401k Plans Suck And Must Die
When they were first introduced back in 1980, 401k plans were celebrated as the future of retirement saving. Companies and workers embraced them almost immediately; companies because of the associated cost savings and workers because it gave them the illusion of control over their own fate. Unfortunately, 401k plans have so many intrinsic problems they are better off dead.
The Rise Of The 401k
Fortunately for the 401k, its introduction and subsequent adoption coincided with one of the greatest bull markets in history leading up to the bursting of the tech bubble. For most of this period, 401k balanced continued to rise steadily despite investors’ best efforts to fudge things up. Investors made every mistake in the book: market timing, investing in expensive actively-managed funds, etc, but a rising tide lifts all boats, and even foolish investors couldn’t help but turn a profit. Life was good.
Throughout this period, companies continued shifting the responsibility of saving retirement to their workers, decreasing pension benefits while holding out the carrot of generous 401k matches. And workers were more than happy to take the bait. After all, their 401k account balances were increasing at a much more rapid rate than that of their stodgy old conservative pension funds.
The Beginning Of The End
And then Enron happened. Hapless Enron employees who had unwisely invested large portions of their portfolio in company stock lost their life savings in a heartbeat. It didn’t hurt that the Enron meltdown happened to coincide with the tech bust. For the first time since their inception, workers were losing big money in their 401k. The backlash was immediate: how could electricians, engineers, construction workers, and doctors (in other words, everybody not in the financial industry) possibly be expected to intelligently invest on their own? It was like lambs to the slaughter.
Why 401k Plans Suck
Despite the obvious problem of forcing unsophisticated amateurs to manage their own retirement portfolios, that’s not why I think 401k plans suck and must die. The problem is a structural one. First, let’s investigate what the 401k was supposed to be.
What are 401k plans supposed to be? For starters, they should be run for the sole benefit of program participants. It is the workers’ money and standard of living in retirement at stake, not the employers’ nor the financial industry’s. 401k plans are sponsored as an added benefit: employers provide a way for workers to save money in a tax-advantaged account in order to attract the best talent. 401k’s are not profit centers for employers, nor should they be. Ideally, employers would seek out the very best investment options at the lowest cost for
Unfortunately, reality doesn’t work that way. Employers choose 401k administrators and investment options based not on what would be best for workers but rather what would be least costly for the sponsor. So what happens? Plan administrators offer their services for cheap to attract business from cost-conscious companies, then populate their plans with ludicrously expensive investment options (taking a cut for themselves, of course). Thus, the plan administrator and sponsoring company both win. But what about the workers? They lose. Workers must choose to either live with their expensive 401k investment choices or forgo the tax benefits and invest elsewhere. Sure, they could always invest in a Traditional IRA instead, but IRA contribution limits are much lower than that of a 401k, raising the risk that workers won’t be able to save enough to live comfortably in retirement.
The Solution
The solution is simple. Since the problem revolves around workers being shut out of the fund selection process, simply give them direct control. The simplest and most direct solution would be to abolish 401k plans entirely and expand IRA contribution limits to match those of a 401k. Company’s could still offer a matching contribution in order to attract talent, but the amount would simply be direct-deposited in workers’ IRA accounts in the exact same way paychecks are already deposited in their checking accounts. This would be a win-win for both parties because employers would be rid of yet another operating expense and workers would be free to choose investment options based on their own criteria. This would stimulate competition, lowering costs and raising quality across the board. The only losers would be the fat-cat Wall Street executives who would have to find another way to bleed this nation’s workers dry.
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Thanks a lot for the link.
I agree with this post – it seems that 401k plans are a good idea that in some cases have gone bad.
Rolling them into the IRA plans makes sense – you guys have too many different account types!
One solution is to increase IRA limits, although I suspect many people contribute less than $5000 to their 401k each year anyway. But this does not alleviate the problems you mentioned of market timing and investor inexperience.
Why not just expand Social Security benefits? This transfers the risk from the individual to the society. As it stands now, some people run out of money, while others oversave. Social security, or some other type of annuity product, would help ensure we save the right amount and use what is rightfully ours.
Steve, I do not advocate expanding social security benefits because it is an extremely inefficient diversifier of risk. That is, while some at the bottom would see a higher income as a result, the majority of Americans would see their incomes significantly reduced in retirement.
I agree and have always believed that 401k’s are nothing but a legal scam.
While there are a few valid points this commentary misses the mark. First off, an administrator is defined as the company providing the 401k plan to its employees. There is not a single administrator/employer that collects fees. The vendor doing the administration does charge a fee, and yes sometimes it is excessive. Not always though. Fees as a percentage of plan assets are almost always higher for smaller plans. There is a fixed cost associated with plan administration.
If the employer has the best interests of their employees in mind it works. When they hire or have a ‘friend’ doing the consulting is when you have problems. Especially if they collect commissions. There are firms that adminster retirement plans that rebate back 12b1’s and sub-ta’s so they have no incentive to put in expensive funds. They charge a fee not commissions.
This is the right way to do it, but most large brand name mutual fund companies still have an outdated revenue model. They collect these fees and may steer assets to proprietary funds. If you have the right firm consulting the process it works. Having a professional perform due diligence on funds is going to be more successful than an indivisual doing through and IRA generally. Most people have a hard time with asset allocation with 12 asset classes. How can they decide from thousands of mutual funds in an IRA?
I also have issues with laws governing retirement plans, and they could be made easier and more cost effective to manage. Getting these laws changed is like pushing a boulder up a hill though.
It sounds like you need un-biased administration, not blowing up your 401k.
Excellent article and I completely agree. Plus we shouldn’t overlook the illusory incentive of an employer match that vests over far too long a period when most employees leave a job in 2 or 3 years. Matching contributions ought to vest immediately. Otherwise it’s just a big shell game.
Why should employees of certain companies receive a more generous tax treatment than the self-employed? It’s all BS and we know it. And if Washington gets its hands on another “reform” they’ll just confiscate more of our money.