and small plans.) But for retirees, the evolution has only just begun. Demand from plan sponsors will create many innovations.
This week, BlackRock launched one such novelty: a target-date series that incorporates annuities into its investments. (These funds are collective investment trusts, created for institutional buyers, rather than registered mutual funds. For practical purposes, though, they can be regarded as mutual funds.) BlackRock is not the first company to bring annuities to 401(k) plans, but unlike the efforts of its predecessors, this feature has attracted customers. The Wall Street Journal reports that five employers have added the new funds to their plans. They represent 100,000 potential 401(k) participants
At this stage, I can say little more about BlackRock's investment strategy. The company's press release, the WSJ article, and previous reports about BlackRock's intent raised as many questions as they answered. That said, the essence seems to be that investors in those target-date funds will accumulate credits that they may either convert into monthly annuity payments or retain as assets, in the form of tradable "lifetime income units." Whatever that means.
No worries. The salient point is not whether BlackRock has invented the next great thing. It is instead that the 401(k) marketplace appears ready to take the next step, by offering its employees job-to-grave investment services. Plan sponsors perceive the flaw in their current approach, which is that upon retirement their employees must either: 1) leave the plan, 2) remain, while investing in funds that were selected for building portfolios, not drawing them down, or 3) take their chances with a target-date retirement plan. For many sponsors, none of those choices looks terribly attractive.
I asked Morningstar's head of retirement studies Aron Szapiro if he thinks that companies can improve their retirees' investment results by enhancing their 401(k) plans. His response, at least for the larger companies, was a qualified Yes. They can demand institutional pricing, just as they now do with funds that they select for their current workers. (For example, BlackRock states that the fees for its target-date funds will not rise above an annual 0.16%.) Also, most freshly minted retirees would benefit by converting some of their investment assets into ongoing income.
Aron did have caveats, though. One size fits all is more appropriate for workers who are gathering assets than it is for those who are removing them. The goals for accumulation are universal: Earn the highest possible total return for a given level of volatility. However, spending needs vary widely. Some retirees withdraw aggressively from their portfolios, while others, from either caution or the desire to leave a legacy, are more conservative. Fund companies will struggle to devise 401(k) lineups that are sufficiently simple for retirees to use, but complex enough to meet their disparate needs.
We shall see if they succeed.
John Rekenthaler (firstname.lastname@example.org) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.