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Should the 401(k) Be Reformed or Replaced?

David Engelhardt | Getty Images

John Greene worked for 30 years at an Oscar Mayer plant in Madison, Wis., deboning hams and loading boxes of hot dogs. His 401(k) plan grew to $60,000, and soon after retiring he began withdrawing $3,600 a year from it, money that allowed him and his wife to take what he called a wondrous two-week trip to Scotland, his ancestral homeland.

But when the financial markets plunged four years ago, his 401(k) dropped to less than $18,000.

“We lost more than 70 percent,” he complained, even though a highly recommended investment firm was managing his 401(k). “They’re very risky.”

For Mr. Greene, 77, the money he withdrew each year provided him and his wife some breathing room — and comforts — on top of the $29,000 they receive annually in Social Security and pension payments.

But though it has rebounded a little, his nest egg has declined so much that he withdraws far less than he used to. The result: “We can’t do trips like Scotland anymore,” he said.

Like millions of Americans, Mr. Greene has suffered losses from his 401(k) even as such plans have largely supplanted traditional pensions and become the central pillar of America’s employer-sponsored retirement system, with 60 million workers participating in them.

Now, although Social Security and Medicare generate far more political heat, a quieter, more nuanced debate of large consequence engulfs 401(k)’s, the voluntary, privately financed plans that some see as a savior of American retirement and others see as an impediment: Should 401(k)’s be fine-tuned and expanded or should they be replaced entirely?

And for many looking to retirement after the Great Recession, there is this pressing question: What to do about woefully underfunded 401(k)’s now.

David L. Wray, president of the Profit-Sharing/401(k) Council of America, an association of companies that sponsor retirement plans, said that 401(k)’s — and the Individual Retirement Account system that many people roll their retirement money into — worked well, despite some shortcomings. These 401(k) plans now hold $3.3 trillion in assets, seven times the level two decades ago. “If the goal here is to accumulate money, this system has accumulated more money than any system ever,” he said. “It’s been an incredibly effective accumulator of assets.”

But many investment experts and economists give the 401(k) system low marks. They note that fewer than half of the nation’s private sector workers are in 401(k) plans and that nearly a quarter of businesses with more than 100 employees do not offer 401(k)’s. Moreover, many Americans put only 3 percent of their earnings into 401(k)’s when investment experts often recommend saving 10 or even 12 percent.

The typical worker age 55 to 64 had just $54,000 in a 401(k) in 2010, according to a new report by the Center for Retirement Research at Boston College, and households with workers in that age group had $120,000 in retirement savings on average, if the money rolled into I.R.A.’s was included. That $120,000 is less than one-fourth the savings recommended by many retirement experts. Moreover, the center calculated, that $120,000 would provide an annuity of a paltry $7,000 a year.

Teresa Ghilarducci, an economics professor at the New School and a leading critic of 401(k)’s, said, “Every good retirement system needs to have adequate accumulation for individuals, the money needs to be invested appropriately and the payout needs to meet the needs of retirees for life. Unfortunately, 401(k)’s fail in all three categories.”

She criticized giving $80 billion in tax breaks annually to 401(k) participants to nourish a system that does not provide secure retirement savings for all. Moreover, she said, 60 percent of those tax breaks go to the top 10 percent of earners — people who would probably save even without the tax breaks.

John C. Bogle, the founder of the Vanguard Group and an esteemed figure in the world of investing, also voiced sharp criticisms. “We have a 401(k) system that is profoundly flawed even as it has moved to the position of pre-eminence in our retirement system,” he said. “There are elements of the 401(k) system that are just unacceptable if you’re trying to build a system that accumulates for retirement.”

In his new book, “The Clash of Cultures: Investment vs. Speculation,” Mr. Bogle rattled off a list of 401(k) shortcomings, among them excessive Wall Street fees, misguided asset allocation and failure to deal with longevity risk; for instance, someone living to age 92, but emptying a 401(k) by age 82.

Mr. Bogle ridiculed how easy it was, despite withdrawal penalties, to take money out of 401(k)’s — whether for a down payment on a house, to send children to college or to buy a new rug. Likening 401(k)’s to savings plans, he said making it so easy to withdraw money was the opposite of what retirement plans should do.

Even fierce critics like Mr. Bogle readily give advice on what investors should do to improve their chances for adequate retirement savings. An early champion of index funds, he recommends them for 401(k)’s; they typically have lower annual fees than, and perform as well as, many aggressively managed funds.

Mr. Bogle said many investment funds charged around 2 percent in annual fees, although he noted that some index funds charged one-twentieth of that — just 0.1 percent a year. He calculated that if one obtained a 5.5 percent annual return when inflation was running at 2.5 percent, then the net return would be 3 percent. With considerable chagrin, he noted that a 2 percent investment fee “would consume fully 67 percent of that annual return.”

A study by Demos, a liberal research center, found that a median-income couple that invested in 401(k)’s for 40 years with fees averaging 1.6 percent a year would achieve $354,850 in assets at average savings rates, but only after paying $154,794 in investment fees.

Alicia H. Munnell, director of the Boston College center, recommends that people jump at the opportunity to join 401(k) plans as soon as they can. “The trick is to contribute from Day 1 if your employer has a plan, and leave the money there,” she said. She voiced concern that 21 percent of workers whose employers offered plans declined to participate and that for those age 20 to 29, 40 percent declined.

Stephen P. Utkus, director of the Vanguard Center for Retirement Research, said most Americans saved far too little. “Certainly by your 30s, you should be saving 10 percent,” he said

He said many Americans emptied their 401(k)’s after they were laid off, leaving them with far too little savings for retirement. “You can’t invest your way out of a savings problem,” Mr. Utkus warned. “To catch up, you have to save more or maybe work longer. My general advice for people is, save 3 percent more of your income each year and plan to work three more years.”

