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Guest Article

Exposing 401(k)s ... Revisited

By Carl E. Johnson, Jr.
Robinson, Bradshaw & Hinson
April 8, 2002

Last week BenefitsLink published Dennis Ackley's thought-provoking opinion piece, When Will the Secret of 401(k)s be Exposed?

The fictitious scenario depicted in Dennis Ackley's article looks at 401(k) plans as retirement plans. As Dennis asks in another article, It's Time to Start Measuring What We Say 401k Retirement Plans Do, if employers say the 401(k) is a retirement plan, then shouldn't they act in a way that will help employees use the plan to retire?

In that article, Dennis says, ". . . if the employers' stated strategy is to use a 401(k) or a profit sharing plan as a 'you'll get some money when you leave' plan-- which is generally how these were originally used-- then not much explanation beyond what the government requires is necessary. And that's fine."

What's happening when-- intentionally or not-- employers, the media, advisors and Congress link "401k" and "retirement"-- sometimes even calling the plans "401k pensions?" Then expectations may change dramatically. In fact, however, 401(k) plans aren't necessarily intended to be retirement plans, even by employers that don't maintain traditional defined benefit pension plans. What's the result when employers do not clearly communicate the purpose of the plan and define the expectations for employees?

Dennis Ackley's Senator questioned Ms. Smith, an employer benefits officer, about her company's 401(k) plan (all make-believe). By way of contrast, I've constructed a different scenario. Here, Ms. Jones, who is Ms. Smith's counterpart at a different employer, has agreed to testify before the same Congressional committee about her company's 401(k). The questions that our hypothetical Senator asks Ms. Jones are identical to those asked of Ms. Smith in Dennis's original article, When Will the Secret of 401(k)s be Exposed? Only the answers have been changed.

SENATOR: Ms. Jones, we're delighted you're here. In previous testimony, we've heard that in voluntary, employee-directed retirement plans-- like your 401(k) plan-- employees must know how to use them to be successful in achieving their retirement dreams. We invited you here because you're responsible for running a typical 401(k) retirement plan.

MS. JONES: Senator, it's a privilege to be here to tell you about our company's 401(k) plan. However, let me correct an impression you seem to have. You just used the word "retirement" three times in asking your question. Actually, our 401(k) plan is not a retirement plan as such. Rather, it's a tax-deferred pay plan. Whether employees want to take advantage of the plan . . . or whether they want to use it for retirement or for some other purpose, then that's up to them. We don't have a traditional pension plan at our company. We used to have a defined benefit pension plan but we terminated it a number of years ago. That's another story.

SENATOR: Ms. Jones, I see in your written summary that nearly a third of all your employees-- mostly lower-paid-- are missing company-matching contributions because they don't participate in your plan. I'm equally concerned that roughly half your eligible employees under age 30 aren't participating. So they're also missing forever the opportunity for what's been called the 'miracle' of long-term compound earnings. Do all your non-participating employees understand what they are missing?

MS. JONES: Frankly, I don't know how many of them understand compound earnings. Our plan literature explains how earnings should make the accounts grow over time, and you would think that anyone with a junior high school education, which is the minimum any one of our employees has, would understand compounding. I'll tell you one thing though, they all understand that by not participating, and therefore not receiving our match, they are leaving money, dollars, on the table. We make sure they understand that, as best we can.

SENATOR: In your report you point out proudly that your plan's average account balance is around $50,000. Yet when we dug into your numbers, we found that half of your participants have less than $14,000. And these amounts don't include the zero balances of the third of eligible employees who aren't participating. Is that right?

MS. JONES: That sounds about right, Senator. We gave you all of the numbers. We want you to understand exactly how our 401(k) plan works. We like it. We think it's a good plan and we're doing a good job with it.

SENATOR: I'm sure that's what you thought. In fact, in your report you point out that your employees at retirement age-- age 60 and older-- have an average of roughly $200,000.

MS. JONES: Yes, and of course some accounts are even larger. Some are larger than $200,000, some are smaller, and the average is about $200,000. That's the way an average works.

SENATOR: I'm sure. I'll bet they belong to higher-paid employees. What I'm seeing is that averages in 401(k) plans seem to hide more than they tell.

MS. JONES: No doubt about it Senator. Averages can be very misleading. That's why we've given you all of the numbers, not just the averages.

