Johnson: Is Your 401(k) Plan a Trap?
In a matter of just 25 years, defined contribution plans have become the predominant retirement tool available to American workers, many of whom have little investment experience.
Nevertheless, the novelty could be wearing off, as 401(k) plans may be ill-suited for the current economic environment.
What a mess we’ve found ourselves in? By all accounts, Europe is an open wound that continues to fester and there simply isn’t enough money to solve the problem. The United States, exonerated by the Federal Reserve, isn’t exactly a model of good health, doing its best to reinforce an exquisite house of cards swaying effortlessly in the wind.
Throughout it all, Wall Street’s marketing machine led retail investors to believe that asset allocation was the universal cure for market volatility. Average American investors, told that a portfolio diversified amongst traditional asset classes would mitigate risk, have been convinced that style-box bingo would preserve their life’s savings through thick and thin.
Nevertheless, large cap, mid cap, small cap and international equities are hyper correlated, offering little reprieve from market declines. Moreover, bonds have benefited from unseasonably low interest rates spawned by loose monetary policy. Should the sovereign debt issue escalate, it stands to reason that the above referenced asset classes would suffer in unison, as has been the case with Italian debt and international stocks.
So where does that leave 401(k) participants? A casual observer of most defined contribution plans would undoubtedly notice the absence of alternative asset classes in the fund line-up, forcing investors to buy long only positions, often times lacking access to hard assets such as gold or commodities. As luck might have it, section 404(c) of ERISA, a voluntary set of guidelines adopted by most plans, requires fiduciaries to minimize the risk of large investment losses by offering a diversified menu of investment options.
Of course, money market and stable value funds are coined as cash-equivalents, although they are protected by a prospectus, not the FDIC. The minute investors think they don’t have access to their money, they’ll demand its return whether they need it or not and begin a run on the bank, which is what happened in 2008 when 36 of the 100 largest U.S. prime money markets had to be propped up in order to survive the financial crisis.
Fortunately, some 401(k) providers give participants the option to transfer a portion of their balance to an account that allows them to invest in the entire universe of options. Others permit an in-service withdrawal that grants the transfer of assets to a self-directed IRA without taxable consequences before separating from service. It should also be mentioned that as alternative assets become better understood, they’ll be incorporated into more plans.
Retail investors are beginning to understand the consequences of unsustainable public obligations. In a perfect world, stock prices would be a reflection of earnings and dividends, although today we must account for the risks posed by potential government bond defaults, the subsequent impact of derivatives and central banks determined to print their way out of a problem they facilitated.
Employer-sponsored 401(k) retirement plans will have to disclose fees that savers pay on investments and transactions by 2012, but the opportunity cost of a weak menu of investment options could be staggering. 401(k) plans are an excellent means to accumulate wealth; they might also be the best way to lose a piece of your nest egg if the sovereign debt crisis remains unresolved.
Ivory Johnson, CFP, ChFC, is the director of financial planning at Scarborough Capital Management, Inc. and has over 20 years of investment experience. Mr. Johnson attended Penn State University, where he received a Bachelor of Science degree in finance. He can be followed on www.IvoryJohnson.com.