In 1999, as executives at Progressive Corp. were preparing to outsource the recordkeeping for the company's 401(k), it dawned on them that 75 percent of the plan's assets were in Progressive stock. So the Cleveland-based auto insurer eased its restrictions against selling the shares. While its matching contribution of up to 3 percent of pay would still be made in Progressive stock, vested employees, those with at least four years of service, could for the first time move the company match into the plan's other investment options.
"We didn't want our people to be invested so heavily and then all of a sudden have something happen to the stock," says Marilyn Muzic, director of financial operations.
Then came the collapse of Enron Corp. and the meltdown of its 401(k). In April Progressive liberalized its rules again, allowing all employees, vested or not, to sell company stock whenever they wanted. Since then two thirds of the matching dollars have been moved out of company stock. Progressive also revised its investment menu and changed the scope of the educational seminars it offers its plan participants. "We have always tried to make the 401(k) as flexible as possible," Muzic explains.
Burned by the bear market and mindful of recent high-profile corporate bankruptcies, employees in 401(k) plans can use all the help they can get. Surprisingly few are pulling money out of the stock market, but they are asking employers and fund managers more pointed questions about how they can protect their retirement savings. In some cases, employees are doing more than just talking: Lawsuits have been filed against a number of companies with spectacular losses, including Enron, Global Crossing, Lucent Technologies and WorldCom, alleging that management was irresponsible in encouraging workers to put 401(k) assets in company stock.
Total 401(k) assets have lost 10.1 percent of their value since March 2000, after having tripled to more than $1.8 trillion from 1993 to 1999, according to Cerulli Associates. "We all knew the risk was there with defined contribution plans, but now it has sunk in," says Alex Sussman, national retirement practice leader at Manhattan-based consulting firm Segal Co. During the long bull market, adds F. William McNabb, head of Vanguard Group's institutional business, "employee expectations got out of hand. This [market decline] has been a real hard lesson."
Plan sponsors, aware of the rising number of pension-related lawsuits filed by employees, are focusing on modest reforms: less risky investment options, educational seminars that explain risk, easier rules on shedding company stock. These changes aim to limit the impact of market volatility, encourage appropriate diversification and compensate for participants' limited investment savvy. But is that enough? The basic principle of the 401(k) -- self-directed investing by the employee -- has been called into question by critics who argue that plan sponsors should be expected to assume more of the market risk from employees, as they do with defined benefit plans.
"I personally would prefer to have a defined contribution when I'm working, to have all the flexibility. But when I get to the point of retirement, I would prefer to have some part of my assets in the form of a defined benefit plan," with its guaranteed payout, says Towers Perrin consultant William Daniels.
Companies like Progressive aren't considering anything quite so radical. Instead, their first step has been to ease restrictions on selling company stock. Although Enron and WorldCom are extreme examples of what can happen to a 401(k) if an employer's stock goes into free fall, no one -- employee or employer -- now underestimates the inherent risk of a plan overloaded with company stock. The difficult question is, How much is too much? Some financial advisers would argue that participants with anything more than 10 percent of their retirement savings in a single stock are insufficiently diversified.
Yet according to a 2001 survey of large-company plan sponsors by Hewitt Associates, about one third of plan assets were held in company stock, by far the largest single allocation. (Large-cap equity was second, with an average 19 percent stake.) The survey also found that nearly half of the employers that offered a company-stock option made their match exclusively in that stock; just 15 percent of those firms let their workers divest out anytime they wanted. Typically, the company stock could not be sold until the employee reached age 50 or 55.
Several bills in Congress would either restrict the amount of 401(k) assets that can be held in employer stock or allow participants to move their company matches out more quickly. Though Congress is not likely to pass legislation before adjourning for the year, a number of large plan sponsors, including AOL Time Warner, ChevronTexaco Corp., Gillette Co., Mellon Financial Corp. and Walt Disney Co., have already relaxed their company-stock restrictions (Institutional Investor, August 2002). These corporations may continue to match employee contributions with company stock, but they now allow workers to shift that money to another plan option as soon as it hits their accounts.
Companies make the match in their own shares because it's a lot cheaper than shelling out hard cash. In addition, they can be confident that the stock is in relatively loyal hands. For their part, too, many participants compound their dependence on their employer's stock performance by placing their own contributions in their company's shares.
EVEN IF THEY MAKE NO CHANGES TO THEIR company-stock policy, many employers are refining their plan investment menus.