He advised 401(k) participants to put money in balanced funds, like target-date funds, that decrease the ratio of investments in risky stocks as investors age. But Mr. Bogle warned that target-date funds often charged one percentage point a year more than other funds.

According to a report by the Congressional Research Service, 38 percent of 401(k) participants age 55 to 64 have 80 percent or more of their 401(k) assets in stocks — even though many experts say it is unwise to invest heavily in stocks so close to retirement age because a large chunk of one’s savings could quickly evaporate in a market downturn.

Jack VanDerhei, research director at the Employee Benefit Research Institute, recommends that all Americans, as they age, step back and do a thorough assessment of their retirement savings and retirement plans — perhaps at age 50. He suggested visiting a financial planner or using a Web site on retirement planning.

“Figure out where you think you need to be at whatever age you think you want to retire,” Mr. VanDerhei said. “Then figure out what that’s going to translate into in terms of what you’re going to need in 401(k) accumulation at that time.”

Mr. VanDerhei stressed that all 401(k) participants should invest at least the amount needed to qualify for the maximum employer match to avoid leaving money on the table. In other words, if an employer is offering a dollar-for-dollar match up to 6 percent of pay, then an employee would be ill-advised to put just 3 percent in a 401(k).

As the debate continues over how well 401(k)’s function, some policy experts have called for scrapping the 401(k) system and replacing it with a more universal, less risky system. One system might, like Social Security, require that some percentage of an employee’s paycheck be withheld to finance a new, government-managed retirement plan. But other critics, convinced that Congress would never enact such vast changes, call for enacting incremental steps to improve the system — for instance, steps to encourage more small businesses to offer 401(k)’s, like allowing them to aggregate their plans to save on administrative costs.

Professor Ghilarducci has won the backing of many labor and liberal groups with her proposal for “Guaranteed Retirement Accounts,” which would require that 2.5 percent of each worker’s pay be withheld to finance a new retirement plan on top of Social Security. (A $600 refundable tax credit would help soften the hit.)

She also calls for requiring employers to match that amount, a mandate that businesses would surely oppose. Such a system would be managed by the government and subsidized by it and would guarantee a 3 percent annual return. Ms. Ghilarducci said her plan would give Americans nearly 25 percent of their preretirement earnings. In other words, someone who retired after earning $75,000 a year might receive $19,000 a year in Social Security and another $18,000 annually from this new plan.

Ms. Munnell of the Boston College center also supports creating a new tier of retirement savings by requiring new deductions from employee paychecks. But unlike Professor Ghilarducci, she does not support a mandatory employer match and she would preserve the 401(k) system, creating a new system on top of Social Security and 401(k)’s.

“We need a new tier,” Ms. Munnell said. “Our retirement system isn’t big enough. Not enough people are in it, and many people aren’t saving enough. No matter how much you try to spruce up 401(k)’s, they’re never going to provide enough retirement income.”

In July, Senator Tom Harkin, Democrat of Iowa, proposed a plan that would be financed by pretax funds from workers’ paychecks, although workers could opt out. Employers would have to contribute. Mr. Harkin noted that half of all Americans had less than $10,000 in retirement savings and that 75 million workers were without access to a workplace retirement plan. “We face a retirement crisis,” he said.

Mr. Wray of the 401(k) council said critics were too quick to condemn the 401(k) system and propose far-reaching changes. He said 401(k)’s had many underappreciated advantages. They generally allow people to pass on far more of their retirement money to their heirs than traditional pensions usually do. Another big advantage of 401(k)’s, Mr. Wray said, is that many corporations are embracing them over traditional pensions because pensions, unlike 401(k)’s, can cause companies to owe millions of dollars in unanticipated liabilities when the stock market falls.

“The great thing about 401(k)’s is the enormous flexibility,” Mr. Wray said. “They’re voluntary. You can structure a plan that works for you,” He acknowledged that many people nearing retirement age had not saved enough in their plans, but he said that was because many had saved for only 20 years, not for their entire career.

“If you consistently participate in these programs over 40 years, you’re home free,” he said.

When created in 1978, 401(k)’s were a way for highly paid executives to shield income from taxation. Later Congress adapted them so they could provide supplemental retirement income for millions of workers on top of Social Security and traditional pensions. It was not foreseen that 401(k)’s would evolve into the nation’s main employer-sponsored retirement system.

“This system just hasn’t produced the type of participation you’d like to see,” Ms. Munnell said. “I think this argument that these plans are new is getting old. They’re not new.”

David John, a pension expert at the conservative Heritage Foundation, dismisses the likelihood of enacting far-reaching changes like those supported by Senator Harkin and Ms. Ghilarducci. Partly because of industry opposition, he said, “starting something wholly new would be virtually impossible.”

Mr. John argued that it would be wise to keep the 401(k) system, imperfect as it is, and improve it. With some reservations, he praised the automatic enrollment features of the Pension Protection Act of 2006, which allows companies that offer plans to automatically enroll new employees,, typically at 3 percent of pay, although workers can opt out.

He also praised the law’s automatic escalation provisions, which enable companies to ratchet up employees’ contribution rate from 3 percent in an employee’s first few years unless workers opted out. He criticized Congress for essentially setting 3 percent of pay as a default investment level. “The 3 percent level is a huge mistake,” he said.

He wants Congress to raise the automatic enrollment’s default participation rate to 6 percent. That, he said, would hardly reduce enrollment and would create a larger nest egg for retirement.

The battle over whether the 401(k) system needs some fine-tuning or radical surgery is still gathering force. “A czar would be able to fix this easily,” Mr. Bogle said. “Whether politicians can fix this is something else again.”

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