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Why we do such a lousy job with our 401(k)s

The 401(k) retirement account, which has become a linchpin of the U.S. retirement system, is also a prime example of how Americans are failing to save enough for retirement. Pending legislation might help. By’s Roland Jones.
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In the roaring '90s, when the stock market was going gangbusters, Nick Bolick, a 42-year-old pilot with United Parcel Service, felt like an investing genius.

His retirement portfolio — including a company-run pension, a 401(k)-style investment plan and investments in blue-chip and technology stocks — was pulling in an annual return of 20 to 30 percent. Life was good — until the market turned south in 2000, wiping away almost half of Bolick’s retirement money.

“One minute everything was making money, and then everything went ‘pop,’” Bolick said. “I left about 30 percent of my money in mutual funds as a cushion against something like this, but I’d say I lost $200,000 when the market bubble burst. I’ve found professional help and bounced back since then, but I’m still probably out $150,000, and I have about 17 years left before mandatory retirement.”

It’s a common story in the aftermath of the market's crash: An investor loads up his 401(k) with stock investments only to see its value slashed by a bear market. But while Bolick’s experience is unusual — his company plan allowed him to take greater risks than the average 401(k) investor — it shows how poorly most Americans save for retirement.

The main problem, experts say, is the shift away from company-directed pension plans where all the decision-making was done by an employer. 401(k) plans, named after the section of the Internal Revenue Code that created them,  have shifted the responsibility for investing from professional managers onto the shoulders of individual employees. Many of them are either disinclined to manage their own retirement needs or just don't do a very good job of it. And much depends on the shrewdness of their investments in the years leading up to retirement.

“We’re asking everyone to become expert savers when they have very little expertise in the field and would rather be doing something else,” said Brigitte Madrian, an associate professor of business and public policy at the University of Pennsylvania’s Wharton School who has researched employee behavior in 401(k) and other employer-sponsored plans.

But help may be at hand in the form of pending federal legislation that would allow employers to offer plans that are far more automatic, provide financial advice so workers can save more effectively or simply allow employees to hand over the reins to their employers.

The changes are designed to make it easier to sign up for a plan, decide how much to contribute and allocate the assets.

“The evidence shows investors are not doing well, and while there are some who enjoy managing their investments, there’s a big chunk of people who want advice and don’t really know what they are doing. So there’s a movement in the industry toward restructuring savings plans so good things happen with minimal effort on the part of the individual investor,” Madrian said.

It wasn’t supposed to be this way. Originally envisioned as a supplement to Social Security and corporate pensions, few expected the 401(k) would become the dominant investment vehicle for retirees, supplanting defined-benefit plans, which provide a monthly payment for the life of the retiree.

But when it was introduced in the early 1980s, the 401(k) had distinct advantages from an employer’s perspective: It was cheaper than a traditional company pension, and the investment risk was transferred from the employer to the employee. Keen to reduce their future financial obligations to retirees, companies soon started offering the plans in earnest.

Yet not a lot of thought was given to the magnitude of the task the 401(k) imposes on workers, or to their ability to make wise investment decisions, notes Madrian.

Studies show 401(k) holders often fail to diversify properly, or make other mistakes. Many tend to invest too much in the stock of their employer, while others invest too conservatively and have no stock investments at all.

Few plan holders regularly rebalance their investments to maintain the target allocation, nor do enough people move money into bonds and other safer investments as they approach retirement. Procrastination is a major — and potentially costly — issue.

“A major problem with 401(k) plans is the average person starts one and chooses five investments when they start out, and they don’t change them for 20 years — more than half of the people I see do that,” said retirement planner Sam Liang of Rubino & Liang, LLC, who co-hosts a weekly Boston-area radio program focusing on the financial challenges of retirees.

Part of the problem, Liang notes, is a lack of good choices in many plans.

“People get to 50 and want to ease their risk, but the choices in a 401(k) are not good for that, aside from a money market fund [that pays] almost no interest,” he said. “So if you are 62 and you have enough money and want to preserve capital, your choices are limited.”

Jack VanDerhei, a fellow at the Employee Benefit Research Institute, which follows retirement issues closely, says the overall 401(k) saving picture is “very depressing.”

The average 401(k) plan balance of near-retirees aged between 60 and 65 is $187,000, which on its own may not be enough to fund some retirees’ financial needs in retirement. A recent EBRI study projects American retirees will fall far short of what they need by 2030 for medical and other expenses.

Some future retirees could avert this shortfall by saving another 5 percent of their compensation for the rest of their careers. But that solution is out of reach for some, such as low-income single women who would need to save an additional 25 percent of compensation, VanDerhei said.

Many Americans have not even gotten started, according to the EBRI. Some 50 million Americans, or 31 percent of workers age 21 and over, are enrolled in 401(k) plans.

One of the early casualties of subpar investing is the baby boomer generation, now approaching retirement, says Mike Benedict, a financial adviser at Weaver and Tidwell Financial Advisors in Fort Worth, Texas.

“Folks in the past were used to a pension funded by a company, but now we are seeing boomers retire and fund own retirement, and many of them are realizing they have not put enough money away. Part of it is the mentality and culture we had in the '60s and '70s, when people assumed that Social Security would handle retirement. And the 401(k) has only been around since the early '80s, and it’s a fairly new concept for this age bracket,” he said.

The underlying problem is a general lack of financial literacy, Benedict added. “We don’t do a good job of teaching in our schools and I think it’s something should be taught,” he said. “Our culture doesn’t reward saving. Instead it rewards consumption — you can see that in the houses we live in and the size of our cars.”

Pending legislation could reshape the 401(k), restoring much of the day-to-day decision-making to the employer and financial companies that administer the plans.

These proposed features would allow employers to enroll employees in their plans automatically, choose a default asset allocation, automatically rebalance their accounts and hire outside financial advisers to guide workers in their investment choices. Contribution rate escalators automatically will bump up an employee’s contribution rates each year.

An investment option known as a “life cycle” fund is growing in popularity. It automatically changes an employee’s blend of stock and bond funds as they approach retirement age. These funds relieve investors of the task of updating their portfolios to reflect their age and investment objectives.

The next frontier for retirement saving may be annuitization, which would allow retirees to turn over funds accumulated in their 401(k) plan in exchange for a regular monthly or annual payment for the rest of their life.

“The last few years were spent focusing on how to get people to accumulate money in a 401(k), but now attention is turning to how get people to manage their spending,” Madrian said. “Traditional pensions gave you a check until you die, so the next frontier needs to be tackled, and it’s certainly on the minds of policy-makers, financial companies and insurance companies: the option to roll over your 401(k) into an annuity at retirement, and as they get economies of scale, companies can bring the cost of this down.”

Some of these 401(k) changes are dependent on the passage of federal pension legislation, but David Wray, president of the Profit sharing/401(k) Council of America, a nonprofit group, is optimistic and expects plan participation to grow. Wray says that as new company hires adopt 401(k) plans they will choose these automated techniques for the convenience and security they offer.

“We are projecting that 80 percent of plan participants will be in these managed funds,” Wray said. “The system is evolving and improving every year, and we are learning how to improve it and make it work. And in just a few months you could see a very different world for 401(k) plans and retirement in general.”