How to Improve Retirement Plans
December 10, 2001
More than 42 million workers now participate in defined contribution retirement plans, primarily 401(k) plans which, rather than promising workers a specific monthly payment, allow them to choose among investment options, in accounts that 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. 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 (see figure).
Many employees with limited understanding of investing make uninformed investments that reduce their retirement income. For example, an examination of a number of large plans 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 (see figure).
- 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. To correct the flaws in defined contribution plans, employers could be encouraged to offer plans that give participants the opportunity to have their funds invested in efficient portfolios (e.g., market index funds) or in portfolios managed by investment professionals.
Source: Brooks Hamilton and Scott Burns, "Reinventing Retirement Income in America," NCPA Policy Report No. 248, December 2001, National Center for Policy Analysis, 12770 Coit Rd., Suite 800, Dallas, Texas 75251, (972) 386-6272.
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