In the context of retirement readiness, how do we identify the circumstances under which reasonable caution and prudence must be exercised?
The standard of care stems from the 1837 case of Vaughan v Menlove. This case established that the standard of care is dependent on the circumstances, and upon whether the individual proceeded with reasonable caution as a prudent person would have exercised under the circumstances.
Employees fortunate enough to work for a company that offered a defined benefit plan didn’t have to worry about contributions or investment decisions. The entire process was managed by the employer and their advisers. The employer defined the benefit, provided the necessary funding and was responsible for overseeing the management of the plan’s investments. Investment performance below the expected return meant higher contributions for the employer.
The plan sponsor bore the responsibility to establish a prudent process to benchmark investment performance, minimize investment related cost, or be straddled with the burden of higher contributions. This model worked extremely well for employees but the employer faced challenges balancing benefits and employee’s need for higher current compensation.
The introduction of 401(k) plans in 1980 provided employers with an alternative to defined benefit plans. The funding obligation and investment management responsibilities were shifted to the employee. Unfortunately for participants, there hasn’t been adequate guidance on what their contributions should be. Worse, in many cases their investment choices have been limited to high-cost, low-performance options. This epic failure of the 401(k) industry over the past 36 years has left many employees inadequately prepared for retirement.
The Yin and Yang of Benchmarking Fees—and Contributions
Retirement readiness is conditioned on two linked, fundamental factors: contributions and investment performance. Employers who offered defined benefit plans understood this concept and established prudent processes to address each factor. The key features of defined benefit plans can provide a framework for establishing prudent processes and checkpoints for 401(k) plan sponsors.
First and foremost, the employer should help define the contribution for the employee. A flexible compensation solution that allows the employee to define their desired retirement benefit simplifies the process of identifying long-term funding needed to achieve retirement readiness.
Employees who start saving later in their career may have a higher funding goal than those who started earlier. Individualizing the target for each employee, based on their own facts and circumstances, establishes a prudent process and a high standard of care.
Plan sponsors understand that both subpar investment performance and high investment costs erodes retirement readiness, and increases the employee’s funding obligation. By establishing a fee benchmarking process, plan sponsors have discharged their fiduciary responsibilities. That method has proven to be an effective method for curbing high investment costs. But benchmarking fees, alone, ignores the impact of contributions.
Benchmarking employee outcomes, rather than just investment fees, measures the effectiveness of all aspects of the retirement plan, including contributions. A focus on outcomes also ensures that plan sponsors have taken reasonable caution, and exercised prudence in establishing a path to retirement readiness. In the end, benchmarking outcomes serves both employees and plan sponsors in a way that is superior to a focus on fees only.