Profit Hunters Club

ProfitHuntersClub · Site Admin Joined: 31 Mar 2006 Posts: 25

By Gordon Powers
October 26, 2007
A major shift in pension plan funding is driving employers to rethink their pension plan structures, forcing their employees to shoulder more risk in the process.

Faced with having to pump more money into plans or decrease the benefits, companies are increasingly moving workers away from relatively risk-free defined benefit (DB) pension plans into more volatile defined contribution (DC) plans. So much so that 33% of public companies and 55% of private companies expect to go this route within the next 12 months, according to data from the Conference Board of Canada.

Why should you care? Well, if you're working for one of these companies, there's a good chance that you'll end up with less money in retirement than you might have otherwise expected.

Under DC plans, both employer and employee contributions find their way into various funds, not unlike an RRSP. You make the investment decisions. Once the money's gone, that's it though. The company is off the hook. That's fundamentally different from a DB plan, which pays out until you die -- no matter how long you live and how poorly the portfolio might perform.

Consider the U.S. experience. There, the 401(k) plan, a close cousin to our DC plans, has become the dominant retirement savings tool of American workers. 401(k) plans are much different, however, from pension plans of the past, where employers hired professionals to outline investment policies, manage the portfolio, and determine the required savings rates to meet guaranteed benefits. With a 401(k), all the responsibility now falls on workers, not all of whom possess the tools to do the job.

A recent study by New York University professors Martin Gruber and Edwin Elton found that many such plans don't offer employees an adequate set of investment choices. Workers also lack the right type of funds to build a truly diversified portfolio.

In fact, almost two-thirds of the 401(k) plans the authors studied resulted in substantially lower returns over time.

Gruber and his colleagues analysed more than four hundred 401(k) plans, studying the characteristics associated with adequate investment choices, including an analysis of the impact of plan size and the use of outside consultants.

For each plan, they collected data on the funds offered, the historical returns and the characteristics of the firms offering the plans. They found that most of the larger 401(k) plans -- those offering at least 13 fund choices -- presented enough options for investors to create diversified portfolios. Smaller plans, however, were especially lacking in the number of choices offered for adequate diversification.

Too many investment choices, meanwhile, can cause information overload, resulting in greater use of the default option -- which is often a money market fund -- and even declines in participation rates, say Gur Huberman and Wei Jiang, professors at Columbia University.

In a study published earlier this year, they found 401(k) participants generally chose to invest their retirement savings in a small number of funds -- usually no more than three or four -- regardless of the number of funds offered.

They found that the median choice was three funds and that 95% of participants used no more than seven funds. In addition, a sizable percentage of investors opted to invest their money equally among their selected funds.

For example, the study found that in plans offering 10 investment choices, 75% of the dollars were concentrated in five funds. In plans with 60 choices, 75% of the dollars were concentrated in 11 funds. In other words, there was an increase in the number of funds used, but the growth was not in line with the increase in funds offered.

A third study, by researchers at The College of William & Mary in Virginia examined the relationship between workers' financial knowledge and their behaviour relative to the number of investment options. That study found that the number of funds had a greater impact on individuals with above-average financial knowledge than on those with below-average investment savvy.

In particular, high-knowledge employees reported increased feelings of information overload as the fund choices jumped past six. Lower-knowledge employees, on the other hand, reported greater overall levels of information overload, regardless of the number of funds. As a result of this confusion, both groups went for the default portfolio more often than not.

The results of all these studies emphasize the need to improve the financial literacy of plan participants. In many ways though, educating plan sponsors works better than educating their employees.

When it comes to pensions, there's no substitute for face-to-face instruction, training and, in some cases, actual investment advice. This costs employers money, however. Nonetheless, if you find yourself in a DC plan, this sort of education and direction is something you need to press for.

Source: http://finance.sympatico.msn.ca/retirement/gordonpowers/article.aspx?cp-documentid=5628427