How To Mend Recession-Torn 401(k) Plans

The drive is on to strengthen the retirement-financing system. Some experts insist on government mandates; others call for more-modest procedural changes.

By Robert J. Grossman Apr 1, 2010

0410cover.gifWherever you turn, you hear of workers postponing retirement because their nest eggs haven’t returned to pre-recession levels. Or you hear of retirees now living anxiously on less than expected. Essentially, you’re hearing serious discontent with the performance of the keystone of retirement financing—the 401(k) plan, the most common defined contribution plan for employees.

To be sure, there are plenty of reasons why 401(k) plan participants’ account balances plunged in 2008. Employees are partly to blame if they paid too little attention to their accounts. And although account balances generally regained a lot of lost ground last year, many employees are blaming employers, at least in part, for the stunning financial beating they’re likely to confront in retirement.

More than 20 class actions have been filed against companies, including Wal-Mart, Lockheed Martin and Boeing. The plaintiffs generally claim that their employers caused retirement plans to pay too much for retail mutual funds and failed to take advantage of the plans’ large size to select institutional funds with much lower fees. At the heart of the cases: the Employee Retirement Income Security Act (ERISA), the 1974 law that establishes minimum standards for managing pension plans.

Whatever the shortcomings of 401(k) plans, there is no shortage of ideas for fixing perceived problems. Proposals range from altering the details of 401(k)s
and making them work more effectively to restructuring the retirement-financing system altogether.

Proponents of starting over may have little chance at this time to reconfigure retirement financing, but their ideas are getting a hearing and may add urgency to the efforts of so-called realists who want to preserve and fine-tune the system. The stakes for benefit administrators and compensation specialists will be significant.

A Wobbly Stool

For decades, workers were told retirement income would have three sources, forming a “three-legged stool” of support:

  • Social Security, funded by taxes paid by workers and employers.
  • Defined benefit plans, or conventional pension plans where the employer guarantees annuities at retirement and employees do not contribute.
  • Personal savings.

The defined benefit leg started undergoing change in 1980, when section 401(k) of the Internal Revenue Code was introduced, primarily to enable higher-paid earners to defer taxes on a portion of earnings. Eventually, companies that offered 401(k) plans were required to offer the plans to all employees and show that the plans are nondiscriminatory.

As 401(k)s have proliferated, conventional pensions—defined benefit plans—have declined. They are still present in the public sector and in some highly competitive private-sector industries, but most employers have concluded that providing for workers’ retirement years is too uncertain and ever more costly as life expectancy rises.

The share of workers participating only in a defined benefit plan fell to 10 percent in 2005 from 62 percent in 1980, according to the Employee Benefit Research Institute in Washington, D.C. During that period, the share of workers participating only in a defined contribution plan—such as a 401(k), or a 403(b) as found in the nonprofit sector—rose to 63 percent from 22 percent.

Most workers, however, hadn’t saved enough over a long period to acquire reasonable 401(k) nest eggs even before the recession. Despite receiving retirement planning education, many low- and middle-income employees have expenses and priorities that soak up their paychecks and push them into credit markets. Says Jacob F. Kierkegaard, a research fellow at the Peterson Institute for International Economics, in Washington, D.C.: “The vast majority of 401(k) savings belongs to people who are in the top quintile income-wise. Below that, those in the other quintiles have trivial amounts in their accounts.”

Norman Stein, professor of law at the University of Alabama in Tuscaloosa and at Drexel University in Philadelphia, says people who were in riskier investments with their 401(k)s and lost a lot—and for whom the market has not come back—“will find themselves in poverty.” Those whose 401(k) investments were less risky and whose losses were less severe, he continues, “won’t be worrying about their next meal, but they’ll find they will not be able to live the dignified life they anticipated.”

Redesigners and Realists

Some proposals for strengthening retirement financing require mandates for employers, employees or both. “It is naive to think you will get people—low and middle earners—to save seriously without more government coercion than is applied in the U.S.,” Kierkegaard says. “Savings toward retirement is another way of postponing consumption. It’s running contrary to every TV commercial that’s urging people to buy and consume. The answer: Make it compulsory and offer attractive tax incentives to make it palatable.”

What separates the United States from European countries such as the Netherlands, Denmark and Sweden, Kierkegaard continues, “is that governments don’t ask; they make people save.” Kierkegaard is co-author, with Martin Baily of the Brookings Institution, of U.S. Pension Reform: Lessons from Other Countries (Peterson Institute for International Economics, 2009).

