When 401k Investing Goes Bad -- from WSJ

August 4, 2008


INVESTING IN FUNDS



When 401(k) Investing Goes Bad
Teachers in West Virginia offer a valuable lesson for what not to do
By JENNIFER LEVITZ
August 4, 2008; Page R1

Seventeen years ago, West Virginia school employees joined millions of workers nationwide in a shift from a pension plan that guaranteed a monthly check, to a retirement-savings plan that would make the teachers, bus drivers, custodians and other staff responsible for their own investment accounts.

LEARNING A LESSON
."It was horrible," says Judy Hale, president of the West Virginia Federation of Teachers union. Most felt poorly informed, and they invested too conservatively, putting the largest sums of money into a fixed-rate annuity, a safe but low-yielding option that typically is inadequate for building a nest egg.

As employees began to retire, most balances were pitifully small. So on July 1, after a vote authorized by the state legislature, 14,871 school employees, or 78%, switched to the old-fashioned pension plan.

After the vote, teachers were "jumping up and down and crying in the halls," Ms. Hale says.

The school employees put their mistakes behind them, but their experience stands as a cautionary tale for employers and employees across the country. As large numbers of workers are starting to retire with 401(k) or 401(k)-like plans to support them, what happened in West Virginia is a window into exactly how things can fall apart for workers, and it serves as a wake-up call for figuring out how to avoid having plans go as badly off track as this one did.

Many workers with retirement accounts have built nest eggs far bigger than they ever imagined possible. But unknowledgeable ones often are far short of comfortable retirements -- and they don't have the option the West Virginia teachers did of appealing to state legislators to get them out of their investing mistakes. On top of all this is the havoc that the current bear market may be wreaking on older workers' accounts if they are too aggressively invested in stocks.

Around the country, a few big employers have ditched retirement-savings plans and returned to traditional pensions. The pace of big companies abandoning pension plans appears to be slowing as well. In 2007, 54 of the 100 largest U.S. employers offered an old-fashioned pension plan to new workers, down from 58 in 2006, according to Watson Wyatt Worldwide, a management-consulting firm in Arlington, Va. That 7% decline compares with a 14% drop as recently as 2005.


Debra Elmore
But there is little question that retirement-savings plans, which have proliferated since the 1980s, are here to stay. Only 21% of full-time employees had an old-fashioned pension plan in 2007, down from 54% in 2004, according to Transamerica Center for Retirement Studies, a nonprofit corporation funded by Aegon NV's Transamerica Life Insurance Co.

"A 401(k) gets employees to the right place if they're using it right," says Pam Hess, director of retirement research at Hewitt Associates a Lincolnshire, Ill., consulting firm, adding: "We still have work to do." Improvements ushered in by the 2006 Pension Protection Act are still being put into place by many employers, such as automatically enrolling new workers and providing investment advice. More employers also are offering account-management services, annual rebalancing of accounts to keep investments in line with designated asset-allocation targets and target-date funds that adjust their holdings from an aggressive to a conservative mix as workers age.

Challenges clearly remain: At the end of 2007, the median 401(k) account balance for people age 60 and above was $34,420, according to Hewitt, meaning half of the group had balances even lower. To be sure, some retirees have other savings, including money rolled into individual retirement accounts from 401(k)s at prior employers.

But studies are starting to document that traditional pension plans, which typically are overseen by professional money managers, outperform programs in which workers control an investment account, like 401(k)s. Between 1995 and 2006, "defined benefit" pension plans, so-named because they give retirees a specified monthly benefit, outperformed defined-contribution plans, in which the employer makes a specified contribution to the worker's account, by about one percentage point a year, for a cumulative dollar difference of nearly 14%, according to a June report by Watson Wyatt.

A Church's Change

The United Methodist Church last year moved its 36,000 clergy and lay employees back to a traditional pension, realizing that "with ministers, really their talents are in creative areas, and often not in investment areas," says Ron Gebhardtsbauer, an actuary in University Park, Pa., and a former trustee with the church's pension board. Barbara Boigegrain, general secretary of the church's Evanston, Ill.-based pension board, adds that the church didn't believe it was fair that its employees "were at the whim of the markets." Those who retired in the bull market of 1999, for instance, generally had a better nest egg than those who retired as a three-year bear market ended in 2002. "We care desperately that they have an adequate income in retirement -- and income that they cannot outlive," she says.

Beginning in the early 1970s, school employees in West Virginia were enrolled in an old-fashioned plan, with benefits calculated by a formula that took into account compensation and years of service. But after the pension plan faced funding shortfalls, it was closed to new enrollments as of June 30, 1991. The defined-contribution plan was set up to take care of new hires, and existing employees were given the option of sticking with the old plan or transferring into the new one.

Under the defined-contribution plan, the state contributes 7.5% of each employee's annual eligible gross pay, according to the Web site of the state's retirement board. Employees have flexibility in terms of their contributions: While the state requires those in the pension plan to contribute 6% of pay into the state fund, those in the savings plan can contribute as little as 4.5% -- a selling point to those who want greater take-home pay.

