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The 401(k) at 40

A Midlife Crisis?

Scott Matheson
CAPTRUST Managing Director and Defined Contribution Practice Leader

It’s that time of year again: the time we pull out our crystal ball and make predictions about developments affecting plan sponsors and their participants in the new year. But this year feels a little different. Maybe the fact that the legislation that created the 401(k) turned 40 years old on November 6 has caused us to be more reflective than usual. The media certainly made some hay over the past several months with the idea that everyone’s favorite retirement savings vehicle is going through some sort of a midlife crisis. Let’s play with that idea for a minute.

A midlife crisis is defined as “a period of emotional turmoil in middle age characterized especially by a strong desire for change.” (Thank you, Merriam-Webster.) The middle-age aspect seems appropriate, not just because it’s a milestone birthday. The 401(k)—and the country’s post-ERISA defined contribution-oriented retirement system, in general—has been growing and evolving over the past nearly 40 years.

During the first half of its life, the 401(k) went from the tagalong little brother to defined benefit plans to the leading workplace retirement savings plan. In the beginning, it was a supplement—a nice-to-have add-on—to a corporate benefit package that allowed employees to sock away some of their own money on a pre-tax basis.

Through the 1990s, little 401(k) grew into young adulthood as companies added employee-deferral features to their plans and more and more plan sponsors converted their profit-sharing contributions into matches to incent employee savings. This evolution was accelerated as technologies such as daily valuation, voice response units (VRUs), and the internet emerged as ways to streamline plan operations, reduce costs, and better service and communicate with participants.

As the new century dawned, mutual funds emerged as the primary funding vehicle for 401(k)s and quickly created a paradox of choice for plan sponsors: how to make sense of the, literally, thousands of investment options available for use in 401(k) plans.

As the 401(k) entered full-grown adulthood, the tracks had been laid for its success. Access to a plan with a broad selection of good investments, typically including target date funds as a default option—most often overseen by a retirement plan committee—increasingly became the norm. The many service providers offered substantially similar services, and price increasingly became an issue. Retirement plan advisors stepped in to help make sense of the landscape with a focus on investment analytics, recordkeeper perspective, and fiduciary best practices.

This is where we find ourselves as tax code section 401(k) turned 40.

I think the midlife thing works. But let’s look ahead to see how much “emotional turmoil” and “strong desire for change” exists in the 401(k)’s world right now. Here come the predictions.

Prediction: The shifting American workforce causes employers to expand their financial wellness offerings.

Much has been made of the generational shift occurring in the U.S. workforce over the past several years. As the first of the Baby Boomers reached retirement age in 2011, that generation’s multi-decade reign as the largest portion of the American labor force ended. Generation X promptly took up the mantle. Four years later, they were quickly displaced by the Millennial generation, who now constitute more than 35 percent of the U.S. labor force—and it isn’t done growing. 

These emerging demographics create new complexity for plan sponsors as they help their employees address a series of difficult financial challenges. A few sample datapoints:

  • Student loan debt weighs heavy. According the U.S. Department of Education, 44 million Americans hold a collective $1.5 trillion in student loan debt—more than $34,000 on average. While 41 percent of this debt is controlled by those 34 years old and younger, the 50-and-up crowd holds a surprising 18 percent of this outstanding debt.
  • Retirement savings continue to fall short. According to the Employee Benefit Research Institute’s annual survey, nearly half of Americans nearing age 65 have less than $25,000 of savings and one in four has less than $1,000 saved.
  • Rainy day funds still come up short. Per Bankrate’s Financial Security Index, only 29 percent of Americans have 6 months or more of their expenses in a savings account and 23 percent of Americans—an estimated 55 million people—have no emergency savings at all. Only 39 percent of survey respondents would be able to cover a $1,000 setback using their savings.
  • 70 is the new 65. According to Willis Towers Watson’s 2017 Global Benefits Attitude Survey, 37 percent of North American workers expect to work to age 70 or beyond, and that number is 67 percent for those struggling with financial worries. 

The result: America’s diverse workforce has different needs and is increasingly looking to their employers for help in addressing them. 

In fact, according to Willis Towers Watson’s 2017 Global Benefits Attitude Survey, 57 percent of North American workers believe their employer should actively encourage their employees to save more for retirement. When asked if their employer should offer employees personalized guidance for employees facing key retirement decisions and on how employees can improve their personal financial situations, 65 and 52 percent, respectively, said “yes.” These numbers are new highs and indicate a shift in the employee view on the evolving role of employers. 