Alicia H. Munnell, Peter F. Drucker professor of management sciences and director of the Center for Retirement Research at Boston College, envisions a new tier of retirement income, probably funded through mandates, that would provide retirees with about 20 percent of their incomes in annuity form. “Where it comes from, we don’t know,” she admits. Likely sources: taxes, employers, workers.

Jane White, president of Retirement Solutions LLC in Madison, N.J., and author of America, Welcome to the Poorhouse (FT Press, 2009), advocates “a 9 percent mandate” on employers in business for five years or more. Companies with 10 employees “should contribute the equivalent of 9 percent of pay to an account that is portable when the employee leaves work,” she says.

In contrast, so-called realists maintain that any proposal for additional mandates on employers is dead in the water. So, too, for mandates that would force workers to save more and penalize them more stringently for raiding retirement savings. Ditto for proposals diverting additional government dollars toward funding individuals’ retirements.

What remains in the short run are renewed efforts to encourage more employers and employees to participate voluntarily in 401(k) programs. Tax incentives for both, and safe harbor provisions that exempt employers from nettlesome reporting requirements, are among the incentives. Especially since the Pension Protection Act of 2006 paved the way, employer-driven reforms are occurring, aimed at improving participation, savings rates and investment choices.

Legislative and regulatory proposals would increase transparency of fees and require 401(k) providers to give investors periodic projections of what they will have to live on when they retire.  

Without mandates, there will never be 100 percent participation, but 401(k) proponents say that may not be so bad. Critics of the current system—those who want wholesale restructuring—concede that positive changes are worthwhile but fear that they are not the solution for Baby Boomers about to retire.

“The people who think there has to be fundamental reform are starry-eyed,” Stein says. “For now, incremental reform has to occur; it won’t be enough, but it will have positive impacts.”

Solutions for Shortcomings

Here are several widely agreed-upon problems with 401(k)s and proposed solutions that experts say would improve the effectiveness of the system without rebuilding it.

Automatic enrollment. About half of all workers—78.6 million—have access to 401(k) plans, and 62.3 million take part. Participation rates vary by industry, plan and earning levels. The Chicago-based Profit Sharing/401k Council of America found a participation rate of 82.7 percent among 908 plans with 7.4 million participants in 2008, according to its 52nd Annual Survey of Profit Sharing and 401(k) Plans report. Fidelity Investments, the largest plan administrator, with 17,500 plans, reports an average plan participation rate of 63.1 percent.

To increase participation, a growing number of companies have adopted automatic enrollment. Each employee is placed in the plan and assigned a savings rate, usually 3 percent of wages, that is deducted and contributed to a default investment. Employees can opt out, or they can stay in and change the savings rate or the investment option.

According to the 401k Council survey, plan sponsors with automatic enrollment reached 39.6 percent in 2008, up from 16.9 percent in 2005. Of those plans, 83.6 percent use it only for new hires. In a 2009 Towers Watson survey of 149 companies with more than 1,000 employees, 47 percent reported using automatic enrollment.

Using automatic enrollment is not necessarily a clear-cut choice, however. Some employers question whether it’s the right thing to do. “It’s hard for me to say to you, ‘If you don’t make a decision, we’ll make it for you,’ ” says Lane Transou, SPHR, manager of benefits and compensation at Parker Drilling Co. in Houston. “That’s one way to get your employees’ attention, but it doesn’t work in some companies.

“If we did auto enrollment when there’s not enough employees out there to fill positions, an employee will leave for very little increase in pay,” Transou continues. “When they find out they’re getting 3 percent cut out of their take-home pay, they don’t like it. It starts the employee out on the wrong foot, thinking ‘What else do these folks have up their sleeves?’ The lower-level employee who doesn’t have a lot of education feels discounted. He doesn’t like to be told you’re doing something to him for his own good.”

Nancy Hwa, communications director at the Pension Rights Center, a consumer organization in Washington, D.C., says, “If you’re automatically enrolled and find you can’t afford to do it and pull out after the deadline, you pay a tax penalty. There’s also a psychological impact; people are made to feel bad because they can’t save through a 401(k). If you’re only making $45,000, it’s really hard to set aside.”

There is a financial rationale for not forcing current employees to, in effect, opt out a second time, especially for companies that match contributions: There are administrative and contribution costs, says Robyn Credico, a senior consultant at Towers Watson in Arlington, Va. “Do I reward the people who are willing to save? Or do I become very paternalistic, try to make everyone save and have less to give to each person?”

