SmartMoney Blogs

A blog about living in and planning for retirement

How 401(k)s Could Work Much Better

I have to participate on a panel that looks at the current state of the U.S. defined contribution system.  This event is forcing me to reassess my views on 401(k) plans.

I start with the premise that the move away from defined benefit plans to 401(k)s in the private sector is not reversible.  Employers do not want a pension system where they bear all the risk in terms of investment and longevity.   Moreover, while “final earnings” defined benefit plans are great for employees who spend their entire career with a single employer, they produce haphazard income for employees who shift jobs frequently.

Moreover, defined contribution plans in the private sector help balance the overall risks to the retirement system.  In the pay-as-you-go defined benefit Social Security system, the risks are primarily demographic.  Lower fertility and increased life expectancy explain why Social Security costs will rise sharply.  In contrast, in a funded defined contribution system, the main risk – which is borne by employees – comes from fluctuations in asset returns.   Longevity risk remains, but it is also borne by the employee rather than the plan sponsor.  Given that the two pension arrangements are exposed to different risks, it makes sense to have defined contribution plans as a component of the nation’s retirement system.

Thus, the problem is not that the U.S. ended up with defined contribution plans in the private sector but rather that 401(k)s are the most extreme individualistic form of a defined contribution plan. People have to decide whether to join the plan, how much to contribute, how to invest those contributions, whether to roll over accumulations when they shift jobs, how much to invest in company stock and how to withdraw money at retirement.  People make serious mistakes at each step, producing low coverage rates and small balances.

Building on the work of behavioral economists, Congress passed the Pension Protection Act of 2006 to make 401(k)s easier and more automatic.  The legislation encouraged automatic enrollment and automatic escalation in the default contribution rates and made target date funds an acceptable default investment.

The problem is that less than 50% of firms have adopted automatic enrollment and only about a third of those have automatic escalation in the default contribution rate.  The other problem is that fees are very high.  The result is only 80% of those eligible participate, and balances are modest.  The median balances for households approaching retirement (age 55-64) are only $120,000 – $575 per month if the household purchases a joint-and-survivor annuity.  Some argue not to worry about low participation and balances because the system is relatively new, coming into existence in the early 1980s.  My view is that the “new” argument is getting a little old.

Participation and balance questions are only part of the story.  Many of those approaching retirement will be reliant entirely on 401(k) assets for income in retirement.  Yet, most will have no idea how to draw down their assets to balance the risks of running out of money too early and depriving themselves of necessities once they stop working.   Annuities would solve this problem, but people hate annuities and don’t buy them.

The question is what to do with a large defined contribution system that is falling far short of its potential.  The obvious answer is “fix it.”  This raises both political and legal questions.  The big political issue is the fact that the employer-provided pension system is voluntary, so legislators are reluctant to make the burden too onerous.  The legal question is how many changes can be made within the 401(k) construct.

My recommendation for immediate fixes is to pass legislation with three changes.  First, make automatic enrollment and automatic escalation in the default contribution rate integral parts of the definition of a 401(k) plan, rather than leaving the choice of whether to adopt these provisions up to the individual employer.  Second, require – at least as a default – that all 401(k) investments be in the form of indexed ETFs or low cost indexed mutual funds and limit fees for rebalancing.  (My reading of the literature is that active management is not worth the additional fees.)  Third, require – again, at least as a default – automatic annuitization of some portion of the balances.

In the longer run, my view is that an ideal defined contribution system should have extensive risk sharing, similar to that in the Dutch collective defined benefit plans. Instead of each employee having his own account, assets would be pooled so individuals would be freed from the burden of selecting their portfolios.  Benefits would be paid as an inflation-adjusted stream of lifetime payments.  If the plan suffers losses, adjustments could be made by an increase in employee contributions, a reduction in cost-of-living adjustments, and/or lower benefit accruals for current workers.  Similarly, if returns come in better than expected, participants would share the bounty.

Such risk-sharing arrangements may not be consistent with American culture, much less with the 401(k) system.  But making 401(k)s automatic and cheap should be an achievable goal.



We welcome thoughtful comments from readers. Please comply with our guidelines. Our blogs do not require the use of your real name.

Comments (5 of 34)

View all Comments »
    • The answer is EDUCATION. This article assumes that the average American is incapable of managing his own money, and needs the benign(???) hand of Government to “help” him save for retirement. The answer is NOT more collectivism, but more individual responsibility. Most people could benefit from something like Dave Ramsey’s Financial Peace University, and many companies offer it. The Social Security Ponzi scheme is broke now, and will require higher taxes and lower benefits if it is to stay solvent. I want to be master of my retirement accounts! NO MORE GOVERNMENT PROGRAMS!

