Lost Retirement Horizon: Why 401(k)s Are Not OK (and Not Just Because of the Lousy Economy)

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News Analysis

Fretting over your 401(k) lately? For all the current turbulence in these retirement plans—from their rocky recent market performance to asset managers’ politicization of their investments through the “environment, social and governance” agenda—the main problem lies in their flawed design decades ago, a range of retirement experts say.

They say many retirees—particularly the less well-off—are losing out because the tax-advantaged accounts favor the well-compensated who are better able to save; also, because of the plans’ temptingly relaxed borrowing rules, typically high fees, complexity, and a presumption of investing competence on the part of ordinary workers.

“This system works fine for the top third of income earners, but not well for the middle- and lower-income earners,” says Alicia Munnell, director of the Center for Retirement Research at Boston College.

Yet as traditional monthly pensions have largely disappeared for private sector workers, American retirement security more than ever hinges on 401(k)s. In an illustration of how they’re failing, Deloitte Global, the accounting and consulting firm, estimates the retirement savings shortfall for Americans at nearly $4 trillion, as relatively few employees are able or inclined to fully exploit these optional savings vehicles.

Worse yet, few plans offer much, if any, protection against market declines, as any 401(k) investor can attest this year. There are no retirement income guarantees in the 401(k) world. And in the face of such uncertainties, the guarantee of a modest monthly federal Social Security check, the other leg of retirement finance, is cold comfort for many indeed.

An Accident of History

Investment experts explain how we arrived at this pass starting with an accident of history. 401(k)s were never intended as a mainstream retirement vehicle. What happened was that a benefits consultant named Ted Benna in the late 1970s discovered an obscure section of the U.S. tax code that allowed employers to offer an extra fringe “defined contribution” retirement savings benefit, mostly aimed at higher-income employees who could afford to put aside significant savings and avail themselves of employers’ matching contributions and expert investment advice.

During the 1980s, only 8 percent of American workers had 401(k)s. But over the decades they have grown into a $7 trillion industry as many companies embraced Benna’s insight, concluding that they were cheaper and easier to manage than defined-benefit pension plans. Now some 43 percent of U.S. employees are offered 401(k) or similar plans, as pensions have virtually disappeared.

Federal legislation compounded the bias toward higher earners. Professor Michael Doran of the University of Virginia Law School faults Congress for expanding 401(k)s by offering higher contribution limits and more generous tax breaks for those who don’t really need them. His recent paper “The Great American Retirement Fraud” contends that despite “reforms costing the government tens of billions of dollars that began in 1995, retirement savings have remained flat for middle-income households and even decreased for lower-income households, after accounting for inflation.”

Although overall 401(k) savings have climbed in recent years, the bulk of the gains went to the upper tiers of income, Doran found. In defined-contribution plans such as 401(k)s, 403(b)s, and 457s, employees are rewarded when they make contributions along with any internal gains in the plans, both of which are tax-free until eventual withdrawal. The more you contribute, the greater the tax break upfront—a big incentive to reduce taxable income for high earners. It was easy for Congress to tweak laws to allow people to contribute more without creating better plans for middle- and low-income workers who could less afford to save.

“The legislation has repeatedly raised the statutory limits on contributions and benefits,” Doran found, “all to the benefit of affluent workers and the financial-services companies and retirement-plan service providers that collect fees from retirement plans and retirement savings. The result has been spectacular growth in the retirement accounts of higher-income earners but modest or even negative growth in the accounts of middle-income and lower-income earners.”

Not Features, but Bugs

Along the way, Congress created 401(k) features that have actually proved to be bugs in the retirement ointment. It made it easier to borrow or withdraw funds from the 401(k) kitty—an obvious disincentive to saving (in contrast with old-style pensions, which couldn’t be tapped before retirement). In doing so, account holders often face steep federal income tax penalties.

Layoffs and other disruptions of the pandemic accelerated withdrawals from 401(k)s, when Congress allowed workers to withdraw up to $100,000 from retirement accounts without being subject to the 10 percent early-withdrawal penalty. Reacting to the pandemic’s numerous financial challenges, some 92 percent of employers allowed “hardship” withdrawals from 401(k)s, up from 78 percent in 2019, reports the Plan Council Sponsor of America (PSCA), which has been doing employer retirement surveys for the past 64 years.

