Why 401(k)s Aren't Fulfilling Their Potential

High Fees, Low Enrollment, and Inequality Plague 401(k) Plans

Why 401(k)s Aren't Fulfilling Their Potential
November 14, 2014

401(k)s and other defined-contribution retirement plans continue to replace traditional defined-benefit plans such as pensions, as they have been doing for approximately 30 years. They were expected to save money for businesses and provide a better avenue for growth of retirement funds through investments in equities. Has it worked out that way?

According to a recent analysis by the Economic Policy Institute (EPI), not so much – unless you are wealthier to begin with.

A gap exists in 401(k) effectiveness that is similar to the income gap between rich and poor. Too many households do not have 401(k) accounts, or any retirement savings at all. A startling 50% of workers have no retirement savings, while the median retirement savings for middle-income earners is only $23,000. Meanwhile, for the top fifth of incomes, the median savings level is $160,000.

Businesses are suffering a similar gap for a different reason. The many smaller companies in America pay more in fees and costs to administer their 401(k) plans for two reasons: simple economy of scale, and staffing.

Large multinational corporations can clearly get better deals from 401(k) providers just by virtue of the amount of business they can provide. Meanwhile, staff at larger companies have better expertise and training, and are devoted to 401(k) administration tasks. Mom and Pop companies may have one person attempting to dig into 401(k) options and handle paperwork while fulfilling their “real” job.

In a way, 401(k)s are inherently more likely to provide a gap between wealthier and less-wealthy participants. An employee-matching structure is one of the best retirement scenarios you can have, because it is effectively “free money” from your employer. Unfortunately, that only applies to the extent you can take advantage of it by maxing your 401(k) contributions that can be matched.

Lower-income households are less likely to be able to afford the highest levels of contribution compared to the affluent. Combine this with the fact that higher-salaried workers are more likely to work for companies with greater matching benefits, and there should be an effectiveness gap by definition regardless of stock market performance.

How does one address this problem? A return to defined-benefit contributions is not necessarily the way to go either, as some pensions arrangements are unstable (ask pensioners from Detroit for their opinion). The low-hanging fruit to pick is with low enrollment in 401(k) plans.

Compared to the defined-contribution plans of the past, 401(k) plans are optional – and even with matching contributions, people are tempted to decline to participate and take their full salary instead. For workers between 26 and 61 (prime-age workers as defined in the study), participation in any type of retirement plan dropped from 52% to 45% between 2000 and 2010, dropping below the 46% rate seen in 1990.

Making 401(k) plans the default option and having employees opt-out is one simple way to address the issue. Pensions systems have no issues with low enrollment because participation is mandatory, and an opt-out default at least is a step in that direction.

At least with opt-out 401(k) arrangements, more people should have some retirement coverage, although typical human behavior suggests that the amount will probably not be enough. For those with default auto-enrollment programs last year, the average savings rate for the program’s automatic salary deductions was just 3%. That’s a start, but in order to increase effectiveness, the default savings rate needs to be higher.

The key is still education and understanding. People must understand that there is a personal responsibility element to 401(k)s and their own retirement savings. Otherwise, we move back toward mandatory defined-benefit programs. Expect this debate to increase as boomers retire and the stress on the Social Security system increases.

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