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Hidden Risks of 401(k)s
Employer beware: Failing to properly
educate employees about investment options
may leave you liable
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Business New Haven
9/11/1995
By: Stephen Carta
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With Social Security benefits predicted to decline drastically and benefit plans becoming more expensive, 401(k) plans have grown in popularity. No surprise.
A 401(k) is a defined contribution plan in which employees decide how much of their salary is put away for retirement years via payroll deduction. The employer typically contributes to with a fixed sum per contributed dollar.
In a 401(k) plan the employer typically makes several investment options available to employees and, until recently, would be the one responsible for researching and introducing those options.
Since 401(k)s are still a relatively new retirement planning alternative (having gained broad acceptance in the mid-1980s), their long-term consequences may surprise employers.
In the 1990s, the number of companies, and employees, participating in 401(k)s has been on the rise for two reasons. Compared with traditional funds, 401(k)s are less costly to administer. Second, 401(k)s permit participants greater latitude in how their funds are invested. Therein lies the problem.
Unfortunately, broad latitude in choosing investment options may lead some participants to misunderstand the types and degrees of risk associated with some 401(k) options - risk that can result in investments that perform below expectations or loss of principal.
Another, less obvious, risk lies in investing too conservatively. While this approach protects the investor against losses common to high-risk portfolios, the results maymeet retirement needs.
Many participants fail to understand the pitfalls associated with conservative investments. Last year, for instance, the most popular investment vehicle within a 401(k) was among the lowest-paying. Fixed-interest guaranteed-income contracts (GIC) pay about five percent annually and account for more than half of all employee-directed 401(k) assets, according to a 1994 study by KPMG Peat Marwick of 1,948 employers with 200 or more employees.
Many of these participants either lacked expertise or didn't get advice they needed to make informed decisions about their plans. Those who fail to monitor performance may realize the consequences of their in action too late to remedy the situation.
While participants can help their plans grow, potential problems stemming from underperforming 401(k)s may not be realized until after the turn of the century. This is when many baby-boomers begin to retire and realize how poorly their plans have performed.
At that point, we may even see legal action taken by some 401(k) participants. This has already happened, with trustees challenged by beneficiaries for failing to act in the interests of employees.
Businesses are now starting to look at these liability issues have begun to take steps to avoid possible legal action. Businesses (especially larger ones) are hiring fund managers to educate participants in the options available to them through seminars.
Seminars have begun to emerge as a means to ensure employees understand differences among investment options. A company that fails to educate employees may be in for an unpleasant surprise.
Seminars may be run by insurance companies, financial planners or trust companies. Such institutions are usually better equipped to handle all 401(k)s entail because they can coordinate the entire package - managing the investments, setting up seminars and even providing personal attention.
For employers, workshops allow them to distance themselves from liability and perhaps avoid legal entanglements. For employees, workshops relieve some of the anxiety and pressure of choosing investment options alone.
It's important to remember why 401(k)s are popular in the first place: They can be quite successful for participants who make informed decisions. Managed properly, 401(k)s can provide comfortable retirement years for participants - and a legally unentangled and inexpensive means to provide them for employers. BNH
Stephen Carta is chairman and CEO of Sachem Trust, with offices in Guilford and Westport.
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