It’s tough enough to get people to participate in their 401(k). Do they really need another reason to just say no?
Ian Ayers, a professor at Yale Law School may be giving them just that. He is advocating that in Connecticut, 401(k) plan participants be tested for financial literacy before they’re allowed to invest in high-cost or esoteric funds. His thinking, according to published reports, is that the state of Connecticut should lead employees away from high-cost plans and assure that there are low cost and a plethora of diverse options. What has some up in arms is the screening out. He reportedly wants to test prospective investor’s know-how about diversification, risk-return, suitability and excess fees.
Ayers has sparked a debate, should you be tested before you can enroll in a 401k?
"I would very much like to see participants receive a basic primer on financial planning before getting started, to help prevent the most common mistakes," says Scott Stratton, founder of Good Life Wealth Management. "With 52 million participants, 401(k) accounts are where most Americans learn about investing and retirement planning. Unfortunately, uninformed participants often make mistakes which jeopardize their long-term success and cause them to give up on their 401(k)," he says.
But that said, "My initial reaction to the proposal is that we need broader participation in 401(k) plans, specifically better representation from lower income employees, and that we should be very cautious about creating additional barriers to retirement savings," says Stratton, though he concedes that he believes Ayer’s proposal has the objective of pressuring plan sponsors to keep investment costs as low as possible, which would benefit all participants.
His concern is that requiring testing for high-cost funds might inadvertently give the impression that those are the "good funds" for sophisticated investors, instead of warning that those funds carry a high risk, says Stratton. There also is a possibility that the additional administrative burden might further discourage small and medium-sized employers from offering a retirement plan. "Given the size of the 401(k) space, literacy testing is a radical proposal, but perhaps not without precedent, given other regulations governing private placements, accredited investors, and on-traded Real Estate Investment Trusts," says Stratton.
What’s the goal of a test?
Greg Rhinehardt, a consultant with Gordon Asset Management, has a few questions. "What is the objective of requiring Americans to pass a literacy test before they can participate in their 401(k) plan? If they pass are they allowed to select investments on their own? If they fail, are they required to let someone else tell them how they must invest? If they fail the test, who will determine the appropriate investment allocation for those workers?"
For sure, he says, there’s no question that increasing the financial IQ of Americans is something to strive for, "But this isn’t the solution to help them reach their retirement savings goals."
Is it legal?
Some suspect that requiring participants to take a financial literacy test in order to enroll may be discriminatory under ERISA and prohibited in a 401(k). "One of the best features of 401(k)s is that they have professional investment management by the ERISA fiduciaries who must pick good investment options for the participants, review the investments available, and in some cases, prudently pick each participant’s investment allocation," explains Jamie Hopkins, associate professor in the American College’s Retirement Income Program. He says that the design of 401(k)s take into consideration and add a great amount of protection for individuals that might not have a great deal of financial literacy.
Share the burden
Nick Ventura, president and CEO of Ventura Wealth Management, says financial literacy shouldn’t fall only on the shoulders of the investor. "Plan sponsors, as well as platform providers like Fidelity and Vanguard, should be involved in the educational process from the beginning. Too often, 401(k) participants who aren’t financially literate, default to either money market reserves or target dates funds, which may or may not be appropriate to their financial circumstances or goals."
Better still, financial literacy should be introduced to people when they’re young. "Before graduating from high school, every student should be required to take a basic financial literacy class with the option to take an advanced class," says David Jozefiak, president of Next Degree Financial. Ideally, he says classes would cover debt, financing your education, budgeting, paying bills, buying a house, "subjects everyone has to deal with in life, but usually never receive any formal education. This could go a long way to lay a foundation for financial literacy," he says.
What really matters?
Mark Zoril, founder of PlanVision, has spent the last 20 years helping middle class people enroll in and take advantage of their employer based plans. He has heard many ideas to improve different aspects of 401(k) plans, but testing, he says, "is the craziest I’ve ever heard." Though he says from the more than 7,000 people he’s worked with, "Many are ignorant about the plan and their investments. Ignorance is an issue."
But more importantly, he says, "I am not sure people that are ‘financially literate’ would end up doing any better than those that aren’t. I have met so many people over the years that are clearly literate, but don’t use common sense in their investments. They try to outsmart the markets or over manage their funds. I believe many of them are worse off than the financially illiterate person who set up his or her account in a well diversified mix and just kept saving," says Zoril.
He adds, "In a perfect world, something like this would make sense. However, we live in a far from perfect world and this would stymie way too many people."