401(k)s

The Looming 401(k) Crisis

The $5 trillion 401(k) industry is about to see major shifts. 401(k)s are tax-advantaged, employer-sponsored retirement plans which offer a group of investment options selected by the plan sponsor. The main problem with 401(k)s is there are no investment options to hedge against a bear market. Some are looking into a 401 rollover for an old 401k. A 401k rollover into an IRA is a great way to add flexibility to your investment choices. The vast majority of these investment choices are mutual funds, pools of funds invested in hundreds of stocks and bonds. But there are a few problems with mutual funds.

The Problem with Mutual Funds in a Retirement Account

Mutual funds offer investors a false sense of security because they can lose a substantial portion of their value, just like an individual stock. Many mutual funds own the exact same stocks (just in slightly different combinations) so the diversification benefits they once had are greatly diminished. And you’re paying higher fees than necessary, especially when compared to ETFs. The average expense ratio for a mutual fund is about 1.25% but that represents only about one-third of the total (hidden) fees.

Also, they can only be sold at the end of the day’s NAV closing price. If the market opens up big and you want to take some money off the table at that moment you’ll find it very difficult to do. This is not a problem in normal times but if markets come under serious pressure the ability to sell out of them could become an issue. If conditions get bad enough, you could see mutual funds close for extended periods of time and halt redemptions. We saw this with a credit fund from Third Avenue. All the hard work and money saved (invested) is gone.

You may be able to use inverse ETFs if they are offered in the 401k by the plan sponsor but that’s not likely to be the case. Because of the daily reset, inverse ETFs are optimally designed for intra-day trading.This is against the long-term buy, hold and compound mission of most employer sponsored retirement plans.

Hidden Risks of Target Date Funds

The second largest investment in 401(k)s are hybrid mutual funds.These so-called ‘Target Date’ funds are especially risky. Clearly, marketed to investors for retirement (hence the date, target date refers to the date of your retirement). But even many investors in these funds aren’t sure what the ‘target date’ actually is.

Target date funds aim to incrementally adjust the asset allocation for an investor as they near retirement. These funds are marketed so an investor can purchase the fund with the appropriate date and ‘forget it’, with the funds managers adjusting your portfolio more conservatively as you approach retirement.

Some of these funds have fixed income portions that can be as high as 50% near retirement. While this seems safe, getting out of some of these fixed income investments is very difficult because many bond funds are so illiquid, especially one’s with high-yield bond components. Given the low interest rates we’ve experienced for several years now, investors have been reaching for more yield. This sounds logical but the risk investors are taking for this extra income is probably not suitable for these investors as they near, or are in, retirement. Investors are not particularly loyal to any asset class and when they try to liquidate the fixed income portions when they sell, the mutual fund may not find buyers for the bond components of the sale. So investors will sell whatever they can to raise the cash which should be the more liquid equity names in the portfolio.

One strategy to de-risk your target date fund is to customize it with alternatives ETFs including market neutral, risk parity, long/short and even inverse ETFs to hedge some of the risk. It may be a fiduciary responsibility to do so.

Another strategy to mitigate risk to your 401k is to roll over all or a portion into an IRA. Many employees have old 401(k)s and those can be rolled over into an IRA. You don’t have to roll over the entire 401(k), but a risk mitigating strategy might include this move. IRAs are traditionally more flexible than 401(k)s in their investment options and could make them a more suitable investment strategy.

You’ll be tempted, and probably advised, to roll all of your 401(k) assets at one location as an incentive to bring down the fees. But this marketing script doesn’t hold water. If you have over $500k at one location the amount above $500k is not SIPC protected. Diversification isn’t just about stocks, its also with custodians and clearing firms. Having all of your assets at one 401(k) (such as with a Prudential or Wells Fargo 401k) or asset manager may have been a failure to diversify.

Investigate Your Money Market Funds

Also, be wary of the money market fund that is often the only ‘cash’ alternative.  If you see titles such as ‘Prime’ or ‘Enhanced’ that means these money market funds (which are actually just portfolios of debt and repurchase agreements) might be more risky than you thought, even though marketed as a cash equivalent. If a conservative money market fund (invested in short-term U.S. Treasuries notes or bills) wasn’t offered it could be negligible behavior by a plan sponsor.

At a minimum, you should have a few money market options to choose from, one being a U.S. Treasury Only money market fund that invests in ultra-short instruments like T-Bills. Investing in T-Bills in a retirement account will send your financial advisor reeling but rolling over T-Bills as interest rates rise will be a safer place to be invested in a bear market. One of the tenets of investing for the long-term (like for retirement) is to maintain purchasing power and beat inflation. Well, when markets (and other investments) come down your purchasing power increases assuming your funds have been held safe. This is what happens in deflation. Prepare for it.