Automatic escalation. Many experts maintain that 401(k) participants are not saving at rates that will give them enough at retirement. “Even before the crash, the median account balance was about $60,000 for people over 45,” says Karen Friedman, executive vice president and policy director at the Pension Rights Center. “That won’t take a retiree very far.”

The 401k Council survey reported that workers who were not highly compensated deferred an average of 5.5 percent of pretax salary in 2008. The maximum allowable pretax deferral for a traditional 401(k) plan is $16,500 for 2010; participants age 50 and older can defer an additional $5,500.

To help accounts grow, some employers are using automatic escalation of employee contributions periodically or after salary increases. David Wray, president of the 401k Council, says most participants have not objected to automatic increases that can move them toward the 9 percent savings rate experts say is necessary. In 2008, 53.8 percent of employers with automatic enrollment also had automatic escalation, according to the 401k Council.

Fuller disclosure of fees. Employers usually pass along to participants the administrative costs charged by fund managers and plan administrators. Fund fees can be easy to find; plan fees can be more difficult. And although participants can get information on fees from their employers, they seldom ask and the information can be difficult to understand. Large employers tend to get a good deal on fees because of the number of accounts they deliver. Small and mid-size employers don’t do as well, and so plan participants may pay dearly.

The Investment Company Institute (ICI) in Washington, D.C., offers an example of how differences in fees can affect account balances: If a $20,000 account earns 7 percent a year and pays fees equal to 0.5 percent a year, in 20 years the balance would be about $70,000. If the fees were 1.5 percent a year—near the industry median, according to ICI—the balance would amount to $58,000, or 17 percent less.

Experts concerned about fees and about participants’ lack of awareness of them and of their impact on portfolio values are advocating legislation that would require fuller disclosure to investors. They’re also pushing for employers to include index funds in their 401(k) plan investment choices. Index funds mirror the financial markets and operate on significantly lower fees.

Fuller disclosure “will make the fees more understandable and enable investors to understand the plan better,” Friedman says. “On the other hand, the various fees are complicated and difficult even for experts to decipher. Providing information to investors, therefore, may not be particularly useful. Employers, however, have a fiduciary responsibility to their plan members to understand and make sure the fees are not excessive.”

Employer contributions. Employers decide whether to match employees’ contributions. Most large employers do, says Kathryn Ricard, vice president for retirement policy at the ERISA Industry Committee, a Washington, D.C., organization that focuses on large-employer benefits. But last year during the recession, she says, many suspended payments, choosing to use the funds to help keep some employees on the payroll.

In a January poll of HR professionals by the Society for Human Resource Management, 46 of 371 respondents said their organizations had reduced, frozen or eliminated various employee benefits in the previous six months. Twelve percent said they eliminated 401(k) matching, 21 percent froze it and 67 percent reduced it.

Now, with the economy possibly brightening, freezes are being lifted. But experience has taught that denying a benefit that workers have come to expect can be demoralizing. As a result, some corporate leaders are looking at ways to lower expectations. Instead of restoring matches to a percentage basis, for example, they’re turning to formulas that tie contributions to company performance on a sliding scale.

“It’s painful to tell people you can’t match; it’s easier to just say the company didn’t do as well, so you’ll get a lower match,” Credico says. “About 20 percent of companies that are reinstating [matches] are looking to see if they can make it variable.”

In industries where companies compete for talent, however, employers are reluctant to tamper with 401(k) matching. “Guaranteed matches ring truer with employees than ‘We’ll let you know,’ ” Transou says. Her company, Parker Drilling, matches employees’ contributions to a maximum equal to 5 percent of salary.

Many companies—often small and mid-size organizations—are less willing or able to match 401(k) contributions, even with federal incentives. To encourage matching, the Internal Revenue Service has established a safe harbor that relieves companies of anti-discrimination testing—the testing and reporting employers must conduct to prove that sufficient percentages of low- and middle-income employees are participating in the plan. “If you automatically enroll, automatically increase and offer a match at 3 percent, you don’t have to do the testing,” Credico says.

Immediate vesting. Another potential drawback to 401(k)s is that employers’ contributions don’t belong to the employee until after he or she is vested, generally after a few years on the payroll. As a result, in retail and other industries with high turnover, most lower-income workers leave without employer contributions.

Many companies—37 percent in the 401k Council survey—now provide immediate vesting.

Cash-out restrictions. Although 401(k) accounts are portable, employees who leave their jobs often cash out instead of rolling money into a new tax-advantaged retirement savings plan, especially when their account balances are small. The temptation to put the money toward a car or a house can be too great. According to a Hewitt Associates survey of 170,000 workers who left their jobs in 2008, 46 percent cashed out their 401(k) accounts. Pamela Hess, director of retirement research at Hewitt, says about
80 percent of participants with balances below $10,000 liquidate when they leave an employer, paying income taxes as well as a 10 percent penalty.

