NCPA - National Center for Policy Analysis

Reforming 401(k) Plans

April 15, 2002

Congress is considering legislation to increase the security of 401(k) retirement savings plans in the wake of the Enron debacle and the recent stock market slump. Analysts say wise reform could lead to higher returns and safer portfolios; but unwise reforms could induce employers to drop these plans altogether.

Defined contribution pension plans -- primarily 401(k) plans for for-profit firms and 403(b) plans for nonprofits -- were essentially created by a loophole in the Revenue Act of 1978.

  • Today, more than 42 million workers participate in defined contribution plans, with total assets exceeding $2 trillion.
  • However, in 2000 the average 401(k) account lost money for the first time in recent years.
  • From 1999 to 2000, the average account shrank from $46,740 to $41,919.

The most important reason 401(k) plans perform so poorly is that unsophisticated investors invest in what they know and/or invest in what is safe.

For instance, many Enron employees lost most of their retirement savings when the company stock price fell dramatically. A Hewitt Associates survey of 375 companies that offer 401(k) plans found that 55 percent offer their own stock as an investment choice. Some 30 percent of plan assets were invested in employer stock. As Enron demonstrates, putting all of one's financial eggs in one basket is risky.

The other major mistake employees make is to invest in securities that are safe but pay a low rate of return. Lower-income workers are particularly prone to opt for this alternative (See Figure I):

  • Historically, almost two-thirds of the funds invested by employees in the lowest-income quintile have been in money market funds or bond funds.
  • By contrast, about 85 percent of the funds invested by employees in the highest-income quintile have been in higher-earning, equity-type investments.

Source: Matt Moore, "401(K) Reform: Doing It The Right Way," NCPA Brief Analysis No. 393, April 15, 2002, NCPA.


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