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
Building a Better Retirement System
The concept of defined contribution plans is a sound one. The assets are owned by the employee, are portable from job to job and a participant's benefits are not affected by job changes. However, as with most new concepts, there are flaws that can be eliminated to the benefit of both employees and employers. To remedy the flaws, we propose a new type of 401(k) plan, which we call the American Freedom 401(k). Employees now in a 401(k) plan should have a choice of remaining there or moving to the American Freedom 401(k) plan. Employers who offer all the features of the American Freedom 401(k) plan should receive a "safe harbor" from litigation, explained below. The plan would have these features:
"The American Freedom 401(k) corrects the faults existing in today's 401(k)s."
Enrollment and Minimum Contributions. The plan would automatically enroll all employees after they satisfy the plan's eligibility period unless they execute a rejection form opting out. The plan would also set an initial minimum contribution rate of about 4 percent to 6 percent of income - an amount that could prudently be expected to provide a reasonable retirement income - unless the employee specifically opts for a smaller amount.35 This minimum contribution requirement would help limit a too-common practice today, where company human resource departments, to make participation rates in 401(k) plans appear to be high, urge employees to "just contribute a dollar or two out of each paycheck."
Premixed Portfolios and Professionally Directed Investments. Since index funds and the managers of defined benefit pension plans have historically produced higher yields on investments, companies adopting the American Freedom 401(k) plan would have to agree to include in participants' options premixed efficient portfolios - ones that give the maximum rate of return at different risk levels - or a professionally directed investment option or both.36 Companies should be encouraged (but not required) to provide employees who choose to manage their own accounts with access to investment advice.
Default Option. The contributions of a participant who made no initial choice of funds should go into a premixed efficient portfolio (e.g., 60 percent stocks and 40 percent bonds) or into the professionally directed investment as a default option.
Fees and Expenses. A plan sponsor either would pay all fees and expenses or would reimburse the plan. This would give employers an incentive to limit fees and expenses (currently there is no required oversight of such spending) and would raise the net returns received by plan participants. As an alternative, fees and expenses might be capped at, say, 1 percent, with the employer required to pay anything above the cap.
Automatic Rollover. The American Freedom 401(k) plan would prohibit benefit cash-outs by the plan or the employee following termination of employment before retirement, death or disability. Instead, the account could be rolled over into a similar qualified plan or could remain in the previous employer's plan if the new place of employment has no qualified plan.
Vesting. Vesting would be 100 percent and immediate.
Hardship Loans. The American Freedom 401(k) plan would have a new feature, the hardship loan, funded from and paid back to the plan's trust fund, not the participant's account. Consumer-type loans and hardship distributions to plan participants from their accounts, now permitted by most plans, would be prohibited. A hardship loan would simply be a loan from plan assets (not the borrower's account), limited to conditions that would meet the legal criteria for a current hardship distribution. This would enable participants to get money from the plan for a true hardship or emergency and pay it back with interest without (i) losing the matching employer contributions for a time, (ii) paying increased taxes due to the prohibition on personal contribution for a time, (iii) being subject to a tax and penalty on the hardship distribution and (iv) affecting the investment return on the account. At the same time, participants seeking a loan for some other purpose could turn to a source of consumer credit and leave retirement funds in the account to grow.
"Employers who establish an American Freedom 401(k) plan should receive 'safe harbor' protection from lawsuits."
Safe Harbor for Employers. Because the American Freedom 401(k) plan would be so beneficial to participants, employers should be given an incentive to establish such a plan. Legislation should provide that, in exchange for providing a plan offering all the features, an employer would have to meet only the basic coverage and nondiscrimination requirements. In addition, the plan would be deemed to comply with technical testing standards now required.37 Finally, the plan sponsor would receive "safe harbor" protection, exempting it from class action civil suits and similar actions alleging breach of fiduciary standards. We would expect industry service providers to respond quickly to such a program.