Personal financial education is an important public and private policy tool. 401(k) plan sponsors, credit card companies, insurance companies, banks, investment companies, Federal Reserve, and federal and state governments all offer and promote financial literacy.
The reason for this effort is that disclosure and choice is the heart of the financial regulatory model governing the transacting of consumer credit, insurance and investment products. Given widespread financial illiteracy, financial education is necessary to make the disclosure and choice strategy workable.
Similar logic applies to participant-directed 401(k) plans, where participants select their own investments. ERISA Section 404(c) requires plan sponsors to provide employees enough information to make educated investment choices.
Because few polled employees show any knowledge of investing, and 75% of plan sponsors admit employees require help with basic investment education, many companies provide more than information and offer their employees personal investment education and financial advice.
However, evidence of the efficacy of these programs is starting to raise doubts about their utility. Complicating this are concerns about the abilities of the average employee and their decision-making biases.
Jump$Start's nationwide survey of high school seniors exposed to financial education shows limited success. Psychologists and behavioral economists have catalogued cognitive problems that undercut the reasoning skills and self-control needed to make investment decisions. Most Americans can't calculate the cost per ounce of a jar of peanut butter.
For 40 years, creditors have used annual percentage rates to help borrowers compare credit products; yet, borrowers of home mortgage money still can't tell whether APR is lower, the same, or higher than the loan contract rate.
This evidence undermines the credibility of participant-directed 401(k) plans and their accompanying requirement of employee investment education. One alternative for HR/benefit pros to consider is a nonparticipant-directed 401(k) plan, as outlined in "A Step beyond ERISA Section 404(c): Improving on Participant-Directed 401(k) Investment Model," a 2005 article published in the Journal of Pension Benefits.
The core of this model is hiring an ERISA-defined investment manager - bank, trust company, insurance company or registered investment adviser - by named plan fiduciaries to manage plan assets. ERISA Section 402(c)(3) allows this option.
The retained investment manager creates various portfolios, not investment options, comprised of passively managed mutual funds matched to different employee age and risk profiles. Generally, five to seven portfolios are enough to cover most employees.
The investment manager chooses individualized efficient portfolios for participants' based on their retirement horizon and risk tolerance. No pooling or profit-sharing of investment money takes place. Individual portfolios determine participant investment earnings.
This strategy solves many problems present in participant-directed 401(k) plans. It increases participant investment returns significantly because of efficient portfolio matching and lowers investment fees associated with passively managed funds.
It boosts participant preparation for retirement. Participants are relieved of selecting an asset allocation, and plan sponsors don't have to provide investment education.
Further, named plan fiduciaries aren't responsible for selecting and monitoring plan investment options or complying with rules in ERISA Section 404(c).
In addition, named plan fiduciaries aren't responsible for acts and omissions of retained ERISA-defined managers if their appointment follows ERISA Section 402(c)(3). Together, these relieve named fiduciaries of responsibilities and cut compliance costs. Named fiduciaries still have an oversight responsibility over their ERISA-defined investment manager.
All retirement plans are imperfect. Participant-directed 401(k) plans have a serious flaw if their ultimate purpose is to help American workers retire securely: Participants lack training in personal investing. Whether sponsors of such plans can correct this problem is open to debate. Emerging evidence detailing the ineffectiveness of investment education and employee judgment biases suggest it might be an impossible task.
HR/benefits professionals must ask what enhancements or alternatives to participant-directed plans fix this problem. One alternative they should review is the nonparticipant-directed 401(k).
Contributing Editor Mark Nadler is an economist and professor at Ashland University in Ashland, Ohio. He is a member of The Financial Education Co. and president of Vincuro, a financial stress reduction firm.
