Morningstar - Q2 2020 - 15

Dispatches

The New American
Retirement Plan
Why the 401(k) system
needs to be replaced.

I VO RY TO W E R S

John Rekenthaler

This article has been a long time coming.
My views on 401(k)s have evolved over the years,
but until now, always incrementally. My
columns advocated this improvement, that change.
Not this installment. It calls for an overhaul.
That statement is, to an extent, a confession.
The 401(k) structure is deeply unpopular with most
investment writers, who regard it as a patchwork scheme that permits companies to foist their
retirement-income risks onto employees.
Over the years, I have been among the handful
of exceptions, defending 401(k)s while others
denounced them. No longer.
As originally created, 401(k)s could never
serve as the nation's mainstream retirement
system. A scheme that is disseminated
through self-education appeals most strongly
to those who need the least assistance:
the company's highest-paid workers. The masses,
very often, are left behind.
This obstacle shouldn't have been a surprise,
as 401(k) plans were not invented to serve
the general public, being instead supplemental
tax-avoidance schemes for the privileged.
The issue wasn't immediately appreciated, though.
Companies spent the 1980s and 1990s attempting
to boost participation and contribution rates
through ever-increasing educational efforts. Their
successes were modest.
Automatic Advantages

Then came the logical enhancement: automation.
Don't expect most people to become investment

experts, any more than expecting them
to become self-trained car mechanics. Do the
investment tasks for them by diverting
money from each paycheck into a preselected
fund, then over time raising the contribution rate. Employees can exit the arrangement
if they wish, but few will do so. That would
involve effort.

In summary, automation's early results-
Laibson calls them "the proxy effects"-are fine.
The complications come later. One issue
is that many employees who are not automatically
enrolled in 401(k) plans, and who, therefore,
fall behind their auto-enrolled peers, eventually
catch up. When they do join their 401(k),
they invest more heavily to compensate for
lost time.

That worked for me. There remained the
considerable problem of serving those who lacked
access to 401(k) plans, typically because
their companies weren't big enough, but at least
the automated approach solved half the
country's problems. Employees who work
in midsize to larger companies would be placed
in well-diversified, low-cost funds that
they would rarely trade. Their contribution
rates would steadily increase, thanks to autