GuidePost - Vol. 4, Issue 5 2008

The GRABot BAG
by Sherrie E. Grabot, CEO

August 2008
Friends don’t let friends give investment advice

Social networks, to judge by the attentions of media and venture capital, are the latest Big Idea that is going to transform our lives. Networks of contacts will boost our careers. Large-scale collaboration will empower our work. Wiki-everything will keep us constantly informed. Plus, we’ll get free phone calls to our favorite people.

There is a dark side, however, to all this connectivity. In a recent article about online investment help, Money magazine senior editor Walter Updegrave leads with a scary statistic: 21% of all 401(k) participants rely on friends and family for advice about managing their plan accounts, as do a whopping 44% of those under age 35.

So much for the idea that the Internet Generation does everything online. Or maybe they’re polling their friends through Facebook?

The piece goes on to give a summary of the most common alternatives to asking your nearest and dearest to play financial advisor. These include that old standby, the online calculator, as well as target-date funds and outside advisory services, such as ourselves. It then offers two important caveats for using an advisor: beware of any additional fees for the service, and make sure to provide a full picture of your overall financial situation. Otherwise, what you’ll get may be “little more than a glorified target-date fund.”

It’s very true that you need to participate fully in the advice process to maximize its effectiveness. But with all due respect, I have to disagree with this conclusion on a few points.

Goals, not targets
For one thing, a managed account still gives participants an asset allocation mix that’s tailored to their retirement savings goal, not simply their target age. For investors who are starting late, saving too little, or both, that’s a very significant difference. A simple target-date strategy may leave them with inadequate savings when the end date comes around.

A true managed account should also consider other company-sponsored assets such as pensions. Information about these will typically be available from the plan sponsor even if the participant doesn’t disclose them. Plus, a third-party managed account provider can make use of the full range of options available through the plan, selecting those that are most appropriate for the portfolio, rather than just those from a particular family or company.

Bang for the buck
It is also true that plan participants should pay close attention to the fees they are charged. This applies not just to managed account services, but to the fees associated with the underlying funds in any account. In fact, one advantage of a managed account approach is that it can compare individual funds’ fee loads as a component of each investment decision, accurately and automatically.

When the typical participant (or more accurately, their plan sponsor) looks at the cost of managed accounts, the value they get in return should be pretty convincing. The benefits of industrial-strength investment management, compared to the popular friends-and-family approach, far outweighs what any reasonable provider might charge.

Full disclosure
In their concern about minimizing fees, however, Money seems to be right in step with recent trends. On the regulatory side, the DOL has proposed a new set of rules to mandate clear disclosure of all management fees and other costs for investment options offered through retirement plans. This would also include the participant’s share of all plan administrative services and any fees for participant-initiated transactions, as well as comparison data on fund performance.

According to a recent Wall Street Journal article, the DOL estimates that the new rules will save participants $6.1 billion over nine years. While some legislators feel the proposed regulations don’t go far enough, the American Benefits Council calls them “reasonable and straightforward.” Which they are – as long as the effort required to comply with them isn’t greater than the benefit they provide, of course.

Collective security
Another sign of increasing sensitivity to management fees is the rise of collective investment funds. These are basically “generic equivalent” mutual funds designed solely for use in retirement plans. Because they are typically managed on a very large scale, are not sold to the retail market, and are not regulated by the SEC, they can be offered very cheaply.

They are new enough, and obscure enough, not to have a catchy nickname yet. But they’re also surprisingly popular: according to a Greenwich Associates study cited in another WSJ article, 39% of large defined contribution plans used collective funds in 2007, along with other institutional-class vehicles. And only 58% of these plans still offered any retail mutual funds at all.

This is a significant change from the participant’s point of view as well. In a world dominated by consumer marketing, brand is everything. At the retail level financial services are almost as brand-driven as Coke and Pepsi. So it’s not surprising that some participants are not terribly happy about the shift, especially when longstanding retail funds get dropped from their plan’s core lineup (as has happened at AT&T and DuPont, among others).

The good news is that collective funds can carry fees as low as a single basis point, which helps justify any “leap of faith” that may be required. The new disclosure regulations may come along just in time to convince participants that they’re getting a good deal. And honestly, anything that helps investors make decisions based on actual financial details and results – rather than brand names, social networks, or what the guy in the next cubicle happens to say – must be a step in the right direction.

~~ Sherrie