SENATOR: Pardon me. Isn't it true that half of your employees who are close to retirement-- those over age 60-- have less than $50,000?

MS. JONES: Yes, I believe that is just about what the numbers show. You've got the details in front of you.

SENATOR: Ms. Jones, you're a retirement expert. So I'm sure you've seen various retirement payout models. Those models usually show that to be quite certain of having retirement income that lasts as long as you live, you can take out only about 4% or 5% of the initial account balance each year. That means an employee who has $50,000 in an account at retirement can count on under $2,500 a year for life-- that's around $200 a month. Does that sound about right?

MS. JONES: Well, I don't claim to be a retirement expert, but I am Vice President for Human Resources and Benefits at our company, so as part of my job I have to be concerned and knowledgeable about all kinds of pay and benefits issues that are important to our employees, including retirement and retirement benefits issues. What you're talking about is simple math. I trust that you've done it correctly.

SENATOR: Do your employees understand this?

MS. JONES: You mean, do our employees understand simple arithmetic? Most of them do, I'm sure. Do they really sit down after work and do these calculations from time to time? I'll bet that a significant number do, but most probably don't, and there are probably some that would have a difficult time doing it correctly even if you sat them down at work with a paper and pencil and said, "Here, as a part of your job, take the next few hours to do a rough calculation of how much money you ought to accumulate to have the kind of retirement income that you'd like." Do they calculate how much life insurance they ought to have? Disability insurance? Have they carefully factored in the likelihood of ever receiving Social Security old age benefits? Do they make the best economic decisions they could when they buy groceries, shop for a car, and so on? You get my drift? It's not our job to teach employees how to live.

SENATOR: Let's look at what else you don't teach your employees. You say an attractive feature of your plan is what's called portability. Employees can take their vested account when they leave the company. Yet most of your employees under age 35 take the cash, pay the taxes plus a 10% penalty, and lose forever the opportunity to use that money for retirement. Why is that a good feature?

MS. JONES: Senator, I think you're missing my point. Sure, portability is a great feature. As you know, however, until recently, you, Congress, substantially limited portability among the different types of tax-deferred compensation programs. Fortunately, you addressed that to some extent in new law last spring. However, it's been what, over 25 years since ERISA supposedly reformed benefit plan rules-- how many people might have continued to save money for retirement, but did not, because you didn't allow them, under the tax laws as amended by ERISA, sufficient flexibility, at least the way they saw it, to move from one kind of a plan to another? Think about that, Senator. But, and here's the real point. Portability-- a rollover-- is available for those who want to continue to defer taxes on their compensation, whether that deferral is for retirement or for some other purpose. For those who want to take the money and spend it now, or invest what's left after taxes, that's their business. As I am sure you know, the law requires that we give employees a notice explaining taxes and rollover opportunities any time the employee receives a 401(k) payment that he is permitted to rollover. Like most other companies, I am sure, we use a notice that was written by the government, the IRS, for this purpose. We could write our own notice, we understand, but the IRS makes it clear that we're sure to comply with the law if we use their language, so that's what we do.

SENATOR: There seems to be a lot your employees should know but they don't. For example, surveys show that roughly half the participants don't know they're fully responsible for their retirement investments. I'd say it's essential that all employees in a voluntary retirement plan know that. Do all your employees know that?

MS. JONES: We'll that's your opinion . . . about what employees should know. I don't know about the surveys you're referring to . . . how they were conducted, whether the questions were phrased properly, and so on. I will say there is an awful lot of survey junk out there about retirement and other benefit plan issues. If you show me a particular survey or surveys, then I'll be glad to comment on them. However, I want to come back to my original point. You've just used the term "retirement" twice in this question. Our 401(k) is not necessarily a retirement plan. Regarding investments, we give employees the option to direct the investment of their accounts. On the other hand, if the employee chooses not to, we have what we call the general fund. Sometimes you hear the term "default fund," although we don't like to use that term because it sounds negative. We're responsible for the general fund. We have invested it in a balanced mutual fund, very roughly 60 to 70 percent stocks, and 40 to 30 percent bonds, depending on how the fund manager allocates the fund investments from time to time. We make clear to our employees that they are not required to direct the investment of their accounts. We'll handle that for them if they wish. The mutual fund is managed by a well-respected investment management company, and is offered by one of the largest mutual fund companies in the world. By the way, I don't mean to imply that bigger is necessarily better, but we've looked at the situation very carefully and we believe this is a good, sound investment for those participants who, for whatever reason, don't want to decide how their accounts should be invested. Obviously, an employee could decide not to participate in the plan because he or she doesn't want to choose his own investments, yet doesn't like our general fund. We hope that's not the case . . . we've never had anyone say that. However, in a company our size you're just not going to be able to please everyone. I repeat -- we think we've got a good program, and we're proud of it.

