The 401(k) debate

Posted by on April 29, 2013 @ 6:40 pm in Retirement

I just finished watching a new documentary on 401(k) plans. It was intended to be an exposé of sorts. The program combined criticisms of the U.S. retirement system and financial services industry with sinister music for added drama. After I finished viewing the show and reflected on it, it struck me how much was left unsaid about the state of retirement in America.

The film started with two misconceptions. The first is that most Americans aren’t prepared for retirement. That’s an over-exaggeration (see my previous post on this issue). Yes, it’s great TV to profile those who are struggling with saving for retirement. There are lessons to be learned and shared. But when you focus exclusively on that group, you do give the misleading impression that everyone is getting it wrong, which is untrue.

The second misconception was about the old defined benefit (DB) pension system. The program suggested most workers had a generous DB pension, and that there were no risks to worry about. By comparison, 401(k) plans are a poor substitute—they’re too complex, too costly, and too risky for the average person.

All of this is equally untrue. About 4 in 10 private sector workers had pensions in their heyday, and the typical pension was modest. The system was full of risks. For example, you could spend your career at a company and find out at age 65 that the pension you were entitled to was inadequate. Or, if you changed jobs frequently, whether by choice or necessity, you often got little or nothing from the pension system. And few workers were aware of these risks.

The central part of the documentary focused on two ideas that are forefront at Vanguard: fees and indexing.  It’s an essential truth—to improve investor and retirement outcomes, it’s critical to reduce fees, either through indexing or with low-cost active managers. As I watched the show, I thought: This is probably the first-ever coverage of indexing on prime time!  (Ok, this was public TV.)

At the same time, this part of the program was also full of hyperbole. The typical 401(k) plan pays less than half the 2% fees quoted, and the claim that most 401(k)s are lousy is wrong. Still, the main point, about the impact of fees, is an enduring, important theme.

Overall, though, I was struck by what the documentary didn’t mention.

  • Growth of 401(k)s. The shift to 401(k) plans comes across as a harmful move by U.S. employers. Yet the move to defined contribution plans (the general term for these plans) has been a global phenomenon, occurring in a diverse set of countries, such as the United Kingdom, Australia, and Sweden, to name a few. Emerging countries setting up new pension systems are also starting defined contribution plans. There’s a much bigger and more interesting (and less suspicious) story going on here.
  • Savings. Strikingly, the documentary said nothing about savings habits and the culture of consumption in America. If only it had! The fundamental challenge facing all retirement investors, 401(k) or not, is saving adequately. Yes, low fees, better portfolios, and good legal regulation matter. But they are second-order concerns to the first-order problem of Americans consuming less today so they can have more tomorrow. We seem to have cultural amnesia about saving—and no one really wants to talk about it.
  • Automation. The 401(k) plan has considerably improved in the past decade. 401(k) plans are becoming automatic in their design and vastly simpler. The changes are based on state-of-the-art behavioral research. Increasingly, new hires are automatically enrolled, their savings rates are boosted over time, and their assets are invested professionally in target-date funds or other balanced strategies. The complexity and decision overload described in the documentary are becoming passé.
  • Risk and return. There was much talk about excessive risk exposure and 401(k) plans  taking a big hit during the market downturn. But for the five years encompassing the great financial crisis, the typical 401(k) participant earned a positive return. Balances grew even faster when you added contributions. The same is true over longer periods. For example, among retirement-age households with retirement accounts, the typical balance was $55,000 in 2001—it nearly doubled to $100,000 by 2010 (source: Federal Reserve). And by 2020?  It’s worth taking the long-term view here.
  • Fees and indexing. The government recently completed a major regulatory project to improve fee disclosure to employers and workers. The employer disclosure has unleashed a wave of fee-cutting. Recordkeeping fees to administer the plans are falling. Investment fees are being sliced as many employers move to cheaper investments —whether cheaper index funds or cheaper active funds.  (The documentary missed the critical role played by employers in overseeing their plans; it also overlooked the fiduciary rules they must follow.) The world is moving in the direction of lower fees—and better outcomes—for retirement savers.

The good news is that if the retirement debate has come down to a debate over fees and indexing, bravo, I say! That’s a great place to be and a great set of issues to be arguing about.

But the retirement debate is broader and deeper than can be portrayed in an hour-long TV program. And the retirement outlook for many Americans is not as bleak—nor the 401(k) services industry as sinister—as sometimes dramatized.

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