During the go-go 1990s sponsors piled on the investment options in their 401(k)s, adding small-cap, midcap, international, global, sector and junk bond funds to the more standard lineup of large-cap equity, balanced, stable-value, index and money market funds. Their rationale: More options would give employees more ways to diversify and would assure that plan sponsors were meeting their legal obligation to provide an adequate range of choices. "They were a little afraid of being exposed as a fiduciary if they didn't offer an option," says Carol Geremia, president of MFS Retirement Services.
In the Hewitt Associates survey, 61 percent of the respondents said they offered ten or more investment options, compared with 42 percent two years earlier. In the early and mid-1990s, the typical plan offered six or seven options.
These days, though, plan sponsors are deciding that the kinds of choices are more important than their quantity. Thus some are trying to offer at least several low-risk investments and to eliminate options, such as sector funds, that are simply too risky for the average participant. Additionally, plan sponsors that offer several growth funds, say, are scaling back to just one, in an attempt to eliminate unnecessary duplication.
"A lot of plans are stepping back and looking at whether there needs to be a simplification of options" and whether the lineup really fits their supposed investment policy guidelines, says Vanguard's McNabb. At the same time, says Geremia, plan sponsors are adding more-conservative options such as value and small-cap value funds.
Increasingly, plan sponsors are encouraging participants to opt for so-called lifestyle or life-cycle funds: mixtures of stocks and bonds that are tailored to a particular age range and risk tolerance and are periodically adjusted as the participant ages or grows more or less risk-averse. Instead of trying to put together their own diversified portfolios of individual asset categories, participants choose a single, premixed, fully diversified fund and turn over investment responsibility to a professional. Typically, there's a more aggressive fund for younger people, a more conservative product for participants in their 50s and at least one moderate fund positioned between the two.
Lifestyle funds were one of the fastest-growing asset classes in the Hewitt survey, offered by 35 percent of the respondents in 2001, versus 19 percent in 1997, and consultants and money managers say they've only grown in popularity in the past year. Consulting firm Segal includes such funds in about 75 of its plan designs each year, up from maybe a dozen in 1997. For MFS's clients this was the second most popular new option in 2001 (after value funds), and Geremia expects it to be first this year.
Although a lifestyle fund seems like a logical approach to planning, participants often misuse these investments. In theory, one such fund will provide all the diversification a person needs, so all of his or her retirement assets should go into that fund. But instead, "participants use them like other funds -- putting money in three lifestyle funds and three other funds," says Ted Benna, who created the first 401(k) back in 1981 and now works as a consultant. That means that their asset allocation is going to be skewed, because the nonlifestyle funds usually overlap with portions of the lifestyle funds. Spreading assets among several lifestyle funds is also problematic. Because the funds all have slightly different objectives, employees can end up with conflicting or overly concentrated portfolios.
That is the case at Brookshire Grocery Co., a 150-store chain based in Tyler, Texas. Since 1999 Brookshire has offered five lifestyle funds as the only options for its $150 million 401(k) plan. "We obviously had the opportunity to go in and just pick out individual funds. But we were so spread out, effectively communicating what each fund was would be difficult at best," CFO Marvin Massey explains. But most Brookshire participants divvy their money up among three of the funds instead of putting it all into one. To help one of his clients, a Pennsylvania manufacturer, avoid the overlap problem, Benna recommended that it add a lifestyle option to its $23 million, 17-option plan, and require that anyone choosing that approach must put all of his or her assets in just one of the lifestyle funds.
HOWEVER SIMPLE OR SOPHISTICATED THEIR plans, employers are offering their workers more frequent educational seminars that include a broader range of subjects. Not surprisingly, the concept of risk is receiving new attention. At Progressive, the Cleveland car insurer, seminar topics now include market volatility as well as investment basics. Says Sylvester Schieber, vice president of research and information at Watson Wyatt Worldwide, "Three years ago it was hard to go out and explain to people that markets go down."
Principal Financial Group, the large, Iowa-based 401(k) money manager, says employer requests for educational seminars, usually hosted by plan providers, are up 15 to 20 percent in the past year. Participant inquiries to Fidelity Investments' phone center and Web site jumped by a similar percentage in the spring, though volume has since dropped back.
