Is It Time to Rethink 401(k)s?

A slew of recent studies have raised serious issues about self-directed plans.

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Like the proverbial elephant, the view of 401(k) plans depends on which part of the retirement beast you're looking at. Started 30 years ago as a largely self-directed investment companion to traditional pensions, 401(k)s have been forced to grow up and become the nation's primary private retirement-savings vehicle.

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A slew of recent studies have raised serious issues about the plans. For example, BlackRock, the large investment firm, concluded in its survey of 401(k) plan participants and managers that continued employment past the age of 65 will be the norm, not the exception. Charles Schwab has concluded that years of efforts to educate employees about how to use 401(k)s and plan for their financial futures have not succeeded. The firm advocates that employers hire professional investment managers to guide employee retirement activities.

If the plans are graded based on retirement readiness, they would have trouble getting a passing mark. As study after study has documented, most Americans have not set aside enough money to fund even modestly comfortable retirements. Half of working Americans aren't even able to participate in the plans, either because their employers don't offer them or the employees aren't eligible to join the plans. Among the other half, contribution rates badly lag levels judged necessary for retirement adequacy.

Yet based on the growing percentages of eligible employees who do join the plans and their recent records of contributions, 401(k)s are doing better than ever and are entitled to some gold stars. Widely acclaimed changes to 401(k)s were contained in the Pension Protection Act of 2006, and have triggered significant improvements in the plans.

It's not easy to sort out the record of 401(k)s from other major economic and demographic trends that have reshaped the retirement landscape in recent years. Without a devastating global recession, all retirement boats would be floating today on a higher tide. Without decades of poor government oversight of spending and taxes, we'd all be better off. And if millions of aging baby boomers were not poised to overwhelm already beleaguered healthcare and entitlement programs, the outlook there would be brighter as well. You can't really blame 401(k)s for these trends.

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But that doesn't mean there aren't legitimate questions about whether private workplace retirement programs have the right stuff to help turn around dismal retirement prospects for tens of millions of Americans.

Chip Castille, BlackRock's top 401(k) executive, says the future of successful plans has three fairly simple components. The first is to identify successful participants and understand what they have been doing that sets them apart. The second is to formalize those behaviors into best practices that other employees should emulate. Imitation, not education, should be the future of employer-employee communications, he says. Lastly, employees strongly prefer retirement programs that generate secure retirement income. Annuities can deliver guaranteed income. Yet only 11 percent of the plans surveyed by BlackRock even offer annuities currently, and the percentages of employees electing them is tiny.

At Charles Schwab, vice president Dave Gray works with the firm's retirement-plan clients. Schwab has been pushing low-fee investments, such as exchange-traded funds. So have lots of others. Vanguard has gained enormous client volumes through its long-term advocacy of low-fee investing. Gray says Schwab wants to go further.

Employee education has not worked, he says. It's hardly a secret what types of behaviors employees should follow—boosting contributions, using low-cost funds, diversifying investments, regularly adjusting their investments to keep the right balance of holdings, paying attention to changing investment risks, and the like.

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"The vast majority of participants will not do all those things," Gray says, "and just providing education is not going to get them there." Instead, Schwab thinks 401(k) plans should provide professional investment advice to employees. These advisers would help employees make the proper decisions.

By combining such advice with low-cost funds, Gray says, overall 401(k) fees could still decline. He says 401(k) fees now average from 65 to 85 basis points a year (100 basis points equal one percentage point). "We can lower that investment expense through index mutual funds to 15 to 20 basis points," Gray says. Tacking on the cost of professional investment management fees—roughly 40 to 45 basis points a year—could still lower overall 401(k) costs from current levels.

"The 401(k) industry has evolved over time," he says. "As part of the next evolution ... we are putting professional management at the center of the process."

Good enough. But underlying all the surveys and proposals for improving 401(k)s is the recognition that a voluntary 401(k) program has trouble producing successful results unless it becomes less voluntary, through automatic enrollments and automatic annual increases in employee contributions. Using "match-the-market" index funds and annuities further removes individual judgment.

In the end, ironically, is what's left still a voluntary program? Or do we have something that tries to replicate Social Security but charges employees several times as much money in fees as does Uncle Sam?