Some experts have called for federal regulations that would lock money into accounts, except in the event of hardship withdrawals, or would require rollovers into new 401(k)s or tax-advantaged individual retirement accounts—IRAs. The Government Accountability Office estimates that such restrictions would raise the typical worker’s projected retirement savings by 11 percent.

Avoiding Investment Risks

Employees, when left to themselves, can make poor financial decisions—choosing investments based on name recognition rather than performance, for example, or buying and selling at the wrong times. “People need help with their decisions,” Munnell of Boston College says. “We have to do it for them; it’s not condescending. We live in a society with people doing other things. I don’t expect people to spend their time learning financial theory.”

Bob McAree, national retirement practice leader at Sibson Consulting in New York City, adds that “People with 401(k) accounts in six figures are still aggressively investing them without figuring out what they really need to achieve their retirement goal. When they reach that goal, the risk should be taken off the table by choosing safer alternatives.”

Says Kierkegaard: “When the market dipped, the asset allocation of the typical 401(k) investor in the U.S. was more aggressive than [that of individual investors] in Europe. So it’s not surprising when you compare portfolios across nations after the crisis hit that the biggest losses were in the U.S.”

In addition, even though the percentage of company stock owned by investors continues to decline, investors—especially in smaller organizations—still tend to sink too much of their resources into their own companies. In 2007, 24 percent of 401(k) dollars were invested in company stock.

One way to help 401(k) participants avoid risks and mistakes that experts warn against could be wider use of relatively new target-date funds. Featuring portfolio mixes linked to age, these funds favor more-aggressive investments for younger people and become more conservative as a participant nears retirement.

Nearly 60 percent of employers offer target-date funds, up from 33 percent two years ago, according to the 401k Council survey. “They are an absolute necessity,” Kierkegaard says. “To encourage people to invest in them, they should get a tax preference.”

Steadying the Payouts

While there’s an emphasis on retirement fund accumulation, little attention has been paid to the post-employment period—when the retiree faces “decumulation” of resources. One possible solution: annuities that guarantee lifetime payout. When you buy an annuity, the provider is gambling on your life, agreeing to pay you a set amount regardless of the economy and even if you outlive your actuary-projected life expectancy. Fewer than 5 percent of retirees go that route, McAree says. Why?

Annuities are tied to interest rates and can be very costly to new retirees looking for secure living expenses. Also, since annuities are priced on the basis of life expectancy, they are more costly for women, who tend to live longer but earn less than men.

Now, new annuity products are being offered that allow 401(k) investors to annuitize portions of their investments periodically throughout their working careers. By purchasing these annuities, investors can lock in guaranteed earnings in retirement. Since interest rates may vary over their working years, they will be averaging their costs. Some observers say these annuities should be part of automatic enrollment’s default portfolio.

Immediate Prospects

With the economy showing signs of recovery, it might be tempting to see 401(k) adjustments as solutions for retirement shortfalls. “People want to relax and bury their heads in the sand, and that would be very bad,” Stein says. “Conditions were in place for the perfect storm well before the economy tanked. The worry is we’ll say we’ve done something and put the retirement issue on hold for another five years.”

Wray sees it differently. The voluntary 401(k) has been evolving, he says. It just needs time to prove itself. “People who are 55 or older have been in their plans a relatively short time; the average is 10 years,” he says. “Give us a little more time to follow through on the reforms we’re implementing. It’s too soon to talk about rebuilding the whole retirement system. We need probably five years before we conduct a significant review.”

Is It HR’s Problem?

If you conclude that employers and employees share the obligation of trying to ensure financial security in retirement, then you may wonder what you can do to make more people listen and respond. Although you’re consistently delivering the message to employees that they must take responsibility for building their retirement nest eggs—and you’re providing financial education to help them make decisions—too often, it’s not sinking in.

On the other hand, some HR experts insist that members of the profession should not be paternalistic, that workers should be permitted to make their own decisions—and then live with the results.

Says Transou: “There’s a push coming from Washington to make people get their retirement set up, and I’m OK with it. But it’s not the employer’s responsibility. The employer pays fair wages and provides benefits to help workers provide for retirement. But at the end of the day, it’s up to the employee.”     

The author is a contributing editor of HR Magazine, a lawyer and a professor of management studies at Marist College in Poughkeepsie, N.Y.

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