When Less Is Best
Sometimes, competition leads to many solutions. The people
don't seek a national television network. They want to choose from among
hundreds of channels (albeit while continuing to complain that there's nothing
to watch). At other times, though, consumers don't require variety. For
example, they are content with two smartphone platforms, and but a single
search engine.
The 401(k) system belongs in the latter camp. The public
doesn't want more 401(k) flavors. Plan sponsors don't want more 401(k) choices.
Retirement investors won't benefit from more 401(k) diversity. Quite the
contrary. The more 401(k) products that exist, the greater the public
confusion, the legal danger for plan sponsors, and the costs to both companies
and their employees.
You needn't take it from me. The marketplace has spoken.
When 401(k) plans began, in the aftermath of the Revenue Act of 1978, they were
highly customized. Companies that adopted 401(k) plans used a variety of
investments, including insurance-company pools, mutual funds, separate
accounts, and company stock. All were actively managed. Effectively, every
401(k) plan was a tiny self-directed brokerage firm, offering a handful of
options from which employees selected.
Moving Toward One
Over the decades, the 401(k) industry has gradually
standardized. Some variety remains, because sponsors tend to adjust their
401(k) plans incrementally rather than overhaul them abruptly. However, the
drive toward conformity is clear:
1) Plan lineups are shrinking, as sponsors eliminate their
actively run funds.
2) Almost every plan now includes index funds.
3) Ditto for target-date funds, which are usually a plan's
default investment.
These trends are most pronounced with Vanguard. Last year,
the company reports, 60% of its 401(k) participants owned but a single fund.
Among that group, 91% did so through one of the company's target-date funds.
Such investors exemplify all three of the industry's prevailing forces. They
require only a limited fund lineup; they index (the method of investing for
Vanguard's target-date funds); and they hold a target-date fund, which was
likely selected for them.
In the fund industry, where Vanguard treads, others follow.
In other words, future retirees will invest quite differently than did the
early 401(k) adopters. By and large, future 401(k) participants will hold
target-date funds. When they invest otherwise, they will mostly use index
funds. The actively managed funds that were once the 401(k) industry's
mainstream will continue to lose popularity.
The Lesson of Experience
These developments have been driven not by dogma, or by
astute marketing from index providers, but instead by experience. People want
1,000 channels because they like television. They enjoy browsing their options.
However, as studies of participant behavior have amply demonstrated, they
heartily dislike looking through 401(k) plan lineups. Investing gives most
employees the shivers. They prefer that somebody else do the thinking for them.
They also prefer that somebody else take the action. From
that desire was born the concept of a default investment, whereby, without
effort, new employees are enrolled into their company's 401(k) plan, into a
fund not of their own choosing. That these default investments eventually
codified into target-date funds, rather than another type of broadly
diversified fund, has been an accident of history. The details were not
inevitable. But the existence of default investments was.
The shift toward indexing was also inevitable. Once again,
the impetus has been practical, not political. Most actively managed funds,
over most time periods, fail to keep pace with lower-cost index funds. Once
that fact had been thoroughly demonstrated, through decades' worth of
investment performance, plan sponsors changed their views. Initially, they
favored active managers, but they switched to another approach after experience
taught them otherwise.
Legal concerns have bolstered that decision. Last year, more
than 200 class-action lawsuits were filed against 401(k) plan sponsors, with
the most common complaint being excessive fees. All actively managed funds levy
higher expenses than do the lowest-cost index funds, and all sometimes trail
their benchmarks. Consequently, putting an actively managed fund into a plan
runs a risk that using an index fund rarely does: being on the wrong end of a
lawsuit.
For that reason, the recently published monograph Defined
Contribution Plans by the CFA Institute--an impartial, not-for-profit
organization that represents investment researchers and managers--recommends to
plan sponsors that "passively managed funds" be "the default
choice for their plans." Indeed, absent a strong belief to the contrary,
"sponsors should make available only passively managed options." (The
italics are mine.)
A Simpler Approach
Which leads to the question: If 401(k) plans are converging
toward a common structure, then why force companies to adopt their own 401(k)
plans? Save them the time, expense, and hassle. Create a single national plan
that all companies can access through their payroll systems. Relieve
corporations from the burden of overseeing the investments for their employees'
retirements. Few businesses seek such responsibility, and equally few are
skilled at the task.
The national plan would hold a default target-date series,
based on underlying index funds, plus several passively managed single-asset
funds. (Those interested in other investment options could open a brokerage
window.) The national plan would be identical for all participants. However, it
would not be a monopoly, as it would hire multiple vendors for its indexes. In
that way, revenues from managing 401(k) assets would be spread among competing
businesses, as they are today.
Such a structure would not prohibit corporate competition.
As with today, plan sponsors could woo employees by matching a higher
percentage of their 401(k) contributions. They could also enhance their plans
by adding investment options. The point is not to limit the activities of
ambitious plan sponsors. In fact, I propose to expand their opportunities, by
protecting companies against lawsuits for selecting expensive and/or unsuccessful
funds. (Since the additional investments would be viewed and presented as
purely supplemental, caveat emptor.)
None of this, properly speaking, is my view. If employees
were fascinated with 401(k) plans' diversity, disliked being enrolled into funds
that they did not choose, and believed strongly in active portfolio management,
then I would have written a different column, with different recommendations.
Similarly, if most plan sponsors wished to bear the expense and fiduciary
liability of running their own individual 401(k) plans, I would have arrived at
another conclusion.
But none of those conditions apply. For 40 years, the 401(k)
industry has conducted a public experiment to determine the best
defined-contribution structure. The marketplace has answered. Broadly speaking,
both employees and plan sponsors seek the same thing: simplicity and
convenience. They want a solution that is easy to understand, with somebody
else doing most of the work. They want a national plan.
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