SENATOR: I have a friend who's a pension actuary. She tells me the first step in planning the funding for pension plans is to have a clear retirement benefit income target. Are you aware of that?

MS. JONES: Sure, that's one of the first things you'd do.

SENATOR: So you and other experts say having a target is step number one in retirement planning. Then why do half the employees who are age 65 and older-- the 'graduates' of our retirement education system-- have absolutely no idea how much money they'll need for retirement? They can't even offer a guess . . . like, "Gee, if I spend $20,000 a year for 20 years-- say from age 65 to 85-- that's around $400,000." Would it be fair to say that most of your employees have missed the first step-- they haven't set their personal retirement benefit target?

MS. JONES: Senator, there you go again. Now you assume that we, whoever that is, have a retirement education system? I'm not aware of any such system. I've never heard of such a thing, have you? Beyond that, to answer your question, I cannot tell you how our employees are planning for retirement.

SENATOR: I see you have a degree in finance. Me too. I remember taking a couple semester-long classes on investing. Is that what you did?

MS. JONES: Well, I see you're changing the subject, Senator. Actually, I took four semester-long courses in what I think you could fairly describe as about investing, as such, although I believe that many of the other courses I took to get my finance degree also help me out as an investor. Now I suppose you're thinking of asking me why, with my finance degree, did I end up in human resources and benefits? (Smiling) Please, let's not go there.

SENATOR: In your report, you say that you provide employees with one-hour meetings when they sign up for the plan. And you send out a few newsletters each year. I assume this is to help your employees become proficient in using investments for their retirement. So what took you and me many months of study in college courses that we wanted to pursue, you provide in a few minutes to people who probably don't share the interest or background knowledge we had. Isn't the employees' investment knowledge critical in determining how successful they'll be in accumulating their retirement income? Would you agree with all that?

MS. JONES: Well, you're wrong about that. Our one hour meetings and brochures, newsletters and so on are not intended to make employees proficient in investing for retirement, as you put it. We're giving them basic information, as required by law, about how the plan works. Actually, we're going beyond that . . . to a degree . . . but if an employee wants to really learn about investing, he needs to do that on his or her own. Now I want you to keep in mind, Senator, that our plan is not necessarily intended to be a retirement plan. You've heard that from me before, haven't you? But an employee could decide to use it for that purpose. If so, he ought to learn something about investing, even if only to be comfortable using our general fund. This is not rocket science. There is plenty of material readily available to any interested person . . . books, articles, TV and radio programs, the Internet. There is a flood of material that is easily available and understandable that can make employees sufficiently educated investors, if they want to be.

SENATOR: Wow, if our professors had used the sophisticated and efficient teaching techniques you're providing your employees, we would have gone through our investment classes in a flash.

MS. JONES: Senator, this is serious matter. I don't appreciate your sarcasm. You and I both know that the kind of investment education you get in college-- working on your finance degree-- is far more complex than what the typical employee needs to know to participate in our plan, successfully . . . regardless of his or her objectives, retirement or otherwise.

SENATOR: One of the things I remember from my college courses is that retirement investments need long-term horizons. For example, a 30-year-old may not be taking money out of a retirement account for 30 or 40 years. But I see you offer both Internet and phone access 24 hours a day, free of charge, to let employees trade their mutual funds every business day.

MS. JONES: I heard the word "retirement" again. That having been said, the answer is "yes," except when our administrator's computer system is down for one reason or another.

SENATOR: That sends a mixed message doesn't it? By the way, I don't know of any Wall Street investment firm that does day trading in mutual funds. Yet that's what your plan offers. Isn't that an odd approach?