While the above list is not comprehensive, it indicates a new normal facing the American worker and, therefore, the American employer. Further, employers are increasingly becoming very aware of the cost to their businesses of burdened employees ranging from financial stress–related absenteeism, presenteeism, productivity losses, increased doctor visits, medication costs, and inflated health insurance premiums, to name a few.   

The intersection of record-high employee demand and record-high employer awareness will certainly lead to an increase in the number of employers expanding their financial wellness offerings in 2019. 

Prediction: Higher interest rates present a mixed blessing (and a few challenges).

It is safe to say that the economic regime the 401(k) came of age in has passed and is not likely to reoccur. The trend of declining interest rates that started in the early 1980s and culminated with the U.S. Federal Reserve’s “zero interest rate policy” in the wake of the financial crisis has come to an end. The Fed began hiking interest rates from post-financial crisis levels in late 2017 and continued through 2018. Meanwhile, we expect additional rate hikes in 2019 and potentially in 2020.

Changes to the status quo—like this—are always a mixed blessing. Over the past two years, money market interest rates have risen from near zero to about 2 percent. This is welcome news to savers and retirees; they will feel noticeable upticks in the cash flow from their certificates of deposit, money market funds, savings accounts, and short-term bonds. Additionally, they will be able to reinvest maturing bonds at progressively higher rates, further boosting their incomes. As a result, workers approaching retirement will feel more confident about their finances and their ability to generate a reliable income, encouraging them to make the move into retirement. Meanwhile, households with credit card debt, auto loans, and adjustable rate mortgages will feel a pinch as rates rise.

Things will be a bit more complicated for plan sponsors as they grapple with the implications of higher interest rates. Target date funds will be one area of focus. In this new environment, glidepath variations, fixed-income composition, and breadth of diversification will create winners and losers that may force plan sponsors using these options as their qualified default investment alternatives (QDIAs) to reevaluate their selections. As they do this, they may find that newer options, such as managed accounts, are better alternatives.

Rising interest rates will also affect capital preservation options offered in 401(k)s, such as money market funds and stable value accounts. As previously mentioned, money market funds will be the first beneficiaries of rising interest rates; they can quickly pass along higher yields to investors. Stable value accounts hold fixed-income securities with longer maturities (and durations) than those held in money market funds, so they will lag money market funds as rates increase. They may suffer in the short term as they cope with volatility-driven participant cash flows and lower prices on their fixed-income holdings. Longer-term, stable value managers will show they can handle these challenges. But, like target date funds, we will see divergence in returns across providers that plan sponsors should be alert to.

Increasing interest rates will continue to drive terminations and pension risk transfer activities for traditional defined benefit plans. The new year will see a significant number of pension terminations as a result of a massive wave of pension contributions spurred by tax reform (although the recent market pullback may put a damper on that). We anticipate that more plan sponsors will proceed with termination—or at least de-risking—on the heels of years of increasing PBGC premiums, muted return expectations, and the potential for higher rates.

Prediction: Regulators and legislators will continue to seek ways to solve the retirement coverage gap and the need for objective advice for plan sponsors and participants.

Looking ahead at 2019, we don’t anticipate retirement reform or significant changes to the retirement system. Instead, what we foresee is the potential for Washington (and perhaps some of the states) to make a few tactical changes that address spot issues. For example, in August, President Trump signed the Executive Order on Strengthening Retirement Security in America. In doing so, he asked the Departments of Labor and Treasury to consider regulations to expand the availability of multiple employer plans (MEPs), loosen the required minimum distribution rules, and reduce the administrative burden on plan sponsors related to notice requirements and other participant communications. And in late December, three senators introduced the Retirement Parity for Student Loans Act, which would permit plan sponsors to make matching contributions to workers as if their student loan payments were salary reduction contributions.

Meanwhile, Congress has long been threatening to pass the Retirement Enhancement Savings Act of 2018 (RESA), a measure intended to expand savings opportunities in several ways. However, despite broad support on both sides of the aisle, the bill has not made its way through the legislative process. And, as I write this article, Washington is understandably more focused on finding ways to remedy a government shutdown. After this crisis passes and new members of Congress settle into their roles at the beginning of the year, RESA may make its way back onto the docket and be passed into law.

While RESA’s biggest impact would be the creation of open MEPs, bringing millions of workers into the employer-sponsored retirement system, it contains several other provisions that would expand savings opportunities such as the simplification of certain safe harbor 401(k) rules and the introduction of a fiduciary safe harbor for the selection of a lifetime income provider, to name a few. We expect to see movement on the open MEP front in 2019.