Of course, a smaller contribution has the effect of holding down the account balance. As for the state's 7.5% contribution, it is more generous than in the average private-sector 401(k), where the most common fixed match is 50 cents per dollar of an employee's contribution up to the first 6%, according to the Profit Sharing/401k Council of America, a nonprofit organization in Chicago. In contrast, to fund the defined-benefit plan for the teachers, the state of West Virginia aims to contribute 15% of annual gross pay for people hired before July 2005 and 7.5% for those hired after. In general, a typical payout in the West Virginia pension plan is an amount equal to 2% of an employee's peak salary multiplied by years of service.

Sales at Lunch

The West Virginia plan initially offered stock and bond mutual funds, a money-market fund, and an annuity, in this case from Variable Annuity Life Insurance Co., or Valic, a unit of American International Group Inc. In addition to the Valic annuity, current offerings include funds from Capital Group Cos.' American Funds unit, Federated Investors Inc., Fidelity Investments and Franklin Resources Inc.


Illustrations by Yan Nascimbene
From the start, most employees favored the annuity. Some say they were swayed by Valic's sales force, which included former educators and school employees who went into the schools during the workday to talk about the option. "These people came during your lunch or during your planning period basically to sell the program," says Debra Elmore, a third-grade teacher in Ansted, W.Va.

Ms. Elmore acknowledges knowing little about investing. "Oh, Lord no," she says. "I had no idea." She set up her account so that 85% of her contributions would go into the fixed-rate annuity. "I just thought, 'Well, these are safe. Let's stay there.' "

AIG spokesman John Pluhowski says the insurance company hires former school employees to sell its products to schools "because the education market is important to us; educators know the needs and concerns of educators." He says the representatives were "not authorized or directed to give investment advice; they were only authorized to sell a fixed-annuity contract."

Anne Lambright, executive director of the state's retirement board, says that the board offered "some general education" about investing to employees, but that "not everyone took advantage of it." She acknowledges that advice was limited and that much of the information employees received was probably from the companies selling the products. "I'm not sure how much information they got in terms of comparison between products or stocks and bonds," she says.

At one point, about two-thirds of all assets in the plan were invested in the fixed-rate annuity, according to the board's annual reports. For the first two years, the annuity offered an annual return of 8.5%, but then it dropped to 4.5%, according to a state official. Mr. Pluhowski says the 4.5% is the guaranteed minimum return, while the higher percentage was based on then-market conditions.

By 2005, complaints from employees and the union about low balances in the defined-contribution plan had mounted. State officials closed the plan to new participants and reopened the pension plan to new hires. The following year, school employees voted on whether to end the defined-contribution plan, but a state court later deemed the vote unconstitutional because those satisfied with the plan would have been forced to return to the old-fashioned pension plan. This spring's election was couched differently: Workers voluntarily could elect to transfer their account into the old pension plan, provided that at least 65% of current employees wanted the transfers to be permitted.

The threshold easily was cleared -- in part because as of April 30 the average account balance in the defined-contribution plan was $41,478, and of the 1,767 employees over the age of 60, only 105 had balances of more than $100,000. "Our members were going to run out of money five or six years into retirement," says Ms. Hale of the teachers union.

Some retirement experts say another problem that surfaces in 401(k) plans is the "red-truck syndrome": Plan participants use some of their nest egg at retirement to buy something they always dreamed of having. Teresa Ghilarducci, an economist at the New School for Social Research in New York, says many workers take their 401(k) in a lump sum and have difficulty making it last. She says the West Virginia case "shows the nation what is wrong with everyone's 401(k)," including a lack of investment knowledge and fiscal discipline.

State Investigation

Meanwhile, West Virginia's state auditor and attorney general have announced that they are looking into whether Valic made misrepresentations to induce employees to invest in its annuity, with the attorney general appointing four prominent state lawyers as special assistant attorneys general to help with the investigation. Also, Valic and AIG are co-defendants in a civil lawsuit seeking class-action status in county court in Moundsville, W.Va. The lead plaintiff, a teacher, accuses Valic of fraud, alleging the company misled employees to get them to invest in a "commission-driven" product.

AIG denies wrongdoing. Mr. Pluhowski declined to specifically discuss the lawsuit or the current state investigation, but says, "We are confident we met the obligations we were contracted to provide." He declined to say how much employees were paid for sales of the annuities, but says that "no plan contributions were used to pay commissions." West Virginia's insurance commissioner investigated Valic's sales practices in 2002 and cleared the company, saying it had found no misrepresentations by Valic agents.

Teachers returning to the pension plan will receive reduced benefits to reflect that they've contributed less than other state workers over the years. But they will have the option to make catch-up contributions to "buy back" the full benefits.

Ms. Elmore, 46, says she realized her disappointment in the defined-contribution plan when she received a letter from the state's retirement board in April projecting that, at age 60, she would have a big-enough nest egg to provide her with $1,571 per month for her life. By contrast, the letter projected, if she voted to go back to the defined-benefit plan, she would receive a projected monthly payment between $2,656 and as much as $3,050.

"I jumped on it," she says. "I was just worried."

--Ms. Levitz is a staff reporter in Boston for The Wall Street Journal.

Write to Jennifer Levitz at jennifer.levitz@wsj.com7

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