As a result, more than half of those surveyed by Bankrate said they are behind on their retirement savings.

Even before that, federal law was already flexible on accessing 401(k) funds: Workers can spend 401(k) funds to buy a first home, pay medical bills, and avert foreclosure through hardship withdrawals. A recent study suggested that 401(k) balances may be drained by as much as 31 percent at age 60.

Moreover, nearly 50,000 businesses slashed their 401(k) matching contributions during the pandemic, although many have since restored their match. Some 86 percent of plans surveyed offer a matching contribution as of last year, the PSCA notes. Small businesses were most likely to make the cuts. All told, although estimates vary widely, some 22 percent of workers surveyed said they tapped their 401(k)s during the pandemic, according to the Transamerica Center for Retirement Studies.

401(k)s Cost Too Much

Then there are the expenses of 401(k)s, widely viewed by financial advisers to be unnecessarily high with few exceptions.

Defined-contribution plans are managed by financial services companies—primarily through mutual funds—and that means layers of fees mostly charged to employees. Be they managers mutual funds, insurance companies, brokerage firms, or banks, their expenses are buried in annual percentages of assets under management called “expense ratios,” even though the U.S. Department of Labor requires that employers disclose fees.

Meantime, personal portfolio and risk management is left to individual account holders, who, research shows, consistently make money-losing decisions (see “Encouraging Money-Losing Decisions” below).

Overpriced, inferior funds will actually eat up total retirement savings over time because workers don’t have the option of choosing funds in their employer’s 401(k)—they are limited by their employer’s selection of funds.

The simple math on how much the high fees can eat into retirement savings is indisputable and dramatic: An increase of 1 percent in your 401(k) plan fees and charges could reduce your retirement earnings by 28 percent, according to FINRA, the federal regulator of the U.S. securities industry.

Let’s say you invested $100,000 in a large-stock fund over 30 years. At a 7 percent annual return, you’d have $483,727 after three decades if you left your money invested for that period of time in a fund charging 1.5 percent in annual expenses.

Lower your annual fund expense ratio to 0.5 percent and your final balance would be almost $655,000. Expenses still ate up $100,000 of your contributions—even in the low-cost fund—so you can see how lucrative 401(k)s are for financial services firms. That was cash that was not invested and compounding in your retirement kitty.

By comparison, the high-cost option took more than $250,000 in fees and lost opportunity cost, that is, money that couldn’t return a dime for you because it went to a third party and wasn’t invested. (Do the math yourself online with Bankrate.com’s mutual fund fees calculator.)

The good news is that, due to intense competition in the money management business, you—and your employer—can find rock-bottom expenses on nearly every kind of fund. But here’s a catch: Some of the big asset managers offering ultra-low-cost exchange-traded and mutual funds—including BlackRock and Vanguard—are also advocates of controversial “environmental, social and governance” investing favoring broader social goals over traditional shareholder value. Such political activism is opposed by many investors and regulators in conservative states. Investors willing to do the painstaking research required could find themselves conflicted, facing appealingly low expenses on the one hand and a political investing approach with which they disagree on the other.

There are 10 funds that charge no management expenses for their exchange-traded stock funds. You can find bond-index funds for as little as 0.03 percent annually, according to the ETF database. Generally, low-cost, static, big-basket index funds don’t trade their holdings and can perform better over time than actively traded funds. The performance difference is largely due to lower fees and avoiding active-trading losses.

But finding these cheaper funds on your own doesn’t mean that your employer will offer them in your 401(k). They are usually limited by what a single financial service company will provide (usually the company’s own “proprietary” funds). These may even load up extra layers of fees through “fund classes” or other poorly disclosed expenses such as “revenue sharing” that will erode your retirement savings. Unless employers absorb fund expenses—most do not—they have little financial incentive to shop for low-fee funds.