Lastly, the Securities and Exchange Commission continues to work toward a September 2019 goal of finalizing its proposed Regulation Best Interest. While this regulation would likely affect retirement industry service providers in some manner, the extent is currently unclear. What is clear is that the Department of Labor won’t be taking up any further regulatory action related to its own vacated Fiduciary Rule until the SEC’s new rule is final.

Prediction: Plan sponsors continue to feel the strain of increasing complexity.

A confluence of increasing participant demands and needs associated with evolving demographics, significant litigation, regulatory changes, evolving services in the face of compressed fees, technology changes, and more third parties seeking to gain an edge by providing the solution will create more and more complexity for plan sponsors to navigate.

Plan sponsors will look to delegate more responsibility and risk in the form of 3(38) discretionary asset management and focus their committee efforts and resources on the core issues their participants are grappling with. Plan sponsors in the middle market will also struggle to manage competing priorities with the need to adapt to a rapidly changing retirement landscape and participant needs while mitigating the risk associated with being a first mover to adopt new solutions and technologies.

We also expect an escalation of the focus on health savings accounts (HSAs) as a supplemental form of retirement savings. According to Fidelity’s annual estimate of retiree healthcare costs, an average couple retiring at age 65 in 2018 could need as much as $280,000 of after-tax savings to cover healthcare expenses in retirement. That’s a tall order for most American households, but HSAs may be part of the solution.

Plan sponsors will continue to look for resources to help them navigate the complex environment and more specifically look for unconflicted advice when solving these issues at the same time asset managers, recordkeepers, and consultants offering discretionary services are blurring lines to bring solutions to the table. Plan sponsors will also look to regulators to provide more clarity around best practices and associated fiduciary protections when adopting these new services.

Prediction: Recordkeepers and investment managers strive to add new value—and new revenue streams.

Recent trends have not been friendly to the business models of many who serve the retirement plan industry—specifically, recordkeepers and investment managers. They face a confluence of trends that have challenged their business models and profitability.

Here are a few notable trends:

  • More fee disclosure—thanks to 2012’s fee disclosure regulations—and fee-oriented litigation have increased benchmarking activity, which has in turn accelerated fee compression for recordkeepers.
  • Plan sponsor preferences have been shifting away from asset-based fees to per-capita fees for recordkeeping and administration services. While this approach is not preferred by every plan sponsor, and certainly is not advantageous for every plan and its participants, it is a trend.
  • A cheap-is-the-only-good mentality has impacted investment managers with their own kind of fee compression. For example, collective investment trust (CIT) fees are frequently negotiable, which has provided plan sponsors another cost-saving opportunity. And for many actively managed strategies, holding onto market share has meant swapping out higher-fee/higher-margin products for passive strategies with low fees and tiny margins.
  • The vast majority of 401(k) and 403(b) contributions are flowing into target date funds, corporate defined benefit plans are steadily decreasing their non-fixed-income investments, and CITs continue to move down-market into smaller plans.
  • Lastly, plan sponsors are demanding better digital and mobile experiences for their participants, and cybersecurity threats are on the rise.

In short, recordkeepers are facing shrinking recordkeeping revenues on one hand and increasing costs to service plans on the other. And for both recordkeepers and investment managers, if you don’t have a relevant QDIA solution, the sledding is currently tough, and the outlook is even tougher.

Since increasing fees on current services is generally difficult, we expect recordkeepers and investment managers will continue to evolve new value-added services—and revenues. This will come in the form of rethinking QDIAs to include lower-cost managed accounts, student loan repayment solutions, HSAs, and financial wellness programs, to name a few. In addition to new services, we also expect to see more partnerships, both among existing industry players as well as new ones, like the recently announced partnership between BlackRock and Microsoft.

As the 401(k) embarks on the second half of its life, it does not appear to be struggling with a midlife crisis. Perhaps it was the decline of the pension plan since the 1980s that caused the adolescent 401(k) to grow up quickly. Maybe it was the billions of dollars of technology investment and sales and marketing spending that made it wise beyond its years. Regardless, at nearly 40, the 401(k) seems more like someone in the midst of middle age looking for ways to be a better parent and provider for the family.

As with most predictions, the only thing we can say with absolute certainty is that at least some of our subject matter experts’ predictions will be wrong. Our track record in 2018 was strong, so hopefully our crystal ball is on the mark for 2019. Regardless, you can expect to hear more from us on these topics and others as what is sure to be an exciting 2019 unfolds.

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