What's Wrong With Your 401(k)-- And how to fix it

What’s wrong with your 401(k) -- and how to fix it Experts agree these ubiquitous retirement plans have gone terribly wrong. Here’s how they would fix the system, but you can take their advice to protect yourself now. By Lynn O'Shaunessy

Ted Benna created the first 401(k) for guinea pigs at his own benefits-consulting firm 21 years ago. No psychic could have predicted that the 401(k) -- named for an obscure section of the federal tax code -- would someday dominate how Americans save for retirement. With traditional pension plans fading into the sunset, the do-it-yourself 401(k) has become as vital to our financial futures as oxygen. Retirement questions? We'll do the math. Try our new planner.

“What we’ve done is conducted a vast experiment in social engineering that almost certainly is going to fail,” insists William Bernstein, a principal of Efficient Frontier Advisors in North Bend, Ore., and the author of "The Intelligent Asset Allocator."

“Although the current system seems robust,” he observes, the swapping of pensions with 401(k)s “is a social and economic time bomb primed to explode sometime in the next few decades.” Why such dourness? Bernstein ticks off plenty of reasons: meager savings rates, dreadful portfolio decisions, outrageously expensive plans and potentially lower stock market returns in the future.

While the Enron debacle has politicians on Capitol Hill clamoring for legislative changes, many of the proposed changes are cosmetic. Here’s our look at some of the worst problems and potential solutions. A sidebar offers advice for anybody wanting to improve his or her own 401(k) performance.

Problem No. 1: Wimpy savings According to the Center for Retirement Research at Boston College, fewer than 10% of Americans max out their yearly 401(k) contributions. And that was before the ceiling was bumped up to $11,000 this year, with a new $1,000 catch-up provision for anybody at least 50 years of age. The Vanguard Group estimates that even when full Social Security benefits are taken into account, workers are saving a mere two-thirds of what’s needed to retire with 75% of their pre-retirement income. Even more alarming, about one out of every four workers don’t even bother to enroll. And will anybody be surprised, a few years from now, when baby boom slackers whine for a federal solution to their financial mess?

Solution: Fatten Americans’ mediocre savings rate with immediate eligibility in 401(k) and related plans and vesting -- eligibility to receive an employer’s match. Full vesting means the workers is entitled to an employer’s total match; partial vesting is also possible. Many companies require newcomers to wait up to a year to enroll in a 401(k), a clear hardship for the young and the restless, who job-hop. Equally problematic, workers often see their match shrivel or disappear if they resign too soon. Some companies confiscate all or part of the match from those who don’t stay at least several years. In addition, automatically enroll new employees, who procrastinate. (Just 14% of companies already do this.) The default savings rate should be meaningful, say 4% to 6%. “There is a fair amount of inertia in how people behave,” observes Annika Sunden, associate director of the Center for Retirement Research. “Studies show automatic enrollment can boost participation rates to 90%”

Problem No. 2: Expensive retirement plans When purchasing in bulk, buyers expect a discount, but not in the land of 401(k)s. Benna estimates that financial institutions are charging retail fund prices or higher in at least 75% of plans even though workplaces are funneling them massive amounts of cash. The expense ratio for today’s average mutual fund is 1.4% of an investor’s assets. (If you’ve got $10,000 in a typical fund, for example, your yearly expense would be $140.) So many workers are probably paying in this neighborhood for the investment management of their own 401(k) fund assets.

Ironically, most workers believe they pay nothing, but, in most cases, that’s just dead wrong. The misconception is understandable because nobody gets mailed yearly invoices; the money is automatically deducted from every worker’s account. To find out how much your 401(k) funds are charging, ask for a copy of the prospectuses.

An extra percentage point in expenses over a long career can easily reduce your final 401(k) balance by tens or even hundreds of thousands of dollars. Let’s say you invest $500 a month in a 401(k) plan for 25 years. If you earn 9% a year (compounded monthly), you should end up with about $561,000. If you lose a percentage point of earnings to fees, your balance after 25 years will slip to $476,000, a difference of $85,000.