Defying many expectations, employees have not rushed to pull their 401(k) assets out of equities. In Principal and Harris Interactive's July financial well-being index, a quarterly survey of small and medium-size businesses, just 20 percent of the more than 1,600 employees who responded said that they had moved their retirement savings "from volatile investments to more stable investments." Money managers and sponsors say that over the past couple of years, only about 1 to 2 percent of participants have been shifting their money out of U.S. stock funds (representing about the same percentage of assets). And that didn't change even during this past July, which saw a record exodus from stock mutual funds.
"We're actually not seeing any evidence of panic out there. It's remarkable how clearheaded participants are about the issues," says Vanguard's McNabb. Adds Daniel Houston, senior vice president for retirement investor services at Principal, "People understand that we're going through some difficult equity markets today, but that's part of a normal investment cycle."
John Franklin, financial analysis manager at grocer Brookshire, watched his 401(k) plunge 23 percent from September 2000 to April 2002. But he hasn't cut back his contribution of 8 percent of salary or switched his asset allocation, which funnels 100 percent of his contribution to the most aggressive lifestyle fund in his company's roster. "I'm 30 years old," he says. "My 401(k) is for retirement, and I don't plan to retire for a while. The way I look at this, I'm buying low. When the market turns around, I'll see the benefit."
Not everyone, of course, can afford such a distant time horizon. Older employees are finding that they may have to postpone their retirement plans. In Principal and Harris Interactive's financial well-being index, 9 percent of the respondents said they had moved back their planned retirement age in response to sagging 401(k) returns. "We are facing the prospect that the average retirement age in the U.S. could go up easily three or four years in the next 15 or 20 years," from about age 62 today, Schieber of Watson Wyatt predicts.
Critics, however, think that tinkering with existing programs or simply working a few extra years are naive solutions. "Who are you kidding?" scoffs Karen Ferguson of the Pension Rights Center, an employee advocate group. "Are you going to keep your job when you get into your 70s?"
Trying to offer more fundamental change, some actuaries and money managers have designed new retirement programs, often known as DB-Ks, that combine features of 401(k)s and defined benefit plans. These hybrids include a 401(k)-style employee contribution as well as a mandatory employer contribution. (Currently, the employer match is voluntary.) The plans would guarantee all employees a monthly payout after retirement. The proposals would require Congress to amend either the tax code or ERISA, the 1974 statute that governs pension plans.
In a plan proposed by Principal, the employer would be obliged to contribute enough to fund a benefit that would equal 20 percent of salary at retirement and would manage the assets. Employees could make a contribution according to 401(k) rules, and either they or the company would manage the investment of those savings.
Without waiting for new legislation, some companies are already trying less radical 401(k)defined benefit hybrids. In an effort to solve a common problem -- people outliving their nest eggs -- S&T Bancorp, a $2.7 billion banking network headquartered near Pittsburgh, has introduced what it calls a pension purchase option. Towers Perrin is pitching a similar idea, says consultant Daniels.
When S&T's 750 employees retire, they have a three-year window during which they can roll over all or part of their 401(k) assets into S&T's defined benefit plan, as they would with an IRA or annuity. The bank then invests the rollover and makes regular payments to the retirees. Employees receive a steady payout, backed by the Pension Benefit Guaranty Corp., without the fees they would pay for an outside annuity. S&T, meanwhile, has calculated a payout rate based on its 8 percent earnings assumption for its defined benefit plan. "The retirement plan doesn't take a hit [financially], and we are providing a service to our employees," says Barry Scott, the bank's vice president of benefits administration. So far, Scott adds, about one third of S&T's retirees have taken the rollover. They have transferred, typically, a little more than half of their 401(k) balances, which average $60,000 per person.
Might the market upheaval, the demographic pressure of aging baby boomers and the looming threat of lawsuits bring about a revival of old-style pensions? "I think there are a lot of reasons for defined benefits to come back. Having a regular income [after retirement] is very important," says Anna Rappaport, a consultant at Mercer Human Resources Consulting. Sussman of Segal predicts "a gradual increase [in defined benefit plans] from now through 2015."
Most industry observers would not go that far, but many do believe that the current 401(k) structure needs to be shaken up. "I don't think we should be stuck in one model," says Representative Benjamin Cardin, the Maryland Democrat who has co-sponsored pension legislation. "My main objective is to get individuals to put more money away and to get companies to participate more in their employee retirement plans." These are worthy goals in any era, but they're particularly apt as the third anniversary of a bear market looms.