    • DC, you need to really slow down, especially on the securities lending issue. as noted in the article you referenced, the idea behind securities lending is simple: it allows big investors like PENSION FUNDS to make extra money on their investments, without having to sell them. In a typical transaction, a pension fund or other institution lets a bank like JPMorgan lend some of its stocks or bonds to other investors, like hedge funds or banks. In return, those investors put up a cash security deposit, in case they are unable to return the securities. The PENSION FUNDS and other institutions then authorize JPMorgan to use that cash deposit to trade. so the PENSION FUND MANAGERS, with authorization of the PLAN TRUSTEES, employ this tactic to ENHANCE RETURNS in the pension fund, thereby reducing the amount of money required of the employer to fully fund the plan. SO THE GREED GOES BOTH WAYS, IF YOU CALL ATTEMPTS BY PLAN TRUSTEES TO DO AS WELL AS THEY CAN WITH THE MONEY “GREED”. I APPLAUD THE MANAGERS THAT TRY THIS, ESPECIALLY THOSE IN THE PUBLIC SECTOR, SINCE MY TAXES ARE HELPING TO FUND THESE OUTRAGEOUS PUBLIC PENSION FUNDS!!

      full and fair disclosure…i’m a financial advisor, and i sell retirement plans to employers. i can tell you that in no other time in our history have fees for kplans been under more scrutiny. with the recent DOL disclosure rules going into affect in the past few months, more and more attention is being paid by those that care to look to the fees in plans. yes there are those out there charging hefty fees, but it comes down to the level of service being provided. if the representatives like me are meeting with employees, helping them with their asset allocations, and are available when an employee has a question, that rep should garner higher fees than those who simply drop off enrollment packets once a year. our fees are very competitive, we offer a broad array of choices (including indexed funds and ETF’s), and work with the clients on reducing fees as balances grow…there are many like me who do the exact same thing. please don’t paint my entire industry as a bunch of lowlifes who “steal” from participants through outrageous fees.

      private employers are seeing what DB plans are doing to public institutions like cities and states, which are rapidly going broke under the weight of them, even with contribution participation by employees. these plans, crafted in onerous negotiations with unions, are generally very expensive to those responsible for funding them.

      regarding the authors claim that indexed ETF’s should be the only investment, i’m not sure what they read, but over the long term, well researched managed money outperforms indexed investments.

      and DB, regarding Enron, while i feel bad for those folks, the only money they lost in their 401k’s was the money they invested in Enron…their other holdings were preserved. that’s why (along with the worldcom debacle) congress changed the law to limit how much of an employee’s money could be directed to their employer’s stock.

      i can tell you i have gotten universal pushback from employers regarding auto-enroll. i don’t have a single employer with graduated contributions, mainly because graduated contributions (from a dollar standpoint) happens everytime an employee is given a raise…their contribution remains the same, but dollars in goes up due to increases in pay. in fact, when i’ve met with employers who have tried auto-enroll, we find they had lower participation (employees opt out) then when they didn’t have auto-enroll.

      so, the article is crap, doesn’t really apply in the real world, and is somewhat typical of what we see in the mainstream media today. i’ll bet both the author, and DB both voted for the disaster that lives in the whitehouse today.

    • 99%er,

      You said, ” Yet, unlike a true DC plan from your employer, you have no say in how that money is invested nor in how it is distributed back to you.”

      Check and see how many funds in your DC plan do securities lending. If they do, what say do you have in how the collateral is invested? None. Most people don’t even know what is being done with their money in their DC plan. See the NYTimes article posted upthread.

    • And I’ll reiterate…

      I’ll believe a 401(k) is better than a DB plan when two things happen:

      1) corporate CEOS give up their DB plans
      2) members of Congress and state legislatures give up their DB plans.

    • 99%er,

      I have taken a real close look at things.

      How much money did the Enron workers lose?

      YEs, Social Security is a DB plan. It’s is a “Defined benefit”. You work x number of years at x dollar salary, and you get a a DEFINED number of dollars at retirement.

      Your dad at least got something because of PBGC coverage and if the PBGC coverage isn’t enough because of bankruptcy loopholes, that is a FIXABLE problem.

      Yes, pension plans generally investing in the bankster/Wall Street — I know that. But the companies have leverage that I don’t have in terms of negotiating, due to their size. And any honest actuary will tell you the most efficient way of providing retirement for employees is through a DB plan.

      Hey, if you want to think you’re self-reliant, when we have flash crash, high frequency trading, securities lending, millions of dollars of lobbying and all of the other stuff Wall Street is doing, then go right ahead.

      But some of us aren’t fools. We know what’s going on.

About Encore

  • Encore examines the changing nature of retirement, from new rules and guidelines for financial security to the shifting identities and priorities of today’s retirees. The blog also explores news that affects retirement, from the Wall Street Journal Digital Network and around the web. Lead bloggers are reporter Catey Hill and senior editor Jeremy Olshan. Other contributors include The Wall Street Journal’s retirement columnists Glenn Ruffenach and Anne Tergesen; the Director for the Center for Retirement Research at Boston College, Alicia Munnell; and the Director of Research for Pinnacle Advisory Group, Michael Kitces, CFP.