Industry Veterans Answer: Shall We Praise the 401k or Bury It?
A number of articles have appeared over the years suggesting the 401k has failed. Most recently, The Wall Street Journal published a story entitled “The Champions of the 401(k) Lament the Revolution They Started,” (January 2, 2017). The article went back to the future and interviewed several 401k luminaries for the 1980s. Nearly to a one they now all regret creating the monster killed the pension plan. One, economist Teresa Ghilarducci, director of the Schwartz Center for Economic Policy Analysis, has even go so far as to advocate killing the 401k and replacing it with a government-run program.
But is this the case of not seeing the trees for the forest? Could it be these aged one-time advocates of the 401k are far too removed from today’s front lines to see how successful their baby has become? Or are we blinded by the rosy glasses of confirmation bias to even consider whether the 401k has a downside? As we so often do, FiduciaryNews.com queried industry veterans from coast to coast, from north to south, from blue state to red state, to find the true state of the 401k. Mind you, the people you are about to hear from are not policy wonks or long-retired professionals. They are on the front lines right now, and this is what they see:
The Pensions Paradox: A False, Misleading Comparison and an Unrealistic Alternative to 401k plans
Speaking of rose colored glasses, it seems that what all those folks praising a false memory of the sanctity of the pension plan are wearing them. Truth be told, pension plans are the buggy whips of the modern retirement world. While once an attractive option in a world where life expectancies were shorter and workers stay longer (like, forever) at one company, companies (and you might include governments here, too) simply can’t afford the liabilities associated with offering defined benefit (DB) plans. “They are too expensive as people live longer, and companies know it,” says Debra Brennan Tagg, Managing Partner at Brennan Financial Services in Addison, Texas.
Likewise, regulations governing pension plans date back to an era that frankly no longer exists. It is possible for pension to return as a viable retirement benefit option, but much would have to change. David Guadagnoli, an attorney at Sullivan & Worcester located in Boston, Massachusetts, says pensions may be a realistic alternative to 401k plans “if employers are properly incentivized. But right now, pension plans are expensive to maintain and administer and the funding rules often mandate contributions when companies can least afford them and put caps on contributions when cash is otherwise readily available.”
Even if pensions are perfect, their high cost makes them inaccessible to plan sponsors. “Pensions are simply too expensive to administer and too hard to manage in today’s environment,” says Tony Hellenbrand, a Partner at Fox River Capital in Appleton, Wisconsin. “Many companies that have 401k’s today would not be able to offer a pension. 401k’s may be far from perfect, but an imperfect savings vehicle that you use beats a perfect one you don’t. Also, pensions are generally heavier on the fixed income side of asset allocation, which at today’s yields wouldn’t be anywhere near feasible as an accumulation vehicle for the average person’s retirement.”
The expense comes mainly from changing demographics. “Traditional pension plans are expensive,” says Adam Pozek, a partner at DWC ERISA Consultants in Boston, Massachusetts. “At their height, normal retirement age was generally 65, and life expectancies were to the late 60s. Companies had to fund retirement benefits for only a few years. Life expectancies now stretch well into the late 80s, so DB plans must now be prepared to pay benefits for 20 or more years.”
But, even without that, the complex language of pension plans just doesn’t register with today’s OMG LOL crowd. Given the choice, today’s movie goers prefer action that is fast and furious and could care less for the slow arc of an intricate plot. Today’s movie goers have a lot in common with today’s retirement savers. Pozek says, “Traditional pension plans tend to not be appreciated as much by employees. I think this is for several reasons. First is that telling an employee that he or she will receive 1% of final average compensation for each year of service, payable in the form of a joint and survivor annuity, beginning at age 65 isn’t nearly as tangible as other more ‘here and now’ type benefits. A 401k plan has an account balance. Health insurance means an employee can go to the doctor when he or she gets the flu. A second reason is that DB plans require longer job tenure in order to provide meaningful benefits. With turnover occurring as often as every 3 years (or less in some segments of the workforce), workers who are covered by DB plans do not stick around long enough for them to amount to much.”