The reason smaller plans charge employees high fees comes down to profit. Your 401(k) plan’s average account balance may impact the fees you pay. Joseph Valletta, publisher of the 401k Averages Book, says “our data finds that average account balance is one of the key drivers of 401(k) plan costs.”

“Plans with larger average account balances will be able to generate more revenue per participant than a plan with a smaller average account balance,” he explains. “For example, a $5 million plan with $50,000 average account balance costs 1.19 percent, which translates to $595 [in revenue] per participant, while a $5 million plan with $10,000 average account balance costs 1.48 percent, which translates to $148 per participant.”

Ironically, on the expense issue, Congress has taken care of itself and federal employees through its Thrift Savings Plan (TSP), a giant defined-contribution plan. The TSP not only clearly discloses and explains all expenses; the total fees on their funds range from only 0.043 percent to 0.053 percent. Note where the decimal point is. These funds are a super bargain for federal employees, although private plans are generally charging exponentially more.

Small plans, typically under $5 million in assets, typically extract high fees from employees. According to 401kSource.com, which tracks plan fees, a plan with $500,000 in assets, for example, may have an average annual expense ratio of 2.23 percent, which is an onerous internal tax on participants. Broken down, 1.59 percent goes to investment managers and recordkeepers and 1.06 percent to “revenue sharing,” a hidden cost that is an incentive for intermediaries to place funds within a plan.

While fund fees have declined overall in recent years, usually the larger the plan in terms of assets, the lower the expenses. A plan with $50 million in assets and 1,000 participants will pay an average 0.88 percent annually, 401ksource reported. Someone who has invested $100,000 over 30 years and is investing $1,000 monthly at 7 percent annual return would have an ending balance of about $1.2 million in the more expensive, smaller plan, compared with nearly $1.6 million in the larger one.

Litigation Blossoms

Not surprisingly, there’s been pushback on high 401(k) fees by employees in recent years.

Employers have faced multiple lawsuits over high fees and poor performance. In legal parlance, litigators representing employees argue that employers have often violated their “fiduciary duty” under federal law to select managers to prudently manage employee funds at a reasonable cost.

More than 90 lawsuits against employers for faulty 401(k)s were filed in 2020 alone. The suits alleged that employers “breached” their fiduciary duty by offering high-cost, low-performing funds. The litigation has also cited inclusion of company stock in 401(k)s, an ultra-risky investment—particularly if the company’s shares tank. The once-giant retailer Sears, for example, was sued in 2017 “for allegedly encouraging participants in its 401(k) plan to buy company stock despite well-publicized struggles that have battered Sears shares since 2014,” according to The Wall Street Journal.

Employers have also been sued for conflicts of interest within plans, such as “self-dealing,” where the benefit of fund managers is placed above employees, and excessive third-party administrative fees and record-keeping, typically the least transparent expense.

It’s no surprise that 401(k) suits have come in waves, usually after major market or economic declines, since defined-contribution returns are directly linked to markets. When stock and bond markets fail to provide consistent returns, high fees sting employees even more since 401(k)s don’t guarantee returns in volatile market environments. More than 100 new 401(k) suits were filed in 2016 and 2017, following an earlier wave in 2008 and 2009 in the wake of the market meltdown and recession in those years.

Many of the suits target investment choices, which are loaded with extraneous fees, conflicts of interest, and often higher risk. To address that issue, fund complexes have offered “lifestyle” or “target-date” funds (TDFs), which are baskets of pre-packaged funds designed to offer a “glide path” to retirement at given years. All of these funds, however, impose two layers of fees that erode returns. They may even come up short on performance and vary widely in risk profiles.

“Excessive risk lawsuits should be the next wave (of lawsuits),” says Ron Surz, a long-time critic of mainstream TDFs and president of Target Date Solutions.

Encouraging Money-Losing Decisions

Handing the complicated decision-making of personal investing to unsophisticated employees has consistently hurt their ability to save enough for retirement. Because employees are free to trade at will—often without much guidance—they often make the worst decisions and lose money in their 401(k)s. In recent decades, a body of Nobel-winning economic research has proven that investors rarely act in their own best interest when it comes to investing on their own.