After paying for mutual fund costs, employees at major corporations usually don’t have to cough up extra cash for additional 401(k) fees, but that’s rarely the case for worker bees at smaller companies. They might be expected to fork over an additional 1% to 1.5% to cover other expenses. Insurance companies, by the way, run some of the most hideously expensive 401(k) plans.

What’s an excessive cost? Ted Benna suggests that if you’re paying more than 1% of your 401(k) assets in fees each year, you could be getting ripped off.

Frankly, most 401(k) plans are pricey because corporations see no economic incentive to act frugally. The beauty of a 401(k) set-up, from a chief financial officer’s perspective, is that it allows the employer to push the costs, as well as the investment risks, onto employees. And employees don’t even see it because the costs are hidden in the returns. By contrast, old-fashioned, paternalistic pension plans assumed both of these obligations.

Solution: Originally corporations primarily gravitated toward inexpensive institutional money management -- which pension funds, endowments and the very wealthy favor -- for their 401(k) plans. But frenetic lobbying by mutual funds, insurance companies and brokerage firms, who craved an entree into the 401(k) biz, changed that. To reverse this trend, companies must be given incentives to dicker on price. One concept from the National Center for Policy Analysis, a Dallas-based public policy think tank, proposes that corporations should be immunized from 401(k) litigation if they adopt a number of reforms, including absorbing all 401(k) expenses. Another approach is requiring employers to pay all fees and expenses that exceed 1% of assets.

Problem No. 3: Keystone cop investing One of the greatest flaws in the 401(k) system is that it requires workers, from the guy who refills the paper towel dispensers to those in the executive suites, to successfully assume a second job: retirement portfolio manager. It’s critical that participants follow basic investing rules, such as diversifying assets, but they often don’t. “The average participant is a long-term investor only in the way that Tony Soprano is a Catholic,” Bernstein suggests. According to Hewitt Associates, most workplace investors divide their money among just three funds, which is hardly enough to be called diversification. The average plan offers 12 investment choices, so it has typically befuddled employees, who stop at three. (Anyone slaving away at a company that doesn’t offer a fund smorgasbord can compensate for a fund deficit by filling in the gaps with an IRA.)

What’s more, there’s the Enron problem: Way too many employees invest a big chunk of their 401(k) money in company stock. Let me be blunt: stockpiling company stock in a retirement plan is akin to leaving a live hand grenade sitting around the house.

Solution: While it's impossible to make investing foolproof, companies should provide more responsible investment choices to employees.

One possibility is offering all 401(k) participants a plain-vanilla 60-40 or 70-30 mix of stocks and bonds that meets industry standards. These asset allocations are similar to those favored by corporate pension plans. The preset portfolios would be extremely inexpensive and would depend upon passive indexing. Nobody would be pushed into this choice -- in fact, other funds would remain on the shelf -- but these ready-made portfolios would be an excellent alternative for just about everyone. In fact, they should serve as the default investment for 401(k) enrollees, who don't check any investing boxes when signing up.

Low-cost indexing is the magic ingredient to creating a model 401(k) program. “We very strongly recommend the use of index funds since very few people can beat the indexes anyway,” says Bill Wolman, a regular CNBC contributor and the co-author with Anne Colamosca of "The Great 401(k) Hoax," which will be released in May.

While a 60-40 benchmark might sound dull, it walloped the collective 401(k) performance of employees at five financial firms, including Morningstar, Merrill Lynch and Citigroup, during a four-year period ending in 1998, according to the National Center for Policy Analysis’s study. The stock and bond mix generated a 21% average yearly return, while the biggest loser, Merrill Lynch, eked out an annual return of 11%.

Problem No. 4: Advice blackout Petrified of lawsuits, many companies restrict 401(k) counseling to the mechanics of enrollment and one-size-fits-all asset allocation pie charts. Corporations are increasingly relying on online 401(k) advice from firms such as Financial Engines, mPower and Morningstar, but most people ignore these services. The financial industry is backing a bill sponsored by U.S. Rep. John Boehner, R-Ohio, that would allow 401(k) providers to offer advice to employees in their own plans. Norman Stein, a University of Alabama law professor and an expert on employee benefit issues, is horrified at the prospects. “One of the lessons of Enron, a lesson that’s been repeated over and over again and never seems to sink in . . . is that conflicts of interest are bad,” he says. “People selling investments in a plan and then giving investment advice seems to me to be a screwy idea.”