And changing movie tastes go in line with changing lifestyles. Today’s on-the-go millennial has a career track more like a revolving door than a steady oak. That makes DBs obsolete. “Pensions were predicated on employees staying with an employer for decades,” says Timothy Yee of Green Retirement Inc. in Alameda, California. “Employee turnover suggests that this may not be realistic. Of course, which came first, the chicken or the egg? Does employee turnover mean that pensions are less beneficial or does not have a pension entice employees to leave? The funding mechanism/ risk of a DB pension also rests with the employer, whereas a DC plan funding is primarily from the employee. With the focus on quarterly profits/ stock prices, is it realistic to think that employers will welcome the risk of an underfunded DB?”
The fond memories of pension benefits that never were paint the perfect picture of a translucent spectre. Today, a pension plan represents nothing more than an incorporeal concept that exists only in some paranormal universe. “An employer pay-all model (defined benefit/DB) isn’t a ‘thing’ anymore,” says Trisha Brambley, CEO of Retirement Playbook, Inc. in Philadelphia, Pennsylvania. “The perceived value of a pension isn’t as generous as 401k plan, which has no PBGC premiums associated with it or any required contributions. 401k plans are less expensive and less burdensome. DB plans are so loaded with regulations and fees that they’ll never make a comeback; they’re just not flexible enough in the design for today’s workforce.”
The State-Run Retirement Plan Alternative: Been There, Done That, Bought the Bail-Out
Though Ghilarducci generally sees a federally run program, the primary movement in the waning years of the progressive Obama administration has been to bypass Washington and seek government-run solutions at the individual state level. Are state-run retirement plans as attractive as they seem to be? “They might be,” says Tagg, “but then politics will be involved with retirement planning. Depending on one’s interpretation of government-run programs, this might be a positive or a negative.”
Others believe there’s no getting over that whole “past being prologue” thing. “We already have a federally run pension system called social security,” says Brambley, “and look at the condition it is in.”
Ironically, federal control over the national retirement system was designed precisely to avoid the current situation we have in the health insurance industry, with the spaghetti code of each state establishing its own rules and regulations. State-run retirement plans pose the same dilemma. Pozek says, “The concept isn’t necessarily a bad one, but the devil is in the details. ERISA was specifically written to pre-empt conflicting state laws so that companies sponsoring plans only needed to abide by one set of rules. State-run plans are generally exempt from ERISA, which means each state (and some individual cities as well) that sponsors a plan has a different set of rules. Companies that operated in multiple cities and states with plans have to keep up with those different sets of rules and try to juggle them. For something pitched as the easy alternative to a 401k plan, it stands to be anything but easy. Then there is the fact that states do not have the strongest track record when it comes to managing retirement plans. According to the Investment Company Institute, state and local DB plans were underfunded by $1.7 trillion as of the end of 2015. Those are DB plans and the state-run plans in question here would be defined contribution plans, but it still calls into question the ability of states to make appropriate decisions with respect to the retirement benefits of such a diverse group of participants. Even acknowledging that states that sponsor plans will outsource the management, a couple of quick Google searches on state-managed competitive bidding processes yields many stories alleging corruption in awarding contracts in areas from public works projects to sporting events to you name it.”
Yee, whose home state of California is among the first to aggressive pursue a state-run retirement plan for private citizens, has the advantage of seeing the sausage being made up close and personal. He laments the multiple avenues of a downside surprise in the state-run option, including “possibly high fees, poor investment choices, investment choices that are too conservative, the list goes on and on. Also, for those employees who wants values-based investment options, that is unlikely in the state plan.”