MS. JONES: No it's not an odd approach and it doesn't send mixed messages. Outside our plan, our employees . . . you and I . . . we can go to a broker or a mutual fund company anytime we want to. Why not in the plan, too? People day-trade stocks outside plans. You cannot buy individual stocks through our plan, although some plans allow it. You, Senator, have enacted all kinds of laws regulating benefit plans; the IRS and Labor Department have issued thousands and thousands of words of regulations. None prohibit day trading in a 401(k) plan, as far as I know. Many mutual fund companies have restrictions on short-term trading, although these limits don't apply to our retirement plan accounts, today. I expect that the system would not work, however, if there was rampant day trading in mutual funds in retirement plans. There would be changes. The market would see to that. Mutual funds wouldn't be able to operate soundly. But the fact is, in our company day trading in mutual funds doesn't happen. Our administrator tells us that our employees change investments very infrequently, and that this is typical. In fact, if anything you might suggest that they should be changing more often-- rebalancing or reallocating among their mutual fund investments. Although we have no way of knowing if this is really cause and effect, some consultants say that just knowing they can change their investments anytime they wish makes employees more comfortable and more stable investors. In short, our employees seem to be quite happy with our system.

SENATOR: I'd hate to think that your role as a plan sponsor is to keep employees dumb and happy. Anyway, let's look at the account statements you send out every three months. They focus on current investment performance. Same with your plan's website. Neither tells employees how they're progressing toward their retirement goal. Aren't the accounts supposed to be for retirement?

MS. JONES: That really offends me Senator. We hope we keep our employees happy-- I have no idea where you get "dumb" out of all of this. But to answer your question, because I am serious about this even if you're not, our statements show performance for the last month, the last quarter, last 12 months, last 36 months and last 60 months. Also year-to-date. You can call that current performance, if you wish. We've only been letting employees direct their accounts in the current funds for the past seven years. Eventually we hope to include ten-year histories, too. I don't want to make too much of this, though. Past performance, short-term and long-term, is interesting to look at, and may be useful, but if an individual is investing long-term, or short-term, he is going to have to know more than about past performance. Among other things, employees get fund prospectuses, which, although not SEC-approved . . . as such . . . are designed to comply with the federal prospectus requirements for information for investors. Other information is available, too, for those who want it. But, again, remember that our plan's accounts aren't necessarily for retirement. If an employee wants to use his account for retirement, he can measure his own progress. If the employee wants to use his account to accumulate funds to use when he quits in five years and goes back to school, or buy a new fishing boat, are we supposed to be telling him how he's progressing toward that goal? We don't see it that way.

SENATOR: Ms. Jones, in surveys we've seen, plan participants say they know more about investing in their company's stock than any other investment option. They also mistakenly say company stock is less risky than a diversified domestic equity portfolio. Is this what your employees think?

MS. JONES: Well, in our company, investment in our company's stock is not an investment option in our plan, so I cannot tell you what our employees would think about that. But I'll tell you this. Not more than two months after you passed the Economic Growth and Tax Reconciliation Relief law last year, or whatever, "Egg-tray" I think they call it, our accountants told us that you, Mr. Senator and your colleagues, had just made investment in company stock in ESOPs a lot more attractive because now dividends reinvested in company stock in the ESOP can be deducted by our company for tax purposes. They recommended that we change the matching part of our plan to an ESOP and make all of our matching contributions in company stock, rather than in cash, as we have been doing. We didn't consider the suggestion very long because we concluded that for what we wanted our plan to do, company stock was just not an appropriate investment. Senator, let me ask you a question. What kind of message were you trying to send when you made that amendment in Egg-tray?

SENATOR: In your retirement plan booklet, you say the plan is intended to help individuals achieve their personal retirement dreams. Yet today you're saying you don't measure how well individual employees are doing in defining, pursuing, or achieving their personal retirement dreams? So how do you know if your plan is achieving its strategy?

MS. JONES: Okay, so you don't want to answer my question about Egg-tray. That doesn't surprise me. But I'll answer yours. We do say that our 401(k) plan can be a good way to accumulate money for retirement. But you've added the word "dreams." At our company we try to be a little more straightforward about the plan, although I admit I've heard other companies talk about retirement dreams, and seen 401(k) booklets showing happy looking retirees resting under palm trees. That's not our style. To your point, however, employees tell us they like our plan. It can be used for a variety of purposes. We believe it is up to each employee to decide if the plan is meeting his or her needs.

SENATOR: We've seen surveys showing that most 401(k) plan sponsors don't believe that even half of their plan participants will be able to afford an adequate retirement. Given that acknowledged 50% failure rate, do you really think 401(k) plans are working well as retirement plans?

