5 Ways to Replace Your 401(k)

Not only has the market hammered 401(k) accounts, but even the bedrock of retirement income, Social Security, has started looking more vulnerable. The Social Security trustees recently announced that the fund would be depleted four years earlier than expected, in 2037. After that point, if nothing changes, benefits will be paid from the taxes collected on current workers, which will make up only about three quarters of the scheduled benefits.

Before panicking about how to make up for the shortfall or bemoaning the unfairness of the system for today's young workers, consider this: Something will probably change. A new type of savings account could replace or augment 401(k)'s, Social Security could be overhauled, or people might even get in the habit of saving more money on their own. Here are five possible scenarios for what could replace the traditional 401(k)-Social Security arrangement:

Participation rates spike. Only about 7 in 10 workers bother to sign up for 401(k)'s when they are offered them, but if employers automatically enroll workers (with the option of removing themselves later), participation rates shoot up to 90 percent. That leads some policy experts to recommend automatic enrollment—or even forced participation—for all employees who have access to such plans. "Auto-enrollment would be more effective than changing matches," says Andrew Biggs, resident scholar at the American Enterprise Institute. That's because raising matching contributions doesn't have a clear effect on people's participation rates, perhaps because workers are unaware of the specifics of the matches. "I wouldn't be morally offended if we forced everybody to participate, although politically, auto-enrollment makes more sense," says Biggs.

[For more, read: "How to Prepare for the End of Social Security."]

The government absorbs any losses. As soon-to-be-retirees well know, the current setup means that investors can get stung pretty badly if the market suffers big declines shortly before they approach their last day of work. That's led some academics, including Alicia Munnell, director of Boston College's Center for Retirement Research, to propose an altogether different method of risk management—one where the government bears the brunt of the risk. She imagines a new kind of guaranteed account, where the government would guarantee that beneficiaries receive a certain rate of return on their investments.

If the market plunged before they retired, then Uncle Sam would make up the difference. If a relatively modest guaranteed rate of return were chosen, such as 6 percent, then she says the government would rarely have to step in, so the cost would be minimal. Another option is to guarantee just a 2 or 3 percent return but to allow investors to keep any higher return provided by the market. If the government found itself needing to pony up during bad periods like the current one, then, Munnell says, "it can take on more debt and spread the losses over several generations," instead of forcing the soon-to-be retirees to absorb most of the pain.

A new type of universal savings account takes hold. Because only about half of workers have the option of participating in some kind of 401(k) plan, much attention has focused on workers who lack such vehicles. David Walker, former U.S. comptroller general, supports creating a new type of savings account that would be available to everybody and offering a range of investments at low cost. Workers could make automatic deductions from their paycheck into this new account. This type of device has been described as the "auto-IRA," or automatic individual retirement account, and has been endorsed by both President Obama and Sen. John McCain.

[For more, read: "Quiz: Do You Understand Social Security?"]

The AARP has also gotten behind the proposal. "Before we talk about creating more avenues for saving for retirement, we want to address the population who has no options—no pension, no 401(k), no opportunity to save," says Cristina Martin-Firvida, the AARP's director of economic security. She says that some 75 million Americans currently have no access to a workplace savings plan.

Social Security is reformed. Suggestions include raising payroll taxes, especially on higher-income folks who currently stop paying Social Security taxes on earnings over $106,800; increasing the retirement age, and lowering benefits or reconfiguring them so they provide more support to lower-income retirees and less to those with higher incomes. A big debate on what exactly should be done is widely anticipated; groups like the AARP oppose changing the current benefit structure and support eliminating the payroll cap. Other policy analysts, such as AEI's Biggs, say the incentives need to be changed so people delay their retirement age. Biggs suggests reducing the Social Security payroll tax on workers approaching retirement age to make postponing their retirement day more worthwhile.

David John, senior fellow at the Heritage Foundation and a principal in the bipartisan Retirement Security Project, says that when Social Security was created, people spent about 16 percent of their lifetime in retirement. Now, they're retired for about a quarter of it. That's part of the reason he suggests changing the retirement age from 65 to 68 and the early retirement age from 62 to 65.

Americans become super savers. This strategy is hard to argue with. As John Bogle, founder of Vanguard, has pointed out, the vast majority of Americans are not saving enough for retirement. In congressional testimony he gave in February, he pointed out that the median 401(k) balance is just $15,000. Even if the average person were to save $300,000 by the time he retired, that would replace only about 30 percent of his pre-retirement income—not nearly enough to live on. Bogle says that the typical employee should contribute 15 percent of his income each year into a retirement account. With a 5 percent return, he would have around $630,000 upon retirement, which Bogle calls a "handsome" amount.

As Biggs puts it, "Young people shouldn't worry. They should just start saving."

Corrected on 06/23/09: An earlier version of this story incorrectly implied that David Walker first came up with the idea of creating "auto-IRA" accounts. He supports the creation of the accounts, but was not the person to first suggest them.