Beyond the logistics, there’s the philosophical barrier. To many, “state-run” anything just isn’t what it means to be an American. “State-run retirement plans for small single state employers might be a viable option,” says Guadagnoli. “But ERISA was enacted in part to avoid employers having to comply with multiple state mandates with respect to benefits issues. More significantly, I do not believe that it should be the job of a state or local government to run a retirement system; that belongs in the private sector. Also, state and local authorities should be focused first and foremost on cleaning up their own pension problems. Finally, I prefer not to even put within the reach of a state legislature any additional funds that could be co-opted (no matter how ‘secure’ the savings allegedly are).”
Others are more blunt. “I don’t know how to answer this one without a soapbox tone: State-run anything is a worse outcome for everyone,” says Hellenbrand.
Counting the Ways: What’s so Good about 401k Plans?
- The Company Match – Hellenbrand says, “401k’s have a lot going for them. To start with: company matching. If you have access to a 401k with a match, it should be your first option for savings until you’re taking advantage of the full match. There’s just nowhere else you can go get a guaranteed 100% return on your money. Another great thing about 401k’s is their flexibility for businesses. Many businesses out there have a 401k for their workers that wouldn’t be able to offer other types of plans.”
- Self-Determination – Tagg says, “Employees should be able to contribute to their own retirement goals. They should be given a menu of investment options that are suitable to them. We should continue to find ways as an industry to keep expenses low.”
- Instant Tax Savings – Guadagnoli says, “401k plans offer many people a tax-advantaged way to save for retirement. They allow employees to participate in the equity markets in a way that is not possible under Social Security and/or defined benefit plans, both of which are more properly thought of, in my view, as a fixed income type investment. They also offer a greater sense of control and self-reliance over ones financial affairs than Social Security and defined benefit plans. That said, down markets, particularly on the verge of or in retirement, can result in substantial harm to a retiree’s income in a way that does not exist with Social Security and most defined benefit plans.”
- That Was Easy – Brambley says, “The simplicity of automatic savings through payroll deduction. Continue to increase auto features.”
- They Work Better Than They Get Credit For – Pozek says, “When covered by a workplace savings plan like a 401k, more than 71% of moderate-income workers actually save for their own retirement. When the only option is an IRA, fewer than 5% save. It’s difficult to call that a failure. In total, 80% of those who actively participate in these plans are from households with AGIs of $100,000 or less, so they are not just a benefit for the wealthy. There is anecdotal evidence that suggests millennials are contributing to their workplace plans at much higher rates than their parents. The retirement industry has done an exceptional job in recent years at communicating the value of retirement plans to both the employers who sponsor them and the workers who save through them. There has also been a realization among both practitioners and participants that these are complex financial decisions, which has led to more ‘do it for me’ options for participants…things like automatic enrollment and escalation, managed portfolios and target date funds have removed some of the complexity that has led to analysis paralysis on the part of participants, making it much easier for them to simply begin saving.”
- They are Better Than the Alternatives – Yee says, “401k plans are an excellent way to save as compared to an IRA or SIMPLE. With higher contribution limits than those vehicles and possibly more investment choices, the employee can benefit from a 401k. Another positive is employer match. A match is not possible in an IRA and is capped in the SIMPLE world. Employees can also contribute on a pre-tax and after-tax basis in the 401k whereas that would require two IRAs and is not possible in a SIMPLE. Economies of scale can make the 401k cheaper from an employee’s POV. Example: A SIMPLE with an A-Share fund company would typically incur those loads. Those same funds are load-waived in the 401k. The employee saves the load fee. On the topic of fees, the advisor fee can actually be lower than it would be in an IRA. Ditto to the annual fee. Finally, in a 401k, the employee will likely get professional advice and guidance. It takes quite a large IRA balance to get any sort of financial advice.”
Nobody’s Perfect: Modest Tweaks to Improve Current 401ks
The spectrum of 401k plan types remains broad, reflecting the ability of some companies to devote significant resources towards plan efficiency while other companies just do their best to tread water. It’s this latter category that can stand to benefit the most from expert guidance. For example, Brambley says, “An array of professionally managed funds and continued focus on providing good value for the fees paid for those funds” is something that can be delegated to service providers.
