New Help With Your Nest Egg
Your days as the chief investment officer of your 401(k) retirement account may be drawing to a close. A small but rapidly growing number of 401(k) plans are offering a new service that lets employees hand the management of their 401(k) to a professional. The goal: to help employees -- many of whom have seen the bear market savage their retirement savings -- achieve higher returns with less risk. "It's the next big thing in 401(k)s," says Bill Arnone, a partner at Ernst & Young.
The new service, often dubbed managed accounts, is more user-friendly than the first generation of 401(k) investment advice. Launched in large numbers after the Labor Dept. gave 401(k) administrators a green light to offer help in 2001, the pioneering programs were generally available only to online users. Moreover, those who wanted to carry out the advice had to do the transactions themselves. With a managed account, however, if you don't want to log on, you can pick up the phone or sit down with an adviser. The service makes the necessary trades. It can even automatically rebalance your portfolio and alter your allocations as you age or as your circumstances change.
Despite these bells and whistles, the advice you'll get with a managed account still comes mainly from a computer. But because investing is as much an art as a science, your managed account might look different depending on who designed the software.
Before signing on to a plan, consider the cost. While the 401(k)s administered by Schwab are making this option available for free, most intend to charge from 0.20% to 0.75% a year, says Darlene DeRemer, executive managing director at Andover (Mass.) financial data firm NewRiver. That's cheaper than hiring your own adviser. But if you've got a six-figure balance, you may come out ahead by paying the $109 to $300 a year it costs to buy no-frills advice from online services such as Morningstar.com and Financialengines.com, both of which participate in these employer-backed programs, and implement it yourself.
CUSTOMIZE THE PLAN
Although you can pull out of a managed account at any time, there's no point in enrolling if you're uncomfortable ceding control over your investments. Consider how you'll feel if you open your 401(k) statement to find that you've been moved out of the stock market index fund you purchased and now hold international stocks or bonds instead.
Here's how managed accounts work: If your employer signs up for the service -- and by 2010, 10% of 401(k) assets are expected to be in a managed account -- you'll have the option to enroll. In some cases, all you have to do is check off a box on a form and drop it in the mailbox.
Then, someone -- most likely the company that keeps the records for your 401(k) plan -- will gather the information necessary to build your portfolio and field your questions. Merrill Lynch, Wachovia, Schwab, and Fidelity are among those that already offer managed accounts to the 401(k) plans they administer. However, Labor Dept. rules prevent them from providing advice themselves lest they steer 401(k) investors into their own funds. So they generally hire outside firms to recommend asset allocations and investments for 401(k) investors. Those outside firms include Morningstar, financial researcher Ibbotson, and advisory firms Financial Engines and GuidedChoice, which were founded, respectively, by Nobel laureates William Sharpe and Harry Markowitz.
These advisory firms need just a little information to create a customized 401(k) portfolio. The basics include your date of birth, account balance, salary, savings rate, gender, and projected retirement date, which the programs use to calculate how much risk you can take. To improve the results, inform your managed-account provider of other retirement assets you and your spouse hold, including individual retirement accounts, taxable accounts, and pension benefits. That way, your 401(k) can be designed to complement your overall portfolio.
The computer models that create managed accounts are hardly identical. For example, Merrill Lynch's program -- designed by Ibbotson -- allows you to designate holdings you want to keep. Financial Engines gives you leeway to park as much as 20% of your money in company stock. And while Morningstar seeks to replace 70% of your current income during retirement, GuidedChoice's default target is 80%. The programs are flexible, though, so you can ask your adviser to modify some of these assumptions -- say, by shooting for 90% of your current income to live on or a retirement age of 60 rather than 65.
To find out just how varied the models are, BusinessWeek asked four advisory services to design a 401(k) portfolio for a married, 40-year-old woman with a $100,000 401(k) using mutual funds that are commonly found in these plans. She and her husband hold $180,000 in other retirement assets.
Morningstar's approach proved to be the most conservative. While it recommends that the subject stash 52% of her 401(k) in bonds, Ibbotson's bond allocation is just 31%. To further reduce the riskiness of her portfolio, Morningstar and Ibbotson put, respectively, 20% and 22% in cash. Meanwhile, Financial Engines and GuidedChoice chose all equities.
Why the differences? Their assessments of the subjects' risk level vary. "This couple hasn't saved enough," says Todd Porter, chief investment strategist at Morningstar Associates. To reduce the likelihood that the pair will find their income falling short in retirement, Morningstar reduces the couple's overall portfolio risk by putting the wife's 401(k) into conservative investments. Since two-thirds of the couple's other assets are in equities -- mainly large-caps -- it makes sense to diversify, he adds.
Ibbotson placed the woman in a "moderately conservative" 401(k) portfolio composed of 31% bonds and 47% equities, says CEO Mike Henkel. The company's standard approach is to fit each investor into one of seven model portfolios stocked with investments from his or her 401(k) plan. Which portfolio you land in depends on factors including your time horizon, savings, and the riskiness of your non-401(k) investments, he adds.
For Financial Engines, the asset-allocation decision is heavily driven by age. However, the firm also designs its portfolios around the funds in your 401(k) plan it deems most attractive. Its criteria include low costs, good track records, and portfolios that don't stray among asset classes, says Wei Hu, manager of financial research. Not surprisingly, Financial Engines' model 401(k) favors index funds, such as the Vanguard 500 index fund and DFA U.S. Small Cap funds.
GuidedChoice puts the woman in the most aggressive of its seven model portfolios. Two of the reasons are her long time horizon until retirement and the high risk tolerance she demonstrated when she invested her 401(k) money entirely in equities, says GuidedChoice CEO Sherrie Grabot.
Which of these companies designs your portfolio depends on who your plan's administrator hires. If you don't like the program that's offered, you can still remain your 401(k)'s CIO.
By Anne Tergesen