January 17, 2017
A recent Wall Street Journal article reports that some of the early inventors and backers of 401(k) plans didn’t anticipate that employers would use the tax-deferred savings tool to completely replace more traditional defined benefit plans. The article highlights how the original intent of 401(k)s was to encourage employees to save as a supplement to existing employer-provided defined benefit pension benefits.
The 401(k) plan gained prominence and was embraced by plan sponsors because it was viewed as a less expensive alternative whose annual cost was more predictable than a defined benefit plan. Participants viewed 401(k)s as “safer” because they were insulated from employer bankruptcies and because they were portable. As a result, although they were not intended to be a primary retirement vehicle, that is what 401(k)s have become – with dire unintended consequences for many.
The Emerging Frailty of 401(k) Plans
The article reports that, while 401(k)s opened profit opportunities for Wall Street and money managers, market downturns revealed undesirable cracks in 401(k) plans – the same shortcomings that are addressed in whole or in part by the defined benefit plans that they replaced. For example, the recessions of 2001/2 and 2008/9 wreaked havoc on the equity markets (Figure 1), highlighting the vulnerability of employees in 401(k) plans to the problem of being forced to sell low (and miss the advantage of a longer-term investment horizon), the possibility of being forced to postpone retirement or, if already retired, the increased likelihood of outliving their assets.
Data from Standard & Poor's
Because of the voluntary nature of 401(k)s, many participants either did not contribute or did so at too low a level. If they did contribute, they oftentimes selected investments not suitable to their investment horizon. Many also used their 401(k) balances as a savings account, taking loans or, worse, taking early withdrawals (Figure 2). Making poor choices in one or all of these areas limit the retirement security hoped for by participants and plan sponsors. Because 401(k)s rely heavily on individual choices, education is critical to building retirement security and avoiding many common mistakes and misconceptions. Lack of education appears to be a major weakness in the system.
Data from ICI Research Report, Defined Contribution Plan Participants’ Activities, First Half 2016, October 2016
Other unintended consequences include broader workforce issues that have emerged as employees postpone retirement, giving rise to potential productivity issues and succession concerns. Moreover, inadequate retirement savings affects the communities in which seniors live. The same seniors, who may consume public services of state or local governments, cannot contribute in the form of taxes to the entities that provide public safety, income support and transportation services to them. To make matters worse, the inadequacies of 401(k)s have placed increased pressure on Social Security and Medicaid to help fill the retirement adequacy gap at a time when those systems face their own challenges.
The Lesson to be Learned
While defined benefit advocates issued warnings of the inadequacies of 401(k)s as they came into fashion, hindsight clearly suggests that the wholesale movement away from defined benefit plans was neither wise nor warranted. The weaknesses of 401(k) plans will not disappear by themselves.
Recognizing and addressing the implications of workers bearing 100% of the retirement security risks is only a first step. True retirement security for today’s workers involves a balanced approach that requires careful planning and education. Understanding and managing the risks associated with any retirement plan, whether borne by the participant, the plan sponsor or both, is critical to success. Innovative shared-risk plan designs, investment risk mitigation strategies, and communication approaches that ensure clear understanding are all important.
While it may be too late for some, there is still time for plan sponsors to mitigate or avoid altogether many shortcomings in their retirement programs. Plan sponsors who give thoughtful consideration to all aspects of a retirement program will be better positioned to achieve their objectives and to provide plan participants with meaningful retirement security.