VOL. 23, NO. 1
SPRING 2010
BENEFITS LAW
JOURNAL
From the Editor
The Secret Life of 401(k) Plans: What
Participants Want to Know
W
hile transparency and disclosure are the watchwords of the
decade, when it comes to 401(k) and other defined contribution (DC) plans, it could be that participants might contribute less, if
they knew more. To illustrate, let’s examine two basics of DC plans—
stable value investment funds and administrative fees.
In one guise or another, stable value is probably the single most
common investment offering of 401(k) plans. Why are they hugely
popular with participants, even though employers, fund companies,
and consultants bombard participants with investment education
booklets, webinars, online guidance, and in-house programs explaining the ins and outs of diversification, long-term returns and risk and
reward? Easy, stable value funds appear simple, safe, and predictable.
Money goes into the fund and earns a fixed and relatively decent
interest rate that is periodically ratcheted up or down, depending on
the bond market. Rate adjustments are relatively mild, so there are
few surprises for stable value investors.
What would happen if participants knew how these highly sophisticated investment vehicles actually worked? Behind the scenes, a
stable value starts with short- to mid-term fixed income investments,
such as publicly traded securities, private placements, or insurance
company guaranteed investment contracts (GICs), and bank investment contracts (BICs). Like any bond or other fixed income investment, their value changes daily, depending on interest rates, credit
quality, and overall market conditions. For example, if a typical stable
value fund has a three-year duration (very roughly a 3.3 year average
maturity) and interest rates spike up 1 percent, the fund suffers an
immediate loss of three cents on the dollar, since bond values move
in the opposite direction of interest rates.
From the Editor
The folks who invest in stable value would not be happy if they
saw their account dip by 3 percent. They might look around for an
even more conservative investment such as a treasury money market
or, worse, stop making 401(k) contributions altogether. The typical
stable value investor can live with equity funds outperforming their
fund by 20 percent, maybe even directing a bit of their contributions
into these riskier investments, and will enjoy gloating when markets
crater. But these participants cannot live with any decline in their
stable value accounts; they only want to see their stable value funds
in a slow and steady, one-way climb up in value.
To cover the inevitable movements in the value of a stable value
fund’s bonds and other holdings, financial alchemists add an insurance
company or bank guaranty. These “wrappers” protect participants from
losses when they switch plan investments, retire, or otherwise withdraw their funds from the plan by ensuring they receive the full book
value of their account, even if the underlying bonds and other fixed
income investments are worth less. (Stable value is not bullet-proof.
Participants can realize a loss if the guaranty evaporates upon contract
cancellation (say, on plan termination) or if the insurance company
goes belly up.) To pay for the guaranty, there’s also a relatively modest
charge for the wrapper that is deducted from the fund’s returns.
While participants pulling their money out when the fund’s actual
market value is down get exactly the safety and stability they expected,
the investment loss doesn’t go to Money Heaven. The loss is shared
by the remaining participants via a gradual, behind-the-scenes reduction in the interest rate credited to their accounts—that is, they’re
credited with less than the fund actually earns. This adjustment continues until the fund reaches equilibrium: book equals market value.
The adjustment mechanism also means that participants who invest
new money in a stable value fund when book value is above market
value (3 percent in the example) receive a lower interest rate than if
they were investing “fresh.” Of course, it’s a two-way street. When
market value is above book—such as when interest rates are falling,
it is the withdrawing participants who lose out, while the remaining
participants benefit.
Ultimately, for a long-term safety-minded investor, a stable value
fund is an irrational choice. Investing in a fixed income fund with the
identical portfolio would avoid the extra cost of the wrap protection
and be immune from the economic consequences of participants
jumping ship when book is above market. So, should the Department
of Labor (DOL) declaim stable value funds to be imprudent violations
of ERISA or make participants read a detailed stable value disclosure before investment? Heck no! Participants do not care what lies
beneath the surface of their stable value funds. All they want is a
slow, steady, and apparently effortless appreciation of their accounts.
That’s why participants choose stable value over bond funds.
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From the Editor
On plan expenses, participants may want to know how much they’re
paying, but not what they’re paying for. I’ve seen plan participants actually protest a change to a transparent fee structure that will save them
money. Under ERISA, recordkeeping and other administrative costs
(except for allusive settlor functions) typically are paid by the 401(k)
or DC plan. It’s also fairly typical for these costs to be covered through
revenue sharing, 12b-1 rebates, or the profit margins embedded in
investment management charges. Despite the largely unsuccessful
efforts of some class action law firms, this is perfectly legal. Employers
and recordkeepers may be aware of how fees are allocated between
recordkeeping and fund management, but participants typically see
only their final cost: the expense ratios of the available investments.
What if an employer decides to break out these costs—say by directly debiting participant accounts a flat dollar amount or small basis point
charge for administration and recordkeeping, and separately deduct
for fund management? Any revenue sharing and the like could then
be rebated directly to the accounts of participants whose investments
generated the revenue. In my experience, an employer who switches
to such an “itemized” structure will be met with complaints, disapprobation, and dissatisfaction from employees, even if it is demonstrated
to save them money. Being human and thus somewhat irrational, participants don’t mind paying investment fees nearly as much as being
charged a relatively paltry amount for a recordkeeper to hold and track
their own money. Indeed, annoyance with a per-account administration
fee can, in my experience, reduce plan participation.
As the DOL considers whether and how retirement plans should
jump on the transparency and disclosure bandwagon, thought should
be given to how much participants really want to know, the impact
on participation, and other unintended consequences. After all, if
people knew too much of what lay beneath the surface, no one
would ever eat a hot dog, or get married, or have children.
David E. Morse
Editor-in-Chief
K & L Gates LLP
New York, NY
Reprinted from Benefits Law Journal Spring 2010, Volume 23,
Number 1, pages 1-3, with permission from Aspen Publishers, Inc.,
Wolters Kluwer Law & Business, New York, NY, 1-800-638-8437,
www.aspenpublishers.com
Law & Business
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VOL. 23, NO. 1, SPRING 2010