How do we make employees better money managers?

With Robert Smart, Founder of RetirementSmarts.com. Bob Smart has spent over 25 years designing, investing, and managing qualified retirement plans for individuals and corporations.

IBM is just one of the latest in the list of public and private organizations that have either already or are considering replacing defined benefit plans with employee managed defined contribution plans. The structure of defined benefit plans causes the employer contributions to rise geometrically in response to simple increases in wages. Benefits are typically based on an average of the final three or five years of employee compensation. This means as workers approach retirement age there is less opportunity for plan investment earnings to supplement contributions to reach the required retirement accumulation.

Defined benefit plan funding is also a function of commercial annuity rates. Since life expectancies are rising and interest rates are falling, more money is needed to fund the same monthly retirement benefit for a retiring employee today than 10 years ago.

These factors, along with the decline in plan investment earnings due to the modest equity returns of the past five years, have led employers to conclude that defined benefit plans are not sustainable. 401k plans that began as supplements to defined benefit plans are fast becoming the principal retirement accumulation vehicle for US workers.

The ability of defined contribution plan participants to successfully manage their retirement accounts will have much to do with the future health of the economy. A 2-3 percent difference in annual return will more than double accumulation over a 20-year period. People wondering whether to buy food and pay for medical care are not buying new cars, second homes or planning vacations.

Current evidence shows the average participant doesn’t have much confidence to select among plan investment options and contribute all that they could. On average, 40 percent of participants’ money goes into whatever safety-of-principal vehicle the plan offers. If company stock is an option, 40 percent goes there. The rest is rather haphazardly allocated to the remaining investment options, with decisions often being made based on prior performance.

How employees allocate investment dollars is much more important than the potential effects of security selection and market timing. A wider array of investment options increases your potential return and lowers risk. Periodic re-balancing allows investors to reap the benefits of sectors that are outperforming their historic mean, while purchasing in those that have not. Re-balancing also guards against extreme highs and lows brought on by major events. Not all investment classes respond in the same way to events, so gains in one investment may offset losses in another.

Modern portfolio theory is the philosophical opposite of traditional stock picking. It is the creation of economists, who try to understand the investment market as a whole, rather than business analysts, who look for what makes each investment opportunity unique. Investments are described statistically, in terms of their expected long-term return rate and their expected short-term volatility. The volatility is equated with ‘risk’, measuring how much worse than average an investment’s bad years are likely to be. The goal is to identify an acceptable level of risk tolerance, and then to construct a portfolio with the maximum expected return for that level of risk.

An effective application of modern portfolio theory spreads your assets across different kinds of investments, consistent with the objectives and risk-tolerance identified at the outset.
RetirementSmarts.com was created to provide an easy to use, inexpensive, but highly effective means to allow employees, regardless of their level of investment sophistication, to apply the most advanced techniques of portfolio management. RetirementSmarts.com is the only service of its kind combining both a proprietary questionnaire to accurately determine each participant’s individual risk tolerance with the only provably effective asset allocation tool in the world today. It offers far more than the ‘one size fits all’ thinking common to most existing retirement guidance tools.

Most people need at least some help in deciding how to allocate their assets in structuring their portfolio. RetirementSmarts.com is much more cost effective than asset based fee structures and because of its proven effectiveness, is the definitive example of fiduciary responsibility. It may be added on to most plans without changing money managers. There is also an IRA version that will allow retirees to continue to utilize this tool.
Much effort is devoted to selecting investment managers. At least as much concern is needed over providing employees the tools and the training to combine investments to produce consistent results.