Risk Software Shows Major Flaws in 401(k) Plan Design
Once a year I do a newsletter about 401(h) plans (the only qualified retirement plan where money comes out tax-free) and why buying life insurance in a qualified plan is a terrible idea. To read either of these two newsletters, click on the following link:
This newsletter will focus on the fiduciary obligation employers have when offering qualified retirement plans.
ERISA and Duties-the Employee Retirement Income Security Act of 1974 (“ERISA”) generally governs qualified retirement plans. ERISA imposes certain duties and responsibilities on the “fiduciaries” who are responsible for the administration of those retirement plans.
Employers who offer qualified plans are fiduciaries and, as such, have duties they must undertake and liabilities that go with those duties. The duties I want to discuss are:
1) Trustees must act in accordance with the standard of care established under ERISA, that is, the care, skill, prudence, and diligence . . . that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.
2) Trustees must diversify plan investments in order to minimize the risk of large losses (unless it is clearly prudent not to do so).
Violating these duties-it’s tough to put a percentage on it, but I’d say that 75% or more of the retirement plans in the marketplace are set up in a way that violates the fiduciary duties of the employer.
The goal is to help employees achieve investment returns that are in line with the market they want to be in. By that I mean if the employee is conservative, there should be options to generate benchmark returns with benchmark losses. The same goes for someone with a moderate or aggressive investment profile.
Helping Employees-what are employers doing to help employees 1) determine their own risk tolerance/risk capacity and 2) what are they doing to help employees find an investment mix to fit their own risk tolerance/risk capacity?
The answer for 99% of the plans in the marketplace is that they don’t help with 1) or 2).
By giving too few or too many options and by letting employees pick their own investments, I’d submit to you that employers who do either are setting themselves up for a fiduciary liability lawsuit.
Too few options means many employees can’t diversify. Too many options with no guidance means that the chances of employees picking an investment mix to reach their goals with the appropriate amount of risk is about zero.
Real World Example-the reason I did this newsletter is because I have a good friend who asked me to look at the investments he chose in his 401(k) plan. He works at a fairly large company that you think would have a good or certainly a fiduciary compliant 401(k) plan.
He was invested in the following:
10% S&P 500 index
15% American Funds Euro Pacific R6
5% Oppenheimer Developing Markets Fund
10% JP Morgan Small Cap Value Fund R6
20% Investco Comstock Fund R6
30% The Hartford MidCap Fund R6
10% TRowe Price Growth Stock Fund
I entered this into the OnPointe Risk program and it came up with a risk score of 75 (on a 1-100 scale)
You know what my friend’s personal risk score is? 24!
Does the above investment mix for my friend sound prudent to you? It shouldn’t and it’s not.
What did I tell him? I pointed out that his investment mix historically is more risky than the S&P 500 index and that the CAGR going back to 4-1-07 was actually less than what the S&P 500 returned. Taking more risk for less reward is a disaster if you look at it from a fiduciary point of view.
Using Risk Software to fulfill your fiduciary obligation
I submit to you now that risk tolerance/scoring software has become more prevalent in the industry that fiduciaries of qualified plans better start offering them in some format to employees. Offering them will allow fiduciaries will help the employees find more suitable investments among the options provides and help insulate employers from fiduciary liability lawsuits.
The cost benefit analysis of offering risk tolerance software to employees is a no brainer. The cost is low and the benefit is high (benefit to both the employee and employer).
So, next time you talk with a potential client about money in their 401(k) plan, you might want to ask them if they have access to risk software to help them pick investments that are suitable for their situation. You know the answer will be no and then you can have a discussion about how you can help.
Roccy DeFrancesco, JD