A ray of choice

By offering their employees freewheeling brokerage accounts within traditional 401(k) retirement plans, some firms crack open new options for tax-deferred investing.

"Don't confuse brains with a bull market."

For decades that slogan, said to be emblazoned on one Texas stockbroker's wall in 1980, was easy to ignore.

An almost 20-year bull market in both stocks and bonds was the rising tide that carried all boats higher. And the investment tool of choice for many - the tax-deferred 401(k), often pumped up by matching contributions from the corner office - looked like a pleasure craft.

Investment options made available through many such plans included a range of stock, bond, and money-market mutual funds. Almost any mix of the three offered smooth sailing from the early 1980s all the way to the spring of 2000.

Many investors, money managers, and retirement-plan sponsors mistakenly attributed profitable performance to the soundness of their strategies.

But a reality check arrived in 2000 in the form of a nasty bear market that lingers today. Most equity funds lost money because their goal was not to protect the money, but to provide investors with "exposure" to a diversified group of stocks, a particular industry sector, or a particular style of investing, experts say.

This practice generally meant a given category of stocks would be owned regardless of whether its value moved up or down.

In this bear market, fund managers have been rewarded by their bosses for outperforming similar funds and relevant indices, rather than for generating positive returns. That definition of performance represents the industry's standard incentive, according to Deb Brown at Russell Reynolds Associates, a global executive-recruitment firm.

For example, a manager whose fund fell 22 percent while the S&P 500 index lost 24 percent would be hailed even though the investors lost their shirts. In many cases, the manager actually had performed "well," given the guidelines he or she was required to follow - guidelines outlined in the fund's prospectus.

Of course, the fact that a manager beats his peers means little to investors losing their retirement money.

Hope for better retirement-plan results in the future may hinge on employers providing better investment options and better investor education.

One sign of progress on that first front: Schwab and other firms now offer optional self-directed brokerage accounts within retirement plans. These accounts give employees access to a vast array of mutual funds not offered in their current plans, as well as individual stocks and bonds.

That kind of access can give small investors the flexibility to eke out gains even when major funds are staggering in lock step, say experts. And some investors are stepping up.

"Today 70 percent of new retirement plans that come on board at Schwab utilize self-directed brokerage accounts," says Jim McCool, a Schwab vice president. Some 5,300 retirement plans at Schwab include 100,000 self-directed brokerage accounts.

In fact, more than half of employers are offering self-directed accounts or considering offering them, according to a 2001 survey by Hewitt Associates.

'What's a bear fund?'

Since most equity mutual funds diversify over many stocks, a high percentage of them tend to perform very similarly to each other and to the broad market indices, such as the S&P 500.

One example of the great uniformity of performance by most equity funds: For the 12 months ending March 31, 71 out of a list of 74 Fidelity equity mutual funds lost money, with 63 of them losing more than 10 percent, and 43 losing more than 20 percent. The odds of picking a winner were slim, while diversification between funds would have virtually ensured a net loss of significant size.

"Almost all equity funds have capital appreciation as their objective," notes Brian Portnoy of Morningstar, the mutual-fund tracker in Chicago. "It's very rare for an equity fund to have capital preservation as its objective."

Jim Rose would not have been surprised by the Fidelity statistics. An active individual investor who lives near Boston, he called Fidelity early in the bear market several years ago and asked if the firm had any bear-market equity funds, funds designed to profit during a declining market.

While he was disappointed that they had no such funds, his biggest surprise was that he had to be passed up through three levels of management before he found somebody who even knew what a bear fund was.

Not that quality equity funds have vanished completely. Generally, good performers in recent years put investor protection first and employ hardier all-weather strategies than those employed by funds simply seeking to provide exposure to parts of the market.

Some funds that hedge, or protect against market declines, such as the Hussman Strategic Growth Fund, some market-neutral funds such as the AXA Rosenberg Value Long Short Fund, and some arbitrage funds, such as the Gabelli ABC fund and the Merger Fund, have done well over the past three years.

Significantly, very few of these all-weather funds have been among the options in most retirement plans.

Today, the average 401(k) account is comprised of 48 percent equity funds, 17 percent company stock, 8 percent bond funds, 8 percent balanced funds, and 19 percent money-market funds and other cash-based investments, according to the Employee Benefit Research Institute (EBRI).

The question facing retirement-plan sponsors and investors is whether narrow choices within these categories can yield profit in anything other than a bull market.

Falling retirement-account balances for investors over age 40 since December 1999 - despite continued contributions to these accounts - can be attributed to significant losses in equity funds.

Bond-fund gains in recent years have been widely attributed to declining interest rates. But "the salad days are over," warns bond guru Bill Gross, who runs the nation's largest bond fund, the $74 billion PIMCO Total Return Fund. When interest rates begin to rise, as they surely will at some point from their 40-year lows, most bond funds will begin to fall.

As for the money-market funds inside most 401(k)s, their minuscule interest rates have not kept up with inflation.

Enter brokerage accounts, with their expansive menus of offerings. Used properly and coupled with employee education, advocates say, investors can build into their portfolios flexibility that could help mitigate market bearishness.

But this flexibility has its drawbacks, warn financial planners. Owning such accounts may lead investors to buy only a few stocks, dramatically boosting their level of risk. Those who trade heavily will also incur high transaction fees, though online trading may help keep these down, according to the Financial Planning Association.

Early signs of success

The record so far points to responsible behavior among the self-directed. In an ongoing study of the 100,000 self- directed brokerage retirement accounts at Schwab, the firm has found that the average investor makes 2.4 trades per quarter, has 22 percent of his or her account in stocks, has 28 percent in cash, and has 68 percent of his or her account in a range of stock and bond mutual funds, according to Mr. McCool.

The large cash positions, the diversification between mutual funds, the largest stock holdings (Microsoft, IBM, General Electric, and Johnson and Johnson) speak to the conservative decisionmaking by the majority of self- directed brokerage participants.

About 22 percent of the pilots at Southwest Airlines have self-directed brokerage accounts within their 401(k)s, says Richard Doherty, executive director of the Southwest Airlines Pilots Association, which began making the accounts available in 2000. The option is working for those who chose it, he adds.

Retirement-plan participants who don't want to use a brokerage account might be more inclined to pursue another option some retirement-plan managers now offer: funds or trusts with targeted retirement dates.

Under such plans, an investor can pick the fund or trust with the date that corresponds most closely to his or her intended retirement date, and let the managing firm do the rest.

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