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The Pension Protection Act of 2006 imposes new fiduciary rules and responsibilities on employers regarding investment advice to employees with 401(k) plans. But increased contact between employees and the personal investment industry brought about by these rules can be dangerous for management, according to Dick Purcell, president of PlanScan LLC, a financial planning software developer based in Boulder, Colorado. It’s quite possible that an ill-prepared investment industry, he warns, could lead employees to invest poorly, nonetheless leaving companies responsible for the results.
In a 2006 working paper, Reducing Risk in Employee Retirement Plans: A Practical Guide, Purcell examines investment industry training, practices and computer models and finds that the emphasis on “risk-adjusted return” is not always conducive to investor goals and often reveals self-serving practices designed merely to increase investment industry fees. For example, risk-adjusted return ignores the reason that someone invests in the first place: to retire. The investor’s purpose is to achieve purchasing power for many years ahead. The risk-return system, however, leads to choosing investments without exploring which offer the best probability of meeting that goal. Purcell suggests that a set of investment tools such as Monte Carlo simulation or Goal Frontier graphing can better show the investor a suitable course of action. But such methods are often at odds with those of the investment companies.
To meet their fiduciary responsibilities, companies should ask three questions of their investment provider.
Ask whether they encourage investments in whole diversified asset classes. Investment advisers’ training and software tools commonly feature a process best labeled allocate-and-switch. While advisers devote much fanfare to the importance of diversification to minimize risk, the actual placement of the employee’s money often is switched from investment in whole asset classes to bets on individual investment managers or funds, both of which usually deliver lower average net returns with greater uncertainty and risk.
Inquire whether the provider’s focus is on comparing portfolios and revealing the best result probabilities for the employee’s lifetime plan and goals. Investment advisers are trained to consider investments with greater future-performance uncertainty and risk in pursuit of higher fees.
Ask whether investments are compared in ways that enable investors (and advisers) to make informed choices. Purcell argues that most comparisons are shown in abstract, technical measures for one year and that investors are presented with floods of data “so lacking in grounds for future-performance assumptions they should not be permitted outside Las Vegas.”
It will be difficult, if not impossible, to find a 401(k) provider prepared to answer these questions satisfactorily. However, Purcell urges companies to pressure the investment industry to meet these needs.
For more information, contact Dick Purcell at firstname.lastname@example.org.