In a recent New York Times column, Thomas Friedman characterized the evolving shift toward self-sufficiency as “a 401k world” that is centered on “defined contributions, not defined benefits.” That’s an apt metaphor for how we are all being tasked with greater responsibility in managing careers that are far more fluid than past generations, health care that is less subsidized, and of course, our retirement security, given that the self-managed 401k has supplanted the old-fashioned defined benefit pension.
But the use of the 401k metaphor suggests that it is simply up to all of us to assume responsibility for our future, do a bit of learning, make informed choices and all will be good.
That is clearly not what has happened, in large part due to the flawed architecture of the 401k. I’d like to think that if lawmakers knew the central role the 401k would assume in the financial security of future generations, they would have taken more care in its design. (It was in fact designed as a side benefit for highly compensated employees.)
What we got-and to an extent what we are still living with-is an extremely compromised retirement system that consistently does its very worst to help Americans succeed.
It took more than 25 years to correct a very basic problem with the original structure of the 401k: You had to make an active choice to join-known as opt-in. It is the rare young adult who will choose to save for a goal forty or fifty years away. Automatic enrollment-introduced just in the past few years-has corrected that problem by switching the dynamic to “opt-out” so you are automatically enrolled in a program, while retaining the right to choose not to participate.
But even the implementation of automatic enrollment has been flawed. Many 401k sponsors automatically enroll only new employees-rather than sweeping through their existing employees as well. And often the employee’s initial contribution rate when they are automatically enrolled is a woefully inadequate 3%. That signals to the employee that 3% is the correct amount. Ask any financial advisor and they will tell you the goal should be to save at least three to four times as much.
And the earlier you can ratchet up to that level, the easier time you will have amassing a sizable retirement account. Yet too often households only start to seriously focus on retirement savings in their 40s, losing out on two decades where compounding could have been a powerful tailwind.
It also took about 25 years for the 401k industry to address the fact that sound diversification and allocation are not easily accomplished. This has nothing to do with the intelligence of participants. Everyone is capable of understanding the key concepts, but when your plan is laden with 15 or so investment options it is not easy to make the right choices. And as behavioral finance has taught us, our brains are not naturally wired to buy low and sell high. Today’s 20-somethings have the benefit of target-date-funds being the default investment when they are automatically enrolled in a 401k. There is always the option to create one’s own portfolio, but for those who don’t want the responsibility of figuring out the right level of risk/reward, the TDF with its age-appropriate mix of investments is a fine solution. Many of today’s soon-to-be-retiring baby boomers would be in much better shape if that option existed 30 years ago.
Nor is it natural to stay on course with a long-term goal when a short-term goal is screaming for our attention and money. Yet to this day 401k participants are given every opportunity to take money from their future retirement to pay for a more pressing current need. The industry refers to borrowing from one’s 401k, or cashing it out (with attendant taxes) when they leave a job as leakage. Spring a big leak and your retirement security will be permanently compromised. Even if you make it to retirement without prematurely raiding your 401k, you’re then tasked with figuring out a rational withdrawal plan during retirement that tilts the odds on not running out of money. Not exactly easy.
The most galling structural flaw of 401ks remains high fees. The investment choices in many plans charge double, triple, even quadruple the costs of low-cost index mutual funds and exchange-traded funds. And we have reams of data that more expensive funds do not perform better. You pay for what you don’t get.
Are we in a 401k world? Absolutely. And it extends far beyond retirement accounts. Have you tried to decipher a health care bill lately? A bill that you are paying an increasingly higher share of? And parents of young children face many of the same 401k problems with College 529 savings plans. What’s scary is not the existence of our evolving 401k world, but that we are failing as a society to provide households the tools to succeed in managing their future. The real conversation we need is how to build a better 401k world by delivering the right systems with easy (easier) to decipher operating instructions. Absent that structural upgrade it is hard to envision how future generations can prosper.