Solution: The government should provide protections to companies that offer truly independent, third-party advice. Paying for this face time could be prohibitively expensive for corporate small fry, which makes it even more crucial that investment choices be as idiot-proof as possible. If the system steers employees to responsible, inexpensive selections, such as indexed portfolios, the need for education isn’t quite as critical. Actually, as sad as it is to admit, education will never be a panacea -- the learning curve is too great for many Americans, who couldn’t be bothered. “The notion that several hours of canned questionnaires and PowerPoint presentations will turn the average corporate employee into a well-informed, disciplined investment manager is absurd to anyone with the remotest sense of financial history and human nature,”’ Bernstein says.

Problem No. 5: Cash hemorrhage By one estimate, only 20% of workers roll their entire 401(k) into an IRA when leaving jobs. The allure of a new SUV, remodeled kitchen or a Maui vacation is so strong that Americans dismiss the pain of paying federal and state taxes, and often an early withdrawal penalty. Pilfering a 401(k) prematurely though can easily consume 40% of the account balance.

Solution: Nail the escape hatch shut. Cash-outs should be prohibited unless a person retires, dies or becomes disabled. All other departing workers would be required to roll their accounts into another qualified plan or keep it in the old plan if the next employer didn’t have one.

Why wait on Washington? There's no need to wait for the politicos in Washington to fix the 401(k) mess. (If they ever do.) With little effort, you can recalibrate your own 401(k) plan. Here are five tips to get you started:

Don’t pig out on company stock. Enron refugees understand this one, but legions of stock jocks remain skeptical. One national survey shows that most people believe holding company stock is safer than investing in mutual funds. Yet betting on one stock is nearly as risky as placing one huge wager on a roulette wheel to pay for your retirement. Devote no more than 5% of your 401(k) to company stock. If your company permits it, dump the rest and move the money into mutual funds. Diversify. Yes, it’s a boring concept, but it should shrink the chances of your portfolio being whipsawed. Invest in at least four fund categories in your retirement plan: large and small-cap domestic stocks, foreign stocks and bonds. Even better, make sure your portfolio is exposed to both value and growth. Don’t cash it in. Rather than cashing in a 401(k) when quitting, transfer the money into an Individual Retirement Account rollover. This way, the money will continue growing tax deferred. The paperwork will probably take no more than five minutes. Avoid 401(k) loans. A loan can chain you to your job because it typically must be repaid within 30 to 60 days after you leave a company for any reason. If you can’t repay it, you’ll owe federal and any applicable state income taxes on the balance, and a possible 10% early withdrawal penalty. What’s more, treating your 401(k) like a Visa card is dangerous if you stop contributing new money to your retirement account. Check your statements for accuracy. Clerical errors happen. Contributions have been deposited into wrong accounts, funds selections have sometimes been inadvertently switched or ignored. Be especially vigilant if your company has recently changed providers or has merged with another corporation.

The article is based on the assumption that most people are too stupid to educate themselves as to how to invest properly for retirement. The best investment book for the neophyte is called A Random Walk Down Wall Street. In it there are sample portfolios for various times in an investors life. The book goes over many of the issues the above article seems to rail against and instructs you how to avoid making those mistakes.

Even listening to radio financial advisors such as Bob Brinker would give you rules such as invest in no-load mutual funds that have low expense ratios. Use index funds because most mutual funds (ie. professional investors) fail to beat the market indexs. Never invest more than 5% of your total portfolio (that's savings, bonds, equities) in a single stock. That rule alone would have saved Enron employees thousands of dollars. So why should we worry about a system when the information to protect your wealth is out there.

The 401K and SEP IRA have been one of the best things to come along in a long time. Of course there would be no need for any of these things if our tax system didn't steal all of our money. If we had no income tax and only paid a sales tax then you would have no need for 401K plans and retirement plans and all savings would be tax free.

