Information For Retirement Plan Sponsors and Leaders of Other Groups and Organizations

Do People Need More Financial Education?

Most retirement plan sponsors and leaders of other organizations are well aware that many of their members need to improve their financial decision making skills.

For example, the 2001 Retirement Confidence Survey (RCS) found that while 67 percent of current workers reported that they had saved something for their retirement, only 32 percent had tried to calculate how much money they actually would need to have saved so that they could live comfortably after they retire. Another survey by the American Association of Retired People found that at most 40 percent of respondents from different groups knew that diversification reduced the risk of losing money on one's investments. Given this level of knowledge, it comes as no surprise that the RCS found only 23 percent of current workers believed they were doing a good job of preparing financially for their retirement.

Why haven't more people tried to calculate how much money they need to save to pay for the retirement they want to enjoy? Earlier this year, Alan Greenspan suggested one reason, when he noted that "one of the most complex economic calculations that most workers will ever undertake it without doubt deciding how much to save for retirement." In short, many workers may simply find the calculation too difficult to do on their own. Academic research by Professor Annamaria Lusardi has also suggested another potential explanation: people are afraid of what they may find out. Avoiding this issue, however, may only compound future problems. Using data from the Health and Retirement Study, Lusardi found that 54 percent of retirees who had not planned for their retirement rated their retirement years as not as good as their working years, while 79% who had thought a lot about retirement rated it as better or about the same as their working years. These data suggest that, painful or not, this is an issue that all of us are better off confronting now rather than putting off until later.>

Moreover, the shift from defined benefit pension plans to defined contribution pension plans has made resolving this issue even more important, for two reasons. At the individual level, improving financial decision making skills should help raise savings levels and improve their allocation, which in turn will increase today's workers future retirement incomes and quality of life. At the corporate level, improving plan participants' financial decision making skills could help to avoid a potential future fiduciary liability issue. A number of recent studies have found that average returns on defined benefit pension plans have exceeded those on defined contribution plans by 1.5% to 2.5% per year. If this gap is not closed, the eventual disparities in plan values may raise issues regarding the quality of information and educational materials provided to defined contribution plan participants by their respective fiduciaries.

Does Financial Education Work?

This, in turn, raises the question of whether, and to what extent, financial education is successful in changing people's behavior. Several recent studies suggest that financial education improves people's financial decision making skills. The RCS found that 58 percent of the people who had attempted to calculate the amount of money they needed to save for their retirement had started to save more, while 26 percent had changed their asset allocation. It also found 41 percent of current retirement plan participants had received educational materials from their plan sponsor over the preceding twelve months, and that 27 percent of the workers receiving these materials had changed their retirement planning as a result.

In another research paper, "The Effects of Financial Education in the Workplace: Evidence from a Survey of Households", Professors Douglas Bernheim and Daniel Garrett found that "employer-based financial education stimulates saving, both in general and for retirement." In addition, in her paper "Explaining Why So Many Households Do Not Save", Professor Annamaria Lusardi found that "planning affects wealth levels as well as portfolio choices. Individuals who plan are more likely to hold large amounts of wealth, and to invest it in higher return assets, such as stocks."

Alan Greenspan recently summed up the available evidence by noting that "while data available to measure the efficacy of financial education are not plentiful, the limited research is encouraging."

Does Providing Financial Education Benefit Employers?

The next logical question to ask is whether or not financial education generates positive benefits for plan sponsors, employers and organizations, in addition to helping them to avoid potential fiduciary responsibility issues. While the data here are quite limited, they generally suggest that the benefits from improving employee financial decision making skills may be quite large. Two studies stand out. The first was done by the U.S. Department of Defense in 1998. It found that about 43% of employees reporting high stress levels also reported decreased job performance as a result. As for the top causes of stress, financial problems were reported by 15.3% of employees, placing them third behind being away from family (19.5%) and increased workload (17.6%).

The second study is entitled "Personal Financial Wellness and Worker Job Productivity." Its author, Professor S. Joo, found that "workers with lower levels of personal financial wellness tended to perform poorly in terms of productivity and performance ratings, be absent more from work, and use more work time for personal financial matters."

These studies suggest that to the extent that financial education succeeds in improving employees' financial decision making skills, it will also generate significant positive economic benefits for the organizations to which they belong.

What Should a Financial Education Program Include?

What then, should a financial education program include? There are two approaches to answering this question, one specific, and one more general. For 401(k) plan sponsors, The United States Department of Labor has provided a useful set of quite specific guidelines (see 29CFR2509, published in the Federal Register on 11 June, 1996). These guidelines are framed as "safe harbors" , so that companies acting within them will escape fiduciary responsibility for the outcomes of investment decisions made by plan participants. First, a financial education program should include information about the retirement plan itself, including "its terms and operations, as well as the benefits of plan participation and the impact of withdrawing one's savings before retirement."

The second safe harbor covers the provision of general financial and investment information, including information and materials that inform participants about general concepts such as "risk and return, diversification, compound returns, and the impact of taxes." This general information can also include "historic rates of return on different asset classes, how to estimate future retirement income and savings needs, the effect of inflation, and the concepts of time horizon and risk tolerance."

The third type of information that can be provided as part of a financial education program relates to asset allocation, including "model portfolios for hypothetical individuals with different time horizons and risk profiles. These models must be based on generally accepted investment theories that take into account the different historic rates of return on different asset classes over specific periods of time." The last safe harbor is closely related to this, and covers the provision of worksheets, software or other materials that "enable a plan participant to estimate future retirement income needs and assess the potential impact of different saving levels and asset allocations."

The second approach to determining the content of a financial education program is to ensure its consistency with the guiding principle of fiduciary responsibility set down in the ERISA legislation and regulations. This requires a pension fund fiduciary "to act with the care, skill, prudence and diligence under the prevailing circumstances that a prudent person acting in a like capacity and familiar with such matters would use." This is a stringent test, and is commonly referred to as the "prudent expert rule". With respect to defined contribution pension plans, we believe that a prudent expert familiar with the latest research in modern portfolio theory should provide educational materials that help employees answer four critical questions:

• Do you know how much money you need to save to achieve your retirement goals?
• What compound rate of return do you need to earn on your portfolio to accumulate this amount by your expected retirement date?
• How should your allocate your assets to maximize your probability of realizing this rate of return, while taking on as little risk as possible?
• Should you implement your asset allocation policy through active management (market timing and stock picking) or indexing?

What Does Index Investor Offer?

We provide three online offerings that all focus on helping your employees or members of your organization to address these four critical questions.

Our website (www.indexinvestor.com) contains a limited number of free resources, in both online (html) and downloadable (pdf) form, which present an overview of these four issues.

Why Pay More For Less? is a downloadable (pdf) 204 page e-book which contains some of our best articles from the past four years, and addresses the four issues in much more depth. It does not, however, include our model portfolios.

The Index Investor is our monthly newsletter. It provides (in both html and pdf versions) updated performance data for our model portfolios, reviews of new index products and strategies, and in-depth analyses to help make our readers more knowledgeable investors. Subscribers to our newsletter also have access to a directory of index investments, including a comparison of their associated expenses and year to date performance, as well as links to interesting recent academic research into the issues we cover. A full library of back issues is also available.

We produce sets of model portfolios for investors whose functional currencies include Australian, Canadian and American Dollars, as well as Euros, Yen, and Pounds Sterling. We use a number of different approaches to construct these various portfolios.

The first approach we use is basically a "rule of thumb" (or, to use the more formal term, a "heuristic") approach. To construct our benchmark portfolios, we used three "rule of thumb" weightings: a mix of 80% equities and 20% debt (for our high risk/high return portfolios); a mix of 60% equities and 40% debt (for our moderate risk/moderate return portfolios); and a mix of 20% equities and 80% debt (for our low risk/low return portfolios). Using different terminology, somebody else might call these three portfolios aggressive, balanced, and conservative. We use two types of equity and debt to construct these portfolios. For our "domestic benchmarks" we use broad domestic equity and bond market indexes and funds that track them. For our "global benchmarks" we use broad global equity and bond market indexes and funds.

The second portfolio construction approach we use is "mean/variance optimization" or MVO. This approach uses three variables for each asset class (its expected return, standard deviation of returns, and correlation of returns with other asset classes) to construct different combinations of portfolios which maximize return per unit of risk (another way of looking at this is that they minimize risk per unit of return). In other words, for each of these portfolios, there is no way to get more return for the same risk, or less risk for the same level of expected return. For that reason, these portfolios are called "efficient", and the set that comprises all of them is called "the efficient frontier" (because when they are plotted on a graph based on their risk and return, they form a line). We use the MVO approach to form two different sets of portfolios, using a wider range of asset classes than the two that we use to form our rule of thumb benchmark portfolios. Our asset classes are broadly defined; in general, we try to keep the correlation of returns between asset classes at .60 or less. However, in our newsletters, we discuss the relative merits of taking different style, size, and other "tilts" within different asset classes. In the first set of MVO portfolios, our objective is to maximize expected return while taking on no more risk than the domestic benchmark portfolio.

In the second set of MVO portfolios, our objective is to match the domestic benchmark's return while taking on substantially less risk. When it comes to MVO portfolios, we favor this second approach because historically the relative risk rankings of different asset classes has been nearly twice as stable as their relative return rankings. As a result, the second approach should generate model portfolios which outperform their benchmarks more often than the first approach (though when the first approach outperforms, it will probably do so by a larger margin).

MVO, however, has some significant and well known limitations. While it is a good approach to single year portfolio optimization problems, in multiyear settings it fails to adequately take into account the fact that poor portfolio performance in early years can substantially reduce the probability of achieving long term goals. It also fails to adequately account for most people's intuitive understanding of risk: what's important isn't standard deviation (the dispersion of annual returns around their mean), but rather the chance that a person will fall short of his or her long-term goals. In response to these concerns, we have employed a third portfolio construction approach called dynamic programming (DP), which is essentially a method for optimization in the face of uncertainty (for more details, see our November, 2001 issue). We use the DP approach to form our four "target return" model portfolios, whose objective is to maximize the probability of achieving at least a minimum compound annual rate of return over a ten year period, while minimizing the risk taken on. The DP approach usually leads to different conclusions than the MVO approach -- in particular, it usually uses a higher percentage of fixed income and real estate so as to minimize the downside risk in any year.

We do not believe that any of our publications constitute "investment advice" as defined by ERISA regulations.

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Tell Me More About Your Company

Index Investor Inc. was founded in 1996, and has published monthly for over five years. Our offerings are produced in accordance with The Investment Advisers Act of 1940, Section 202(a)(11)(D) which excludes publishers of bona fide financial publications of general and regular circulation from the definition of an investment adviser, and the obligation to register as such under the Act. The publisher of The Index Investor is Susan Lee Miller. She is a graduate of Northwestern University and formerly worked as a credit officer at Standard and Poor's Corporation and as an investment banker at Kidder, Peabody, Inc. The managing editor of The Index Investor is Thomas Coyne. He is a graduate of Georgetown University and Harvard Business School, and has worked at the United States Treasury Department, Chase Manhattan Bank, and The MAC Group, a leading general management consulting firm.