What Is A 401k Plan? Flaws In The 401k Retirement System

Undoubtedly, one of the most powerful retirement vehicles available to the mass public is the employer-sponsored plan called the 401(k). While there are other forms such as the 457 or the 403(b) for instance, the 401(k) is the most widespread among for-profit employers. As we have reached the 30th anniversary of the 401(k) there is probably more debate about its function and utility than ever before.

What Is A 401k Plan? A Closer Look

This revolutionary retirement savings plan has, in essence, replaced the old pension plan and now empowers an individual to take part in the markets (stock and bond) and to be more in charge of their financial destinies. But, like anything else, there are also some cracks in the system.

For now, let’s set aside the political debate over personal versus employer / government responsibility. The facts have shown that the average person struggles to truly harness the power of the 401(k). For instance, many workers who left the workforce in 2008 and 2009 (not to mention other bad years) had the misfortune of having lost a large portion of their retirement funds. What do they do then? Because of these recent events, there has been more focus on the 401(k) and not just because it turned 30.

Flaws In The 401k Retirement System

In my opinion, the major cracks in the system really fall along a few fault lines: portfolio management, utilization, and costs. In a perfect world, every individual would have the tools and knowledge to embrace the 401(k) concept, but in reality leaving it all up to the individual really does not make sense. Luckily, these cracks in the system are prompting many asset managers, regulators and retirement experts to take a hard look at these 401(k) flaws and how they can be fixed.

Of course, some of the cracks have begun repair. For instance, automatic enrollment (which helps with very low savings rates), default funds and target-date funds (which helps with poor portfolio management) have been added. But with only 50 million U.S. workers participating in 401(k) plans, with a total of $2.3 trillion saved, the 401(k) is clearly vastly underutilized. And, people clearly are not saving enough.

Put into more personal terms, the average 401(k) account balance is shy of $46,000 and the median value is $12,655, according to the Employee Benefits Research Institute. How do we plan on supplementing social security (if it’s there) with that? That same survey found that 54% of those who have saved for retirement have less than $25,000 saved, and 27% have less than $1,000 socked away. Sadly, it reminds me of an article entitled “how to avoid eating Alpo when you’re 80.” Or something like that… Dramatic, but true.

And to make things worse, recent savings rates are becoming worse rather than better: 48% of Americans are saving less for retirement. Could it be because of the dismal disappointment of seeing their online stock broker accounts shrink or 401(k) balances fall? Or could it be due to job losses or wage cuts? Only 12% have increased savings, and it’s status quo for 35%, according to a survey conducted by Rasmussen Reports. The crack along that fault continues to rear its ugly head.

And there’s more. Although 41% have moved their portfolios into less risky retirement investments, 41% are more confused about how to save for retirement after weathering the recession. So while default or target date funds have been fine in concept, they’ve also had little impact: investors are still ill-equipped and not confident about managing their 401(k) portfolios.

All things considered, it’s not surprising that only 30% believe it is possible for a middle-income family to save for a secure retirement, a five-point drop from 2009 and a seven-point decline from 2007, when the survey began. The last crack in the 401(k) structure that most people don’t realize is this: there are hidden, high fees that do not decrease commensurately as plan balances rise. These fees alone are single-handedly costing investors hundreds of thousands of dollars over a lifetime of saving.

Let’s take for example a 30-year-old making $50,000 a year, with a plan balance of $50,000 and a typical matching and savings rate. This person would have $115,000 more in their retirement savings account if he or she paid 60 basis points in fees, rather than 90 basis points (according to a report by Hewitt Associates). Even with increased legislative and legal scrutiny of plan fees over the past few years, Hewitt believes that federal action is needed to help plan sponsors and individuals receive better information on these fees from investment managers and administrators.

After 30 years, you would think that most of the wrinkles would be ironed out. But the fact is, retirement planning is not a static entity. Instead, it really has a life of its own and must adapt to changes in demographics (aging of America), human behavior (investor knowledge, savings rates), and the economic climate (recessions, bull markets). I doubt that any one vehicle will resolve all the issues we describe above, but personally, I think that the 401(k) comes pretty close. If only we could get more people to harness the power of this great retirement vehicle.