The 401(k) Plan Turns 40

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1 CALLAN INSTITUTE December 2017 Research The 401(k) Plan Turns 40 Six Lessons from 1978 In 1978, a section of the Internal Revenue Code was enacted into law that made 401(k) plans possible. That year is notable for other reasons as well: the Dow closed at 805, 10-year Treasury yields hit 9%, and a first class postage stamp cost 15 cents. In 1978, the first Garfield comic strip was published in U.S. newspapers and Space Invaders launched a video game craze. Over the past four decades, 401(k) plans have become commonplace: more than 640,000 defined contribution (DC) plans exist, 1 accounting for $5.1 trillion in assets. 2 We might even say that DC plans have flourished: Employers are 14 times more likely to offer a DC plan than a defined benefit plan. 3 For the most part, plan sponsors have taken advantage of DC plan improvements that have transpired since 1978 under legislation such as the 2001 Economic Growth and Tax Relief Reconciliation Act and the 2006 Pension Protection Act. Notably: Nearly three-quarters of DC plans offer Roth-designated accounts Likewise, approximately three-quarters have automatic enrollment Four out of five also offer automatic contribution escalation Nearly all (99%) have a qualified default investment alternative Most (91%) offer target date funds Many (75%) offer investment guidance/advisory services 4 Yet some aspects of DC plan management may still be stuck in the era of bell bottom pants and earth shoes. In this article we take a walk down memory lane while observing lessons sponsors can apply to their DC plans in Knowledge. Experience. Integrity.

2 The Twinkie Defense: In an infamous case in 1978, overindulgence in Twinkies was used as a defense in a murder trial. The Twinkie Defense is now synonymous with improbable legal defenses. But plan sponsors may find themselves relying on it if they fail to monitor the investment advice provided to plan participants. The DOL s recent Fiduciary Rule 5 created a new standard for what constitutes advice to 401(k) plan participants and arguably results in additional responsibility for plan sponsors to monitor those newly minted advisers. Yet 43% of DC plan sponsors don t know how they will go about monitoring advice given to plan participants by the plan recordkeeper under the Rule, according to Callan s 2018 DC Trends Survey. Consider evaluating written advisory communications, call scripts, and sample participant calls involving advice. While one plan sponsor indicated to Callan that he listens in on six hours of calls a month to understand the distribution advice his plan s recordkeeper gives to plan participants, less intensive periodic reviews can also be very effective. Review credentials of representatives giving advice, require reports on advice interactions, and generally understand typical recommendations or outcomes. Stayin Alive: In the iconic dance floor scene in Saturday Night Fever, John Travolta danced to the Bee Gees Stayin Alive instead of Boz Scaggs Lowdown, reportedly because approval was not granted to use the Boz Scaggs song in time for the movie s release. The evident procrastination of executives at Columbia Records in 1978 undoubtedly makes it painful for them to watch the disco-fever film to this day. Plan sponsors can apply this lesson to DC plans in multiple ways, including by regularly benchmarking plan fees. According to Callan s 2018 DC Trends Survey, reviewing DC plan fees is the number one means of improving fiduciary positioning over the past 12 months, and remains an area of focus over the coming year. And plan sponsors are reducing plan fees and making them more transparent by moving away from revenue sharing to an explicit dollar administration fee. But more than one-third of plan sponsors report that they have not calculated and benchmarked plan fees within the past 12 months. What are they waiting for? Calculate and benchmark plan fees every year. Conduct an in-depth review of plan administrative and investment fees at least every three years. A little late: It took nearly 70 years, but in 1978 a major revision of copyright law went into effect, reflecting advancements in technology such as the advent of television, motion pictures, sound recordings, and radio. The good news first: Most DC plans have an investment policy statement (IPS). The bad news is that many DC plan sponsors fail to keep their IPS up to date: In 2017, just over half reported that they had reviewed and/or updated their IPS in the past 12 months (down from 60% in 2016). Much like the pre-1978 copyright law, an out-of-date IPS can be of limited usefulness. And even if the IPS is up-to-date, it is important that investment committees review it on a regular basis to ensure that they are familiar with its guidelines: In its 2012 ruling in Tussey v. ABB, the U.S. District Court for the Western District of Missouri ruled against 2

