Reinventing Retirement Income in America
Table of Contents
- Executive Summary
- The Importance of Retirement Income
- Determinants of Retirement Income
- The Change in Retirement Pension Plans
- The Performance of 401(k) Plans
- Explaining the Poor Investment Returns
- Other Causes of Low Returns
- The Threat of Future Liability
- Goals for an Effective Retirement System
- Building a Better Retirement System
- About the Authors
Traditional defined benefit pension plans, which are managed by employers and which promise workers a specific monthly payment on retirement, are disappearing. Instead, more than 42 million workers now participate in defined contribution retirement plans, primarily 401(k) plans, which specify the annual contributions to an employee's pension fund. A worker's contributions to these plans, the employer's vested match and any interest or dividends reinvested in the plan are the worker's property. Workers are responsible for choosing among investment options, and the account can be moved when the worker changes jobs and can be passed on to heirs.
As now constituted, however, defined contribution plans are performing poorly. The consulting firm Watson Wyatt found that among 503 employers sponsoring both a 401(k) plan and a defined benefit plan during 1990-95, the defined benefit plans averaged an annual return that was 1.9 percentage points better than the 401(k) plans. Even the 401(k) plans sponsored by firms in the financial services industry have often had below-average returns.
- An examination of plans sponsored by five leading financial services firms reveals that from 1995 through 1998, none had returns that matched a simple index of 60 percent stocks and 40 percent bonds.
- Although these companies offer investment advice to the public, the investment choices of their own employees underperformed the market index by 3.2 to 10.5 percentage points.
Companies offer little assistance in making wise investment choices, fearing they will open themselves to lawsuits charging them with responsibility if employees have investment losses. Many employees with limited understanding of investing make uninformed investments that reduce their retirement income. For example, in examining a number of large plans we found:
- Within plans, regardless of years studied or geographical location, the lowest-paid 20 percent of participants receive the worst returns and the higher the participants' average pay, the higher their returns.
- Almost two-thirds of the money in the lowest-income quintile was in a money market fund or bonds.
- By contrast, about 85 percent of the money in the highest-income quintile was in equities.
If designed properly, defined contribution retirement plans offer the best hope for a comfortable retirement for most workers. The changes that are needed are both politically and economically achievable. To remedy the flaws, this study proposes that employers be encouraged to offer a new type of plan: the American Freedom 401(k) plan. In exchange, employers would enjoy "safe harbor" protection from certain kinds of lawsuits. To take advantage of the American Freedom 401(k) plan, employers would have to:
- Give participants the opportunity to have their funds invested in efficient portfolios (e.g., market index funds) or in portfolios managed by investment professionals.
- Automatically enroll all employees (both new and current) unless they opt out.
- Set a minimum contribution rate of 4 percent to 6 percent of income by the participant - an amount that could prudently be expected, when combined with the employer contribution, to provide a reasonable retirement income - unless the employee specifically opts for a smaller amount.
- Require plan sponsors to pay all plan fees and expenses, and to disclose them fully.
- Prohibit cashouts of 401(k) accounts by the plan or the employee following termination of employment and allow all funds to be rolled over into another qualified plan or to remain in the previous employer's plan if the new employer does not have a plan.
- Make vesting 100 percent and immediate.
- Prohibit loans or hardship distributions from an individual account but allow "hardship loans" from the plan's trust fund.
The American Freedom 401(k) plan would maintain the advantages of defined contribution plans, while producing higher returns and encouraging more saving for retirement.