As 401(k) turns 30, let's make it better

Patrick Burke - April 10, 2012 at 3:06 PM

The 401(k) turned 30 last year and has shown itself to be a noble experiment. But as a vehicle to provide retirement security to most Americans, it has failed.

Consider this: The average 401(k) balance of workers nearing retirement is a meager $64,000. As a matter for comparison, a retiree wanting a $30,000 annual retirement payment would need a balance of about $445,000. Since the advent of the 401(k), private-sector defined benefit pension plans have dwindled by more than two-thirds. Today 401(k) plans, known as defined contribution plans, outnumber traditional pension plans 12 to 1. Expenses associated with 401(k) plans are more than twice the costs of defined benefit pensions. So the shift to 401(k)s was a way to shift most of the cost, as well as the primary responsibility of retirement savings, to the employee.

A new retirement plan is needed, and we can design one with some changes to the federal tax code. But to understand what must change, we first need to understand what went wrong with the 401(k):

  • Most people start saving too late and don't save enough. Current recommendations for retirement savings range from 10% to 20% of income — twice as much as originally recommended.
  • Many 401(k) participants don't diversify their investments appropriately or rebalance their portfolio on a regular basis.
  • Many participants panicked during the real estate crash and financial crisis and moved assets into stable funds, locking in losses while missing the subsequent rebound. In short, most employees have shown they are not skilled investors. It's not a job they wanted, and based on the numbers, it's not a job they were very good at.
  • Market cycles can create retirement winners and losers. When a strong market coincides with the beginning of one's retirement, everything is rosy. But if a major correction occurs just before a planned retirement, individuals might have to scale back their plans or keep working.
  • Longevity risk is the big unknown. Today, 1.9 million Americans live beyond 90 years of age. It is projected that by 2050, the number will exceed 9 million. People outliving their money is a significant, and growing, risk.

There will always be market cycles and some people will live longer than others, but under a traditional defined benefit plan, the risks and costs were mitigated by sharing with others in the plan.

Let's take the occasion of the 401(k)'s 30th birthday to consider a change to a new retirement plan. Here's one idea: a hybrid approach that would combine the advantages of the 401(k) with those of defined benefit plans. We would need to amend the tax code to allow pre-tax employee contributions into employer-sponsored defined benefit plans that would provide a guaranteed monthly retirement income. Such a plan would offer professional investment management to reduce risks to workers due to market volatility and longevity uncertainty. The new plan would have the portability of a 401(k) and investment costs would be lower, but participants would give up investment decisions.

Federal legislators need to hear from employers and employees who have seen the shortcomings of our 401(k) system. Members of Congress might not recognize the problem because they do not trust their retirements to a 401(k) plan. They enjoy a pension under the Federal Employees Retirement System — a hybrid plan that includes elements of both defined benefit and contribution plans.

The 401(k) came by chance, and stayed by choice, to be our default retirement savings plan. It is time to start a national discussion about a plan that provides security for all Americans.

Patrick Burke is managing principal of Burke Group, a retirement, actuarial and compensation consulting firm in Rochester, N.Y.