401(k)s: A Chance to Improve a Good Concept

Commentary by Pete du Pont

It's unfortunate that it took something like the Enron debacle to focus attention on improving 401(k) retirement plans. Despite what happened with Enron, defined contribution plans, including 401(k)s, are still enabling the 75 percent of workers who change jobs to accumulate meaningful retirement savings. But the system does have flaws that can and should be corrected.

Defined contribution retirement plans, of which 401(k)s are the most prominent type, have only been around since 1978. Today there are an estimated 42 million participants in about 340,000 401(k) plans with about $1.7 trillion in assets.

Meanwhile, traditional defined benefit pension plans have dwindled from 175,000 in 1983 to fewer than 50,000 today. These plans offer a specific monthly benefit upon retirement, but the formula for calculating the benefit is heavily weighted toward rewarding workers who spend a lifetime with a company.

A major advantage of defined contribution plans like 401(k)s is that a worker can take the assets from job to job, and pass them on to heirs. Most employers match a certain percentage of the worker's contributions to the plan. In about 2,000 plans, mostly large ones, all or part of the employer contribution is in company stock.

Many employees invest a large percentage of their own contributions in additional company stock. That's what happened at Enron. About 63 percent of employees' retirement money was invested in company stock. When Enron imploded, some $1 billion of savings disappeared.

Congress seems to be concentrating on making sure that workers don't have all their retirement eggs in company stock. But education about the advantages of asset allocation, rather than legislation, seems to be called for. Congress shouldn't be in the business of investment advice. Besides, if there are limitations on the amount of company stock an employee's account can hold or if employers aren't allowed a full tax deduction for stock contributions, employers may decide to reduce their contribution or not make any matching contribution at all.

By coincidence, about the time Enron stock was plummeting, the National Center for Policy Analysis published a study of 401(k)s by benefits lawyer Brooks Hamilton and financial columnist Scott Burns that pinpointed major flaws and recommended remedies.

Hamilton and Burns found that large numbers of 401(k) participants know little or nothing about the principles of investing - and employers are afraid to give them any help. The reason: the current rules, written with good intentions, say plan trustees aren't responsible for participants' investment losses provided they leave all plan participants alone to exercise independent control over their accounts. Employers and their lawyers read that to mean they open themselves to lawsuits if they give any advice.

Making matters even worse, many plans use fixed-income funds such as money market funds as the "default election" if participants don't designate where their contributions are to be invested.

Hamilton and Burns found from examining a number of large plans that in plan after plan, higher-paid workers generally had higher returns on their 401(k) investments than lower-paid workers because a high percentage of those with lower incomes had mostly fixed-type investments. And large numbers of those lower-paid workers were young people, who shouldn't be investing retirement money that way.

Further, many plans, especially smaller ones, offer mutual funds with high retail price structures, chosen because the funds handle the administrative chores. The participants - and often the employers themselves - are not aware that the administrative costs are being paid from their accounts.

Hamilton and Burns propose that employers be encouraged to offer what they call the American Freedom 401(k) Plan. In exchange for "safe harbor" protection from lawsuits, an employer would have to agree to certain provisions.

The choices for investment would include what are called premixed efficient portfolios (index funds that offer the maximum rate of return at different levels of risk), or portfolios managed by investment professionals or both. And employers could provide access to investment advice to employees who choose to manage their own accounts. The default option would be a premixed efficient portfolio, such as 60 percent stocks and 40 percent bonds.

All employees, both new and current, would automatically be enrolled unless they specifically opted out. The initial minimum contribution rate would be set at about 4 percent to 6 percent of income - again, unless the employee specifically opted for a smaller amount.

To give employers an incentive to limit fees and expenses of administering the plan, the employer would agree to pay all fees and expenses, or would reimburse the plan.

While 401(k)s are in the spotlight, Congress has an opportunity to make meaningful reforms that go beyond, and are far more significant than, deciding how much company stock is appropriate in a worker's retirement account.