Similarly, Hellenbrand says, “I think too many plan sponsors and even their investment committees need to delegate more to 3(38) fiduciaries. While I’m seeing better investment lineups today than I saw a few years ago, generally I still see too many plans with gaps, overlap, or just bad options in their lineups that I really think plans would benefit from more outside 3(38)’s.”
Altering the manner in which we educate employees can be modified. “Two thoughts here,” says Guadagnoli, “First, we need to be educating all employees (ideally in high school or earlier) basic financial literacy. Employers spend far too much time trying to fill gaps (what does tax deferral really mean? what is a mutual fund? how does someone manage a portfolio? etc.). Second, we need to ensure that participants are not overwhelmed with information, particularly information of marginal utility. For example, the Department of Labor’s regulations mandating fee disclosure to fiduciaries generally made sense; mandating fee disclosure to participants less so. Unless participants are sufficiently knowledgeable (see the first thought), one runs the risk of the recipient either being focused on the wrong issues or simply shutting down.”
There’s always an advantage in making present systems simpler. “Current laws assume that people know too much about investing, that they understand the magnitude of what they need to save, and that they will make the choice to forego expenses now to direct funds to retirement goals,” says Tagg. “We should make a baseline contribution the default, as well as an annual increase. We should also require education about investing, and companies should do a better job of making sure their employees understand how large the retirement goal actually is. We should separate education about retirement with the 401k plan itself. That way, we can keep the expenses of a 401k plan tied directly to the investments, operations, and compliance requirements of the plan. Companies that choose to educate their employees about retirement should receive a tax credit. If people really understood the magnitude of their retirement goal and directed their money towards that goal, they would be relieving the potential future burden of the government to support those people in later years. In my opinion, that deserves a tax credit.”
But subtle improvements aren’t limited to company policies and procedures. They can occur at the regulatory level, too. Yee says, “Auto-enrollment and auto-escalation are optional but should be mandatory. How else can we get Americans to save? I was also reading in the Journal of Pension Benefits about whether top heavy and ADP/ACP testing is still needed.”
Here’s an example where loosening regulators may provide greater benefits to all. “It is not uncommon for companies, especially small businesses, to say that they would be glad to open up the 401k plan to all employees right away, even short-service and part-time employees, except that employees in those groups tend to not save as much, which in turn, hurts the annual compliance testing results,” says Pozek. “Congress has partially addressed that by including rules that allow companies to include short-service/part-time workers in their plans but still disregard them for purposes of annual testing until they have completed a year of service. It’s the proverbial ‘win-win’ situation. Unfortunately, there is one test that requires counting everyone who is eligible for the plan no matter how short a time they’ve been employed, and that particular test triggers a mandatory company contribution of up to 3% of pay for all non-owners/non-officers. That is quite detrimental to encouraging companies to include workers in the plan any earlier than is absolutely necessary. It’s a simple change that could broadly expand coverage among the short-service/part-time work force. Turning to the private-sector side of the equation, we need to improve financial literacy. We are a very consumption-based society. Everywhere we turn, we are encouraged to spend our money. The attitude has become ‘spend first and save what (if anything) is leftover.’ It should be the other way around, at least when it comes to discretionary spending. That’s a fundamental requirement for the success of any savings-based plan.”
Thinking Outside the Box: The Future “New and Improved” 401k
In the four decades of its existing, the 401k has undergone several major evolutions. Soon after its birth, it morphed from a turbo-charged profit sharing plan to a microcosm of Modern Portfolio Theory. Within the past ten years, we’ve witnessed another shift, this time under the guidance of behavioral finance research. We see this in auto-enrollment, auto-escalation, and even in the number of options offered. “More funds in a plan does not necessarily mean better; too much is just confusing,” says Brambley.