Individuals consistently underperform the market, particularly in their 401(k) accounts, according to research by Dalbar, which has been studying personal investment returns for the past 27 years. What many investors do is sell during downturns and buy during upswings. That means they lock in losses when they could be buying shares at a discount, which is how professional investors make money.

Dalbar estimates the gap between what individual investors returned versus a static index of stocks was 2 percentage points during the first half of last year, when many investors bailed during market swoons and the pandemic. “This would come back to haunt the average equity fund investor,” the Dalbar report stated.

Since little education on risk management or investing is required for employees, they are likely going to repeat their missteps over time and lose even more money.

Last year, for example, some $7.3 billion flowed out of stock funds, according to Alight Solutions, which tracks 401(k) trading. That money was mostly moved to bond and “stable value” funds during a year in which the broad Bloomberg Barclays Bond Index lost 1.54 percent. Stocks, as measured by the S&P 500 Index, gained nearly 29 percent in 2021, thanks to a market rebound. It’s hard to know how much money was lost by moving 401(k) funds, but it was substantial; losses further needlessly eroded 401(k) balances.

Richard Thaler, who won the Nobel Prize in Economics in 2017, discovered that investors, when given free rein over their investments, tend to make bad choices based on behavioral biases. They get scared about losing money, so they make rash trading decisions, i.e., they sell low and buy high. They think they know what’s going to happen in markets based on the day’s headlines. Many—mostly men—are overconfident in making these decisions. And they tend to contribute too little or nothing at all, which results in inadequate retirement savings.

Working with UCLA Professor Shlomo Benartzi, Thaler developed a 401(k) program called Save More Tomorrow (SMarT), which automatically enrolls workers in a 401(k) when they start with an employer, then increases their contributions with every raise. They found that the SMarT program tripled 401(k) savings over a two-year period.

While no employer is required by federal law to automatically enroll participants, today more than half of employers—mostly those with more than 5,000 employees—offer auto-enrollment 401(k)s. Better yet, of those offered this plan design, 65 percent of those surveyed report they saved more. Workers who don’t have to make a decision about whether to contribute and then increase their contributions later clearly fare better than those faced with an array of personal choices.

Congress Slow on the Uptake

Despite all the flaws noted in the 401(k) system, Congress tends to do the same thing: raise contribution limits, which is great for higher earners who can save more. Due to inflation, the IRS recently upped 401(k) contribution limits for 2023.

But Congress also has been slow to grasp innovations in the marketplace to improve retirement savings. A bill slowly moving through the legislature—nicknamed “SECURE 2.0”—proposes auto-enrollment features, along with other enhancements such as expanding a “saver’s credit” for lower-income workers.

As with previous efforts to improve retirement contributions, the legislation would allow workers to contribute more. The bill does not address high fees or “middlemen” expenses. There is no “universal” savings plan proposed that would emulate the government’s superior Thrift Savings Plan (see above) or that would provide plans for those who are self-employed or who are not offered defined-contribution plans through employers (a handful of states do this).

Can the 401(k) be fixed? Many defined-contribution advocates think so, starting with making 401(k) transfers to new employers easier when employees switch jobs, instead of options such as a tax-triggering cash-out. Another proposal would allow workers to simply convert their 401(k) lump sums into fixed-payment annuities when they retire.

“Seamless plan-to-plan portability would not only help participants avoid cash-out leakage, but it would also save participants time and money in managing their retirement savings, and position them for the transition to retirement income,” says Tom Hawkins, vice president for 401(k) Clearinghouse.

There is active lobbying within the 401(k) industry to support changes that would boost savings for most Americans. The truth is that millions will not be able to enjoy a comfortable retirement from Social Security alone, which provides as little as 42 percent of pre-retirement income. Proponents of 401(k)s argue that defined-contribution plans can supplement the often-meager income from Social Security.

“For anyone other than a career minimum-wage worker, Social Security benefits are too low to provide a comfortable retirement and must be supplemented by either a traditional pension plan or the worker’s own retirement savings,” writes David John, a former senior research fellow for the Heritage Foundation.

“This situation will be made even worse by Social Security’s coming financial problems that will make it difficult to pay full promised benefits to everyone.”