Why 401(k)s Have Failed

Logo of the United States Thrift Savings Plan.

Logo of the United States Thrift Savings Plan. (Photo credit: Wikipedia)

Last night's "Frontline" show on PBS did Americans a great service. It showed the folly of the 401(k) structure, which has been a problem for decades.

Unfortunately, while Frontlne's Martin Smith and his many great guests focused on costs (too high), poor guidance and employer neglect, the larger point is that employers don't have to provide 401(k)s at all -- and probably shouldn't.

The 401(k) plan was never meant to be a mainstream pension plan and is a poor substitute for one. It's a voluntary program that was intended to supplement retirement savings --  one of those quirky little options in the byzantine tax code that employers seized upon as a way to save money while pretending that they were doing the right thing by their employees.

As Prof. Teresa Ghilarducci has been saying for years, the 401(k) was an experiment -- and it's failed. They cost too much because employers can pass along most of the costs to employees, which eat away returns. Some absorb plan expenses, but they are the rare exceptions. Unlike big medical insurance plans, employers don't work hard enough to get the best price on mutual funds within the plan, although they are compelled by law to do so.

Even though a St. Louis-based law firm has taken the lead in suing big employers over excessive 401(k)  fees, employers can still pat themselves on the back because they offer plenty of retirement funds.  And that's despite new Department of Labor guidelines requiring disclosure of costs;  most employees don't know how to compare fund returns to benchmarks nor do they know what they should be paying for 401(k) funds. Ignorance is bliss if you're an employer.

What You Should be Paying

For the sake of simplicity, employers can offer funds that charge less than 0.10 percent annually. These are available in off-the-shelf mutual or exchange-traded funds. But far too many plans charge employees "retail" rates of 1 percent or more annually. Why such a disparity? Because employers can pass along the costs and there are no minimum standards for a 401(k) other than it be "prudently" managed. Even more criminal are small-company plans set up by insurance companies, which charge more than 2 percent annually.

Several attempts at legislation have been floated to offer universal, low-cost options similar to the program offered to federal employees, but it always gets shot down by employer and financial service lobbies.

Taking issue with the Frontline program, employer-linked groups noted that the presentation focused too much on fees. The American Society of Pension Professionals and Actuaries (ASPPA), a benefit professional's group, issued this statement today:

Nothing in the history of this country has promoted more savings by average Americans than the 401(k) plan, with total assets in excess of $4 trillion (plus over $5 trillion in IRAs, much of which is from 401(k) rollovers). Three-quarters of American families became investors first through their workplace retirement plan. It is hard to imagine where we would be without our nation’s private retirement system. The system is not perfect. We need to expand coverage to those without a plan at work. We need to make it seamless for workers to save through greater utilization of auto-enrollment. And we need to make sure we focus on outcomes so the system produces the retirement results reasonably expected by both plan sponsors and participants."

True, 401(k)s have encouraged workers to save. But what if they all had low-cost index funds in their plans instead of actively managed funds, as suggested by Vanguard Group founder Jack Bogle? What if employees had professional financial planners guide them into allocations that were right for their age and risk tolerance? What if they knew how to diversify properly to avoid the stock debacle of a 2008 or 2000?

There's no way of measuring how much further they'd be ahead, but I'd suspect that we'd see fewer daily industry surveys of how little people have saved for retirement.

Authors like Helaine Olen have been right on the mark in saying that the financial services industry and employers are all too eager to tell us how little we're saving, yet don't serve as honest brokers in maximizing our retirement savings. That would require cutting fees, eliminating middlemen, increasing employer contributions and getting rid of the fee structure that is based on assets under management. And above all, the most dangerous part of this equation: Educating employees on how to invest cost- and risk effectively.

The more money in our kitties, the more money financial mavens make, even though they do little to deserve the extra compensation.  But only a handful of companies like iShares, Fidelity, Schwab and Vanguard seem to be interested in providing basic funds at rock-bottom prices.

Did you know a price war in exchange-traded funds has been going on over the past two years? Many basic index funds are offered at no commission and are among the lowest-cost funds on the planet. Have you seen these funds turn up in your 401(k)? It's highly unlikely since few employers regularly audit their plans to lower costs.

Brokers and financial service providers that set up 401(k)s are hard-pressed to acknowledge this in-bred conflict of interest.

They can set up a suite of mutual funds, but the more money they charge, the worse off future retirees are.  Until this conflict is resolved by making retirement-plan managers fiduciaries -- legally responsible to put employees first -- little will change. Such a rule has been pending before the SEC and Labor Dept., but the coalition of Wall Street and employers have been fighting to dilute or kill it.

Future retirees are offered little or no protection under current laws. Observes the National Association of Personal Financial Advisors (NAPFA), which represents fee-only certified financial planners (who are also fiduciaries):

While broker-dealers largely want to maintain the status quo, Americans are struggling to make ends meet and save for their futures — they deserve the protection of a fiduciary standard from every professional who touches their financial lives. This is a wake-up call for legislators and regulators to finally do something to protect American investors."

The fiduciary standard is a good place to start. Then we need to commoditize 401(k) funds and de-link them from employers. There should be a national program open to anyone (regardless of whether you're employed or not) that offers a complete suite of diversified index funds at the lowest-possible prices. Such a program already exists in the Thrift Savings Plan for federal employees. Let's make it available to everyone.

Then, Congress should require that every 18-year-old know the basics of compound interest, investment risk, diversification, debt management and fund expenses. We require that people know the rules of the road and pass a driving test before they get a driver's license in every state and license everyone from hairdressers to plumbers. Why not require that everyone possesses some essential financial knowledge? Why not consolidate all of the 401(k), 403(b), 457, IRAs, SEP-IRAs, SIMPLEs and Keoghs into one vehicle?

As my contribution to Money Smart Week, which is sponsored by banks and credit card companies, I propose a mandatory standard for financial education. This basic education might do more to end the retirement savings crisis than any number of exposes on 401(k)s.

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