The reality is the 401(k) was never intended to be the primary source of retirement income when it was created in the 1980s. The pension plan (defined benefit plan) along with Social Security was to be the backbone of future retirement income. The 401(k) was an additional method for plan participant to save more for retirement. With the high cost of pension plans, most employers have made the 401(k) their primary retirement plan option and have done away with the pension plans.
The fallacies of the 401(k) are based in the Employee Retirement Income Security act of 1974 (ERISA). The government’s premise was to mandate certain conditions that must be met in order to offer a 401(k) plan.
The first fallacy is the requirement that the plan participant direct the investments within their 401(k). This is diametrically opposite to a pension plan where professional money managers and actuaries decide the investment methodology.
It has been well documented that the average investor fails to capture the average market return. In one study, where the market return was over 10% the average investor earned less than 2%. This is due to: a lack of understanding about investments, asset allocation, risk and return, Generally Accepted Investment Principles as well as inappropriate investor behavior such as buying high and selling low. Requiring that the participant make the investment decision is dooming the individual to failure.
The second fallacy is requiring the employer or plan sponsor to effectively run the 401(k) plan. The owners of most small and midsize companies are primarily concerned about making their business successful and effectively monitoring their 401(k) is not high on the list. Few of these employers truly understand their ERISA required fiduciary responsibilities. As a result, the employers often rely on the advice provided by the financial services industry that has sold them the plan. This is sort of like allowing the wolf to guard the henhouse.
The third fallacy is the outrageous and often hidden fees that the financial services industry extract from the billions of dollars of 401(k) assets each and every year. When reviewing one 401(k) plan for a technology firm in Silicon Valley, it was discovered that 31% of all of the plan assets were in a money market account. That account last year earned 0.08% and the total fees extracted were over 2.4% therefore leaving each participant with the loss on their money market account.
The hope is that the Department of Labor’s recently published proposed regulations will help fix some of these issues. The department understands that the plan participants need more investment advice to make proper decisions. To do this they are proposing the use of modeled portfolios that are certified by an independent third-party as being unbiased. The regulations also mandate that any fees or commissions received by an advisor not vary on the basis of the investment options selected.
The DOL feels that participants investment results will improve by $4-$8 billion per year due to improved quality of investment advice and a reduction in poor trading strategies.
Since these are proposed guidelines we will have to wait and see if the lobbying efforts by the financial services industry will shoot down these changes much like the fiduciary standard in Sen. Dodd’s recent banking regulation bill.
A worker’s 401(k) is often their second largest asset and it’s about time the workers of this country get a more fair shake with their retirement money.