There is increasing awareness of a need to start a serious effort to constrain the negative impact of premature withdrawals while at the same time allowing people to weather life’s toughest storms. “This is a tough one,” says Yee says. “I have had long conversations about whether loans should be allowed and even if hardship withdrawals should be allowed. Hardship withdrawals in particular are challenging. For example, $10K can be taken from the 401k for first time home purchase. That $10K become $8K after the mandatory 20% upfront withholding. Next, the employee will still pay a 10% federal penalty and possible state penalty (2.5% in CA) on the withdrawal. Finally, the employee is precluded from participating in the plan for six months under hardship thereby missing 6 months of match.”
Thinking outside the box sometimes mean forsaking theory, no matter how elegant and correct it may be, and focusing on practical reality. The media likes to write about fees, and the DOL has made genuinely honest efforts to address the worst cases, but sometimes you can have too much of a good thing. “I think many pundits hammer on the expenses involved in a 401k, but that’s really not what needs fixing in the 401k space,” says Hellenbrand. “Don’t get me wrong, I agree many 401k’s are far more expensive than they need to be, but the bigger issue is education. Many workers simply don’t have the experience or know-how to figure out just what they’re paying or what different investment options mean and an even bigger issue than education many times is interest. They’d rather do anything than research their retirement plan. I think if advisors and sponsors could focus more on the giant effects these decisions can have, not only from a purely financial/dollars standpoint, but also from a benefits standpoint, i.e. ‘This means you get to spend more time fishing in retirement,’ etc… we’d see much higher interest levels, and then better education/knowledge, and the long term results would be better plans for everyone. In as few words as I can: We need to stop talking to participants like they’re CFP’s. They’re not. Make it fun and their interest will lead to better outcomes for everyone.”
Just as Congress nudged the behavioral finance shift in 401ks, we can expect future changes to find their origins in legislative efforts. “We should stop assuming that plan-sponsored educational material is enough to motivate people to save enough for retirement,” says Tagg. “Instead, companies should offer better educational resources to their employees. We should also increase the contribution limits. We should find ways that highly compensated employees don’t get so restricted on their contributions. The HCEs are likely the same people who make decisions about how much the company should match, whether to have a 401k at all, and how much money the company will spend on educational tools. Maybe if a company makes a higher contribution for the employees as a match, then the HCEs don’t get restricted as much.”
Of course, change for change’s sake, a disease that often afflicts professional politicians, can’t continue. Guadagnoli says, “Constantly tinkering with the rules and creating multiple retirement plan systems (qualified plans, SEPs, SIMPLEs, etc.) does not help employers who are voluntarily putting these arrangements in place but for whom offering retirement benefits is not a full time job.”
Finally, true beneficial change won’t happen until we face the facts that lofty slogans don’t always reflect the situation on the ground. While it always remains good to shoot for the ideal, never let the perfect be the enemy of the good. “We need to stop blaming 401k plans for the retirement shortfalls that exist,” says Pozek. “The 401k plan was initially intended to be a savings plan that was supplemental to other retirement/savings vehicles. It was never intended to shoulder the retirement burden on its own, yet critics speak of the failure of the 401k plan as if it was always intended to be the end-all, be-all of retirement benefits. With all of that said, the industry has done a remarkable job of adapting the 401k into an arrangement that has been quite successful in many ways. Second, we need to stop selling 401k plans using fear. Fiduciary responsibility and operational compliance are critically important but regaling a business owner of officer of all the horrible things that can happen to them if they make a mistake paints the plan as a huge liability rather than a benefit.”
Certainly, the 401k is an honorable solution to many problems that didn’t exist fifty years ago. Recognizing this is important. Just as important is accepting that, in fifty years, new problems with exist. If we choose to bury the 401k, we must ask ourselves this question: Are we burying it to dredge up the rotted carcass of an extinct notion, or are we burying it as we bury a seed, to feed it, to nurture it, so it may grow into a mighty tree that bears fruit when we need it.
Christopher Carosa is a keynote speaker, journalist, and the author of 401(k) Fiduciary Solutions, Hey! What’s My Number? How to Improve the Odds You Will Retire in Comfort and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.
Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.