3 plan fiduciaries in part because they failed to adhere to their own IPS which was deemed a governing plan document within the meaning of ERISA section 404(a)(1). A Court of Appeals later reversed much of the ruling, and noted that it was concerned that construing all investor policy statements as binding plan documents will discourage their use. Make a practice of reviewing the IPS regularly at least annually and keeping it up-to-date so that it remains a useful tool for guiding decision-making.! Defcon V: A computer testing malfunction caused the U.S. Department of Defense to accidently fire up its nuclear missiles with no provocation, nearly igniting World War III. Computer problems are clearly not a new phenomenon, but they have become much more pervasive. Data breaches seem to be a common occurrence consider the 143 million consumers affected by the Equifax data breach. It is difficult to imagine a breach more financially devastating to workers than a hack into their DC plans. Even so, auditing of security protocols of DC plan service providers remains a fairly low priority for plan sponsors: it ranked near the bottom of the list in 2017 and in the middle of the pack for Plan sponsors might be daunted by the challenge where do they even begin to ensure that cybersecurity threats have been addressed? Enter the SPARK Institute. In 2016, it formed a Data Security Oversight Board (DSOB) comprised of recordkeepers and consultants to help plan sponsors evaluate recordkeepers cybersecurity. The DSOB identified critical data security control objectives, including encryption, cloud security, compliance, incident communications, and access control, among others. Work with your consultant to leverage SPARK s framework for protecting plan participants information online, and to revisit and update the cyber auditing process. Nick Nolte as Superman? In the 1978 movie Superman, Marlon Brando was paid $3.7 million merely to play the bit part of Superman s father. Meanwhile, legendary actor Christopher Reeve was almost passed over in favor of Nick Nolte for the lead role. This Superman takeaway is evident: know who your stars are and treat them right! Ninety-one percent of plans have a target date fund (TDF), with the average TDF holding more than one-third of plan assets. Arguably, this gives TDFs the leading role in DC plans, yet they often get anything but star treatment. In 2017, only 29% of plan sponsors evaluated the suitability of their TDF. The DOL s 2013 Target Date Retirement Funds Tips for ERISA Plan Fiduciaries recommends that plan sponsors with TDFs establish a process for comparing and selecting TDFs that considers how well the TDF s characteristics align with eligible employees ages and likely retirement dates, as well as other characteristics of the participant population (salary levels, turnover rates, contribution rates, and withdrawal patterns). Regularly undertake TDF suitability studies to keep up with changing plan demographics (due to mergers, acquisitions, spin-offs, etc.) and evolving target date strategies. Knowledge. Experience. Integrity. 3

4 Short Sighted: In 1978, the Maryland state legislature clearly not a fan club for musician Randy Newman considered making it illegal to play the song Short People on the radio. Much like the Maryland state legislature, DC plan sponsors may not have the right focus: More than a third of DC plan sponsors have no policy for retaining assets for retired and terminated participants. With 401(k) plans lumbering into their 40th year, retiree/terminated assets are now a major consideration. According to the Employee Benefit Research Institute, approximately one-third of 401(k) plan assets are in accounts of participants aged Plan sponsors are wise to consider the impact on both retirees and current employees of sizeable assets exiting the plan. Retaining retiree assets can afford all plan participants greater economies of scale when it comes to things like paying for investment management fees. (Of course, conversely, retired participants can be more expensive for plan administration e.g., tracking down changes of address, etc. and are potentially more litigious.) Thoughtfully consider and document a policy around retaining retiree assets. Those that opt for asset retention should ensure the plan s design, delivery, investments, and communication support participants staying in the plan by addressing the following questions: Do any elements of the plan design (e.g., force-out provisions) make it challenging for workers to leave money in place? Should the plan offer more options that can be particularly attractive to retirees, such as brokerage windows (which increase investment flexibility)? Are there drawdown solutions that can help retirees determine how much to extract from their DC plan? Unlike popular culture, where decades-old movies and fashion might reappear at any moment, DC plans are clearly not stuck in the 1970s. However, plan sponsors can certainly take lessons from that era that will ensure their plan participants thrive in retirement and benefit from the advances made in DC plans over the past 40 years bell bottoms optional. Endnotes 1 Department of Labor Employee Benefits Security Administration, September ICI Research Report: Defined Contribution Plan Participants Activities, First Half Department of Labor Employee Benefits Security Administration, September Callan 2018 DC Trends Survey, December Callan 2018 DC Trends Survey, December

5 About the Author Lori Lucas, CFA, is an Executive Vice President and Defined Contribution Practice Leader at Callan. Lori is responsible for setting the direction of Callan s DC business, providing DC support both internally to Callan s consultants and externally to Callan s clients, and developing research and insights into DC trends for the benefit of clients and the industry. Lori is a member of Callan s Management Committee and is Chairman of Callan s Defined Contribution Committee. She is a shareholder of the firm. Formerly, Lori was Director of Retirement Research at Hewitt Associates. Lori has also served as a vice president at Ibbotson Associates, a pension fund consultant at J.H. Ellwood & Associates, and an analyst and product development leader at Morningstar, Inc. Lori received a Bachelor of Arts from Indiana University and earned a Masters from the University of Illinois. Additionally, she earned the right to use the Chartered Financial Analyst designation. Lori is a former columnist for Workforce Management online magazine and her views have been featured in numerous publications. She is Chair of the Defined Contribution Institutional Investment Association and the former Executive Chair of EBRI s Research Committee. Lori is also a frequent speaker at pension industry conferences. Knowledge. Experience. Integrity. 5

6 If you have any questions or comments, please About Callan Callan was founded as an employee-owned investment consulting firm in Ever since, we have empowered institutional clients with creative, customized investment solutions that are backed by proprietary research, exclusive data, and ongoing education. Today, Callan advises on more than $2 trillion in total fund sponsor assets, which makes it among the largest independently owned investment consulting firms in the U.S. Callan uses a client-focused consulting model to serve pension and defined contribution plan sponsors, endowments, foundations, independent investment advisers, investment managers, and other asset owners. Callan has five offices throughout the U.S. For more information, please visit About the Callan Institute The Callan Institute, established in 1980, is a source of continuing education for those in the institutional investment community. The Institute conducts conferences and workshops and provides published research, surveys, and newsletters. The Institute strives to present the most timely and relevant research and education available so our clients and our associates stay abreast of important trends in the investments industry Callan LLC Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Institute (the Institute ) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute s permission. Institute clients only have the right to utilize such material internally in their business. 6

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