MS. JONES: Again, I haven't seen those surveys, but that would not surprise me. And, personally, I think that for some people 401(k) plans are working just fine for retirement, and for others they're not. As I have said before, and as I'll say again as long as you keep bringing it up, our plan is not especially intended to be a retirement plan. Senator, as you well know, your tax laws, ERISA and so on, drive how so-called 401(k) and other benefit plans, including retirement plans, work. I'm not going to take the time to go into detail here, because I wouldn't be telling you anything you don't already know, but there is very little in the law, nothing really, you can point to that indicates 401(k) plans are only supposed to be retirement plans.

SENATOR: Ms. Jones, you've stated that employee education is a critical element in helping employees be successful in using 401(k) plans.

MS. JONES: Actually, I've never said that. With 401(k) plans, and with investments, as with managing other life issues generally, better-educated people do better than poorly educated people. At least that's what we all like to think. Does that mean that better-educated people are happier? More successful? But I digress. Next question, Senator.

SENATOR: If it's that important, then I'm sure you have a clearly written policy statement that guides your retirement education and communication activities. Can you tell us about the specific goals and measures you have for your retirement education program? Are those measures based on what successful participants know and do?

MS. JONES: Senator, you're STILL NOT LISTENING. We do communicate with our employees. We give them information about the plan and the investments in the plan. We have guidelines for doing that. However, we do not try to give them what you call retirement education. So we don't have any goals or measures related to that. Moreover, we don't try to educate them about how to raise their children-- although I think you would agree that's very important, too. Get it?

SENATOR: Ms. Jones, are all the education and communication issues we've discussed today things you've known about for several years?

MS. JONES: Sure, and its been longer than for several years. I've been in this business a long time.

SENATOR: So you've had several years to fix your education program and you've chosen not to.

MS. JONES: Senator, you're driving me nuts. We do not have an investment education program to fix. Now if I was a high school teacher, or any kind of an educator, your question might be relevant.

SENATOR: Would you say that all your actions in retirement education-- as well as actions you've chosen not to take-- were in the best interest of participants?

MS. JONES: Senator, this is getting ridiculous. For the last time . . . we don't have an investment education program. That's not part of our 401(k) plan picture. If you think employers with 401(k) plans ought to be providing investment education to employees, which is what you're implying, then pass a law to require it. It's not required now . . . it's not the law now. I don't think that would be a good law, but I could see you reaching that conclusion with logic like, "Well, if we're going to give employers and employees tax breaks for retirement plans, including 401(k) plans, then we're only going to give them those tax breaks if they spend so much money, in addition, for retirement education or investment education or whatever." Some companies may already be providing what you would call investment education to their employees. We haven't chosen that route. We're very happy with the way our plan is working and believe it is in the best interests of our employees.

SENATOR: Ms. Jones, I don't want anyone to think that what you did or didn't do in retirement education was illegal or that you intentionally did anything to hurt your employees. But I do wonder if you would agree that most 401(k) plan sponsors need to completely reevaluate the goals, techniques, and measures they have for retirement education? Because without knowledgeable employees, how can voluntary, employee-directed retirement plans work well? Oh never mind . . . that's another question your attorney won't let you answer.

[After the Senator's remark about "another question" her attorney isn't going to let her answer, MS. JONES tries to respond but the Senator cuts her off, cold, and closes the matter with final sarcastic remarks.]

Thank you for your testimony of how well-run defined contribution plans provide retirement and investment education for employees.

Now, ask yourself, how would your company answer these same questions? Do you feel good about that?

Author's note: Dennis Ackley offered his paper as a "thought-starter." This article continues in the same spirit. The author thanks Mr. Ackley for permission to use the Senator's questions from his original article, and for his subsequent suggestions about this piece. However, the final product is mine alone. Ms. Jones, her company and its 401(k) plan are entirely fictitious, to make a point. Moreover, the reader is cautioned that the views, both expressed and implied, by this paper are not necessarily the personal political or professional legal opinions of the author.

The author, Carl Johnson, is an attorney with the Charlotte, North Carolina, law firm of Robinson, Bradshaw & Hinson. Mr. Johnson has practiced almost exclusively in the benefits area for over 25 years.

Not for publication or distribution without written permission of the author. All rights reserved. Copyright 2002, Robinson, Bradshaw & Hinson, P.A.

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