Many years ago, I visited Grand Canyon National Park with my mom and aunt. It was unseasonably hot, but I wanted to walk down into the canyon on the Bright Angel Trail. My companions were not up for the hike, so I went alone. My mom—slightly worried—questioned whether I had enough water and cautioned that the journey back up was much harder than the way down.
I hadn’t planned to hike the full trail but wanted to see how the canyon view changed with each step. It all ended up OK, but my mom was right. I needed more water and should have turned around sooner. In short, I hadn’t fully prepared for the hike.
Unfortunately, many defined contribution (DC) plan participants are in similar circumstances. They are not adequately outfitted for the long and challenging trek to retirement. However, as Benefits Magazine author Richard Hudson explains, financial education on some key topics can equip them for success.
In his article “The Long Hike to Retirement: Equipping DC Plan Participants for Financial Success” in the March/April issue of Benefits Magazine, Hudson uses the hiking analogy to detail several concepts that DC plan participants should be aware of. Hudson is a consulting actuary at First Actuarial Consulting, Inc., in New York, New York.
Hudson suggests that participants in DC plans, including 401(k) and 403(b) plans, should be aware of the following concepts.
Investment Expenses
“It’s important to understand the concept of investment expenses to navigate the financial terrain efficiently. Just as a hiker seeks to minimize the weight of their backpack, you should strive to streamline investment expenses to ensure a smoother financial hike,” Hudson writes.
He provided the following example to illustrate:
Start with the assumption of a 25-year-old participant who earns $60,000 per year and receives a 2% annual pay raise. If both funds earn 6%, a participant who chooses a fund that has a 5.75% sales fee and investment management fees of .6% would end up with $613,000 at age 65 compared with $700,000 for a participant who invests in an index fund with no sales fee and lower investment management fees.
“Just as an extra water bottle or an unnecessary gadget can weigh down your backpack on a hike, excessive fees can weigh down your realized returns and negatively impact your retirement savings,” Hudson explains.
Gradual and Slow vs. Steep and Fast
Like hikers in the Grand Canyon, DC plan participants can choose a steep path (investing more heavily in equities) that carries more risk but may get them where they’re going quicker, or a more stable route that takes longer (investing more heavily in bonds).
The optimal decision on the route varies with each participant and their risk tolerance or ability to absorb risks, Hudson explains. He recommends considering factors such as job risk, health, time to retirement and the ability to work later than planned.
DIY vs. Guided Tours
Participants can choose to manage their own portfolios, like a solo expedition, or invest in a target-date fund (TDF) or work with a financial advisor, equivalent to a guided tour.
Those who go it alone select their own investments but might need some additional education to ensure that they make the best choices, Hudson notes. Participants who opt for TDFs or financial advisors delegate the responsibility of asset allocation and rebalancing to professionals. This may provide more stability and less worry, but they will likely face higher fees and generate lower returns, he adds.
The Advantage of an Early Start
“The benefits of starting early on the retirement savings hike are akin to beginning the trailhead before the sun rises,” Hudson writes. Hikers who start earlier can cover more ground and see more sights. DC plan participants who start saving earlier should be able to save more because they can take advantage of compound interest.
Using the same salary parameters and investment returns mentioned in the fees comparison, the participant who starts saving at age 25 will accumulate $700,000 while someone who starts just ten years later would accumulate $425,000.
What Can Plan Sponsors Do?
“In this extended journey through the world of DC retirement planning, participants must be equipped with the essential financial education to endure the journey,” Hudson writes.
Plan sponsors and trustees should consider how they can help their participants succeed, and providing financial education is an important part of that. Seminars and education can be provided by the DC plan administrator or recordkeeper, but Hudson suggests that plans should consider working with an independent financial professional.
Advantages of using the recordkeeper or administrator may be familiarity with the plan and lower cost. However, having the investment firm that administers the DC plan provide the education may create a perceived conflict of interest since the firm may benefit from the investment selections participants make, Hudson contends.
“Regardless of whether it is independent, one potential drawback of providing financial education is the risk of overwhelming participants with information. Finance can be a complex and daunting subject, and some participants may feel inundated with details, leading to decision paralysis,” he writes. To counter this, he recommends structuring financial education programs to provide manageable, step-by-step guidance. Trustees and plan sponsors can work with educators to discuss any feedback they have received from generic education materials and what they think will better resonate with their members and employees.
Plan participants have many paths to take when it comes to their retirement savings. It’s important they consider their options so they are ready for the road ahead. I hope to hike in the Grand Canyon again someday. I may not hit the trail before sunrise, but I will make sure to prepare a little better so I can fully enjoy the view.
