401(k)s: It's Not All Fun and Games Being the New Retirement Superpower By Matt Smith, Managing Director, Russell Retirement Services, and Robert Collie, Director, Research and Strategy Russell Investment Group March 2007 Being #1 is sometimes not all it's cracked up to be. The burden of responsibility can weigh heavily, and expectations run high. Every fault, every wrinkle is in the spotlight. These truths are starting to hit home for 401(k) plans. The story of how a convenient supplemental savings plan grew into America's primary source of retirement provision for private-sector workers is not one to retell here. But it happened. 401(k) plans have grown up. They're the new retirement superpower. And a world of responsibilities and expectations is being laid at their door. Some of these expectations are set out in recent developments — specifically, in the Pension Protection Act of 2006 (PPA), the Department of Labor's (DOL) proposed default investment rules, and the General Accounting Office (GAO) report on fees. The interest by policymakers — and lawyers — has turned up the pressure to get this right. Enrollment Even when a 401(k) plan is available, inertia prevents many workers from getting over the basic hurdle of joining, rendering the plan valueless to them. For employers, the best response to this inertia is auto-enrollment of eligible workers (with the choice of opting out). The PPA acknowledged the problem of low enrollment with an antidiscrimination-testing safe harbor intended to encourage auto-enrollment. But not every 401(k) issue is going to be that simple to address. Contributions Current contribution rates may be adequate if you regard 401(k)s as supplemental savings vehicles. But rates fall short once you start regarding 401(k)s as the primary — or sole — vehicle for retirement provision. The PPA made a first step toward addressing the need for higher contribution levels with minimum rates (which escalate with years of participation) required in order to qualify for the auto-enrollment safe harbor. But really good retirement provision is expensive. It needs to deal with life expectancies that are longer than ever. It ought to handle inflation. It ought to cover not only the plan participants but also spouses and possibly other dependents. That could be quite a stretch with a total contribution of just 6 percent of salary. To encourage higher savings rates, what's needed is more transparent disclosure of likely income-replacement levels. Being told "You have a pot of money worth $50,000" can give a worker a false sense of security, because it sounds like a lot of money. Adding, "This is likely to be enough to replace about 15 percent of your salary if you retire at age 60" might make the challenge more clear. Default investments Most 401(k) participants (especially in an auto-enrollment world) invest in line with the default option provided by the employer. But many cautious employers have preferred to avoid default options that might suffer capital loss (such as the fixed income or equity investments that other long-term investors favor), because they did not want to be blamed for those losses. The result was, in many cases, inappropriate short-term investments, such as money market funds or GICs (guaranteed investment contracts). The DOL has proposed rules to encourage default options that accept the risk that must be taken in order to offer more chance of earning competitive long-term returns. Again, the way this has been done is through a safe harbor — in this case, protection for the employer against liability for losses, provided certain requirements are met. Default choices that meet these requirements will be known as QDIAs (qualified default investment alternatives). Fundamentally, the DOL is saying participants need default vehicles that are simple, diversified and age appropriate. It is exactly this combination that Russell Investment Group and others had in mind in the creation of what are known as lifecycle funds, or alternatively, target date funds. These funds feature portfolios that reallocate over time to become more conservative. That is, they become less heavily weighted in equity investments as participants approach and pass beyond retirement. Employees are simply placed into the fund with a target date nearest the year the employee is expected to retire. For instance, a person who reaches retirement age in 2040 might default to a 2040 fund. The percentage of equities would begin high, perhaps even at 100 percent, when the participant was young, but would gradually reduce as the participant aged. At retirement, some percentage of equities would remain in order to grow the fund to provide income through the participant's life expectancy. Auto-enrollment with a target date default option appears likely to become the new norm for 401(k) plans. We believe the components of a good target date fund include: a sound glide path for managing the asset allocation exposure over time (in particular, for managing the exposure to equity markets); appropriate breadth of strategies, including the use of active management strategies where appropriate; management of risk, including manager risk; objectivity of decision making, including selection of underlying funds; sound implementation, including rebalancing, cash management and transitions; and quality of investments and appropriate fee structures. Advice Of course, even with multiple target dates to choose from, a default option has to be a one-size-fits-all option. As such, lifestyle products will fit some participants better than others. Defaults cannot take into account workers with substantial savings outside the DC plan, or those with unusual tolerance for risk, or with different future-earnings expectations. To enable more help for those who want or need customized investment options, the PPA makes it easier for plan sponsors to offer advice to participants, and it provides fiduciary cover for plan sponsors who offer such advice, as long as they go through a prudent process when selecting a provider. However, best practices in this area are evolving. In the new world, plan sponsors will likely focus more on doing the most good for the most participants by improving returns on default investment vehicles. They will spend less time trying to build appropriate investment strategies one at a time through advice and employee involvement. Our experience the past 20 years is that most employees don't want to have to make those sorts of choices. Fees There is concern among some policymakers that 401(k) fees may be unreasonably high, or that undisclosed fees may be leading to conflicts of interest. The GAO report — produced in response to a request from Congressman George Miller (D-Calif.), incoming chairman of the House Committee on Education and the Workforce — identifies disclosure as the primary means of managing these concerns. 401(k) fees are likely to be an area of major attention for some time to come. Other issues With the PPA's new rules — and a number of class action lawsuits — concerning company stock in 401(k) plans, the role of company stock going forward is likely to be much smaller than in the past. The bar is being raised for 401(k) plans in many other ways, too. These include: communication and reporting; post-retirement decumulation; breadth of asset classes and value-adding strategies; fund mapping (for example, when plans merge); and portability. These are just a few of the challenges being laid at the door of 401(k) plans, now that they have become the retirement superpower. This flurry of activity is not a one-time deal. 401(k)s are now firmly in the spotlight of regulators, the press and the public. In their role as the new retirement superpower, they are going to have to live up to some pretty high expectations. NOTE: Fund objectives, risks, charges and expenses should be carefully considered before investing. A prospectus containing this and other important information can be obtained by calling (866) 676-7680 or visiting the mutual funds section of russell.com. Please read the prospectus carefully before investing. The LifePoints® Funds are a series of funds of funds which expose an investor to the risks of hte underlying funds proportionate to their allocation. Investment in LifePoints funds involves direct expenses of each fund and indirect expenses of the underlying funds, which together can be higher than those incurred when investing directly in an underlying fund. Each of the LifePoints® Funds, Target Date Series, invests its assets in shares of a number of underlying Russell Investment Company Funds. The allocation of each fund's assets is based solely on time horizon and will become more conservative over time until approximately the year indicated in the Fund's name, at which time the allocation will remain fixed. From time to time, Russell Investment Management Company expects to modify the target asset allocation for any fund and/or the underlying funds in which a fund invests. In addition, the funds may in the future invest in other funds which are not currently underlying funds. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Russell Investment Group is a Washington USA corporation, which operates through subsidiaries worldwide and is a subsidiary of The Northwestern Mutual Life Insurance Company. Securities products and services offered through Russell Financial Services, Inc. (formerly Russell Fund Distributors, Inc.), member FINRA, part of Russell Investments. For information on the Financial Industry Regulatory Authority, go to www.finra.org. RFD 07-6517. First used: March 2007.			Expert insights Read more Russell market analysis.   Why Russell? 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