“The machine does not isolate man from the great problems of nature” as author Antoine de Saint-Exupery says, “but plunges him more deeply into them.” Not according to Wall Street. 

They believe that they now have the best solution for the dismal efforts made by employees who pay little heed to their retirement savings. The well-warted Pension Protection Act was signed into law this week by the president in the hope that it will solve the problem of lackluster enrollment in many company sponsored retirement plans.

But enrollment is not necessarily the problem. Statistics trotted out by leading mutual fund companies do show that a significant portion of investors know little about what retirement savings is or how lack of it will affect them. And that is problematic. But legislation will not necessarily bring more folks into the fold.

The Pension Protection Act tries to fix the lack of full enrollment where these plans are offered. It may, however only deliver on half of the intended promise. 

The workers the Act tries to protect have repeatedly been found guilty of three major offenses: they are not enrolled in their employer’s plans, they are enrolled but have been given the default investment at the time of their hiring (which is usually a balanced fund or worse, a money market account), and thirdly, those enrolled buy too much company stock.

Since the inception of the 401(k), the investment industry has failed to reach individuals who show an obvious distrust for investing. Citing confusion or too many choices, employees when faced with making enrollment decisions on their own will either opt out of the plan or simply enroll in the default investment.

The Vanguard Group recently completed a study involving 12,000 retirement plans and how employees use them. The study uncovered a cross section of American workers who had investments deemed either too risky or too conservative. This should come as no real surprise. Although financial education has been fully embraced by many mutual fund families in an effort to change this, employees have still remained financially illiterate and almost wholly out of touch with their own personal risk assessment. 

Employees, like investors everywhere face the possibility of making bad decisions. But is the employee to blame for their overexposure to risk or their underexposure to reward? 

This piece of legislation relegates the lowly employee as too dimwitted to save him or herself. And with the Vanguard report, the mutual fund industry has what appears to be empirical evidence supporting the claim. As a result, what we now have is the chance to move towards full enrollment as companies mechanize those investments. On the surface, this seems to solve the second problem facing employees and their retirement once they are enrolled: how to increase the amount saved, achieve proper asset allocation, and most importantly, good diversification.

The mechanization of the defined contribution plan, currently being referred to by the industry as managed accounts, will not be cheap. These accounts are believed to have three main benefits for employees. 

The first problem the Act addresses is savings. The study revealed that almost every currently enrolled employee has set a fixed percentage to save for retirement. Many simply use the template of the employer match to arrive at the percentage, and, consequently, they never change it. If the employer offers a 3% match, the employee tends to set their percentages at the same level. If the employer does not match, employees often have little incentive to join the plan.

The legislation should have encouraged companies to beef up or reinstate the incentive of matching contributions. The Act could have insisted on a universal match for all employee contributions up to 3% and continue to do so up to 5% in increments to coincide with increased savings by the employee. For example, employees contributing the maximum allowed (15%) would get the maximum match. This could have been easily offset with tax incentives. Instead, the law sets minimums far below what will be needed to retire.

Which brings us to the second problem. How do you get the employee to properly allocate their assets? While tens of thousands of books have been written on the subject with several offerings of my own included, the new law seeks to address a glaring flaw in how the sample 12,000 investors involved in the study allocated their money.

In many instances, the enrolled employee possessed too many funds that had similar investment charters or worse, they held a balanced fund, a 50-50 split on stocks and bonds. A managed account, the thinking goes, would rearrange those allocation factors and increase the employee’s gains in the process. 

Managed accounts are not new and in many cases, are already a part of many employee plans. They use computer modeling to determine risk based on age and years left to work and invest accordingly, periodically realigning the portfolio to suit the investor’s age and risk tolerance. 

While this type of goal profiling is good, all employers needed to do was make these types of accounts the default for newly enrolled employees or make these kinds of funds the focus of their matches. While the other funds would still be available, at least a portion of the employee’s retirement would be “in the right place”. 

The Act seems to embrace Karl Marx in the quest for a better invested employee and consequently, a better-financed retirement: “Without doubt, machinery has greatly increased the number of well-to-do idlers.”

Too often, managed accounts use a form of indexing. Index funds by their nature are the most tax efficient of investments and should be kept outside of tax-deferred accounts. 

While a retirement set on autopilot with a fixed contribution might seem like a good thing at first glance, it can fall short of a total assessment of the employee’s financial health. These accounts do not take into consideration the presence of additional investments held outside the retirement plan, how they could jeopardize the goals the managed account has set forth, and how you can align everything. All managed accounts seem to do is increase the average employee’s exposure to stocks.

Speaking of stocks and lastly, did we really need a law to direct companies to stop selling their stock to their employees at attractive prices, often well below what the average investor pays? 

The Labor Department, the branch of government that overseas 401(k) plans, could have simply demanded that company stock be removed from all plans. Setting up a separate direct purchase plan would still allow the employee to bulk up on one stock but they would have to do so after their 401(k) was at least minimally financed.

According to the supporters of the Pension Protection Act, this little law will fix the so-called investor inertia. As the law unfolds over the next several years and the costs are determined (fees for additional education and administration of these new accounts will be passed on to us), only time will tell whether these plans will allow the well-to-do idler be able to retire with enough. 

When it comes to investing, I believe that de Saint-Exupery said it best. “The one thing that matters is the effort”.

© 2006 Paul Petillo
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Paul Petillo
Blue Collar Dollar.com
Portland, OR USA
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