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Positive currents in DC market

More retirement savings, easier investment choices, lower management fees. A worker’s dream? No it is not, according to recent research about new trends in US defined contribution (DC) plans. Thanks to regulatory and market pressures, in 2006 DC plans, like 401(k)s, will conquer more participants and will be more understandable.
The 401(k) plans are available to 105m US workers, but only 74% enroll. A way to boost the participation rate is automated enrolment. Almost a quarter of employers surveyed by Hewitt Associates, a human resources and consulting company, already follow this strategy, and another 48% said that they are “very likely” (23%) or “somewhat likely” (25%) to introduce automatic enrolment this year. Until now the biggest obstacle has been state laws banning paycheck deductions without employee consent. But new legislation, approved by the House and Senate, would make it easier for employers to automatically enroll workers in 401(k)s. It could increase 401(k) participation by as much as 26% in the next 20 years, according to Financial Engines, an independent online financial adviser for DC plans’ members: assuming the accounts grow at 5% after inflation, as much as $1.8trn (€1.5trn) may flow into the 401(k) market.
But what happens to the retirement savings that go automatically into a 401(k) plan? According to the survey, among the 52% of employers that declared they are “somewhat” or “very unlikely” to offer automatic enrolment in 2006, the second most common reason cited (after simply “not being interested”) was the need for the Department of Labor to provide guidelines on the appropriate default investment option. So far, most default options in automatic enrolment schemes have been stable value or money market funds and these ‘prudent’ choices have been challenged in courts as not adequate for a long-term strategy. Maybe that is why some concerned DC sponsors are planning to change default investment fund from a stable value or money market fund to a balanced or asset allocation fund.
Last year the trendiest asset allocation funds were target-maturity funds: their inflows surpassed $22.5bn, a 50% jump from the previous year and 34% more than risk-based lifestyle funds, according to the research firm Strategic Insight. It was a sharp reversal from three previous years in which the lifestyle fund flows dwarfed target-maturity alternatives in DC plans. With risk-based lifestyle funds, participants have to decide their risk tolerance and then choose from a range of ‘conservative’ or ‘moderate’ and ‘growth’ or ‘aggressive’ funds. Participants then re-examine their risk profiles regularly.
Target-maturity funds are easier to understand and use: participants select the fund that most closely matches their targeted retirement year and the fund automatically becomes more conservative as the target approaches. It is “a solution to the very complicated problem we have in making decisions”, comments Avi Nachmany, director of research at Strategic Insight. The leading player in this market is Fidelity, which manages the DC industry’s largest service platform: last year its target-maturity funds got $9.4bn flows; second is The Vanguard Group, with a distant $5.3bn and third is T Rowe Price with $4.3bn.
Making choices easier motivates DC sponsors to offer online third-party investment advisory services. The Hewitt survey says 25% of employers already offer such services, and 44% said they are “very likely” (16%) or “somewhat likely” (28%) to offer them in 2006. Also, 401(k) providers such as Fidelity and Goldman Sachs, are pushing in this direction, asking Congress to let them advise owners of the retirement accounts they manage.
Finally, 49% of DC sponsors surveyed by Hewitt plan to find “ways to reduce costs of funds offered” in 2006. Mutual fund management fees have been dropping since 2003 and will continue to fall in 2006, says Rick Meigs, president of 401khelpcenter.com. In 2003, 622 funds contractually reduced fee levels; that figure increased to 2,830 in 2004.
Invesmart, a financial services firm, has constructed a retirement portfolio cost barometer that calculates the average cost of investment management for 64 top mutual funds: currently a balanced portfolio with 60% stocks and 40% bonds should cost plan participants no more than 50bps, down from 55bps in November 2004. But plan sponsors should not expect that just because fees are dropping in general that they automatically will benefit, warns Rob Rossi, Invesmart vice-president. They should negotiate, use benchmarking and urge their providers to separate investment management fees from servicing and marketing fees in mutual fund expense ratios.

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