Pensions are the worst thing. Think of Enron, if they had a pension plan do you think that when they defaulted there would be a dime left in the pension plan? Look at IBM they just recently changed the pension payout that basically screwed retirees with the longest contribution history to the pension fund. Pension funds continually get raided by their corporate overseers. 401Ks are owned by the individual. The company you work for has no claim whatsoever to the money inside it.
What the article fails to realize is that while you can come up with horror stories of foolish investors loosing their retirement savings. There are also stories of people making a killing in their 401K. The system has to be looked at statistically are people on average able to save for retirement as compared to when we had pension plans. You would need to account for all the bankrupt companies and corrupt unions. In the end people able to save for their own retirement will enjoy security and independence in the twilight of their lives. People who do not will have to continue to find gainful employment or live off the charity of others.

"The article is based on the assumption that most people are too stupid to educate themselves as to how to invest properly for retirement."

I didn't come away from the article with that impression. The article emphasizes the need for people to become more educated in the workings of their 401k, especially w/r/t fees, but that's not the same as calling them stupid. Another issue raised is the need to give employees more control over their money, not less. If Enron employees hadn't been locked into the stock by the company there would have been a lot fewer people wiped out in the collapse.

Why such dourness? Bernstein ticks off plenty of reasons: meager savings rates, dreadful portfolio decisions, outrageously expensive plans and potentially lower stock market returns in the future.

Well, if the stockmarket is lower when I retire 30-some-odd years from now than it is now, I think I'll have bigger problems than my 401k to worry about. Like space aliens and all the giant insects roaming the earth....

Right now because I'm young, I'm invested very aggressively, but I'll start changing allotments as I get older to cut down risk...

Interesting points. I didn't get the impression that the article was assuming we are too stupid to make 401(k)'s work. The statisical evidence is out there(30 yr olds invested in money mkt funds, etc.)The article brings out alot of points that people not in the industry probably don't know like penalties associated with cashing out instead of rolling over. I Hope ENRON taught the country about diversification. You are correct however, about the numerous millionaires that the company stock inside the 401(k) produced. Ever heard of the term Dellionaire? This points out hte absurdity of Sen. Corzine's proposed limit on company stock iside a 401 k. The pension fraud you mentioned is why the 401 k section of tax law was written.

Yet while the 401(k) boasts attractive features -- unlike a traditional pension, you don't have to occupy the same cubicle for decades to leave with a hefty payout -- the system badly needs an overhaul. And if the fixes aren't made, our increasing addiction to 401(k)s will only turn the nation's Social Security conundrum into an even bigger economic Frankenstein. If the flawed 401(k) system ultimately fails its struggling retirees, the resulting pressures on an overburdened Social Security system and, just as importantly, the nation's economic well-being, could be astronomical.

The point is made that the system is flawed and if we don't fix it well we will have a catastrophy. There is nothing wrong with the 401K system other than we are all taxed so much that we need 401Ks in the first place. Now being pragmatic I'll drop my over taxed argument(for the moment) and base my analysis on the current situation.

The article complains that not all corporate 401Ks are the same. That is true but all company health plans are not the same. The answer is if you don't like the overall benefits go find another place to work. It's time people took responsibilty for their own lives and made realalistic decisions taking all factors into account. My own situation is that I went off into some not so lucrative businesses outside of corporate America and have 3-4 years where I didn't have enough money to cover a measly IRA payment. In terms of retirement savings that's 25 to 30K I should have had in a 401K 10 years ago. Well with the run up in the market over that 10 years that would be close to 100K right now. But I'm not complaining just showing you that everyone has a hard luck story that doesn't necessarily get caused by big business going awry.

The article goes on to say that investors in 401Ks need to moonlight as their own money managers. It is not portrayed as a good thing. Again the answer to everything in the article is that 401K needs to be changed so that investors can't hurt themselves. So they can invest mindlessly. This is typical liberal thinking too much freedom (to invest your money) is bad. We must legislate so that everyone is equal. We can't have savvy investors making more in their 401Ks than the not so savvy and we can't have those who mistakenly believe themselves to be savvy (and aren't) ruining their retirement savings.

What this all fails to realize is the greatest contributor to personal wealth is a growing economy. Let's face it we wouldn't be having this discussion if we weren't in a recession. If the market was booming no one would care. So rather than fix 401Ks how about get government to stop confiscating our hard earned cash. Then we would all have more money to invest. That would inturn send the price of stocks up and everyone would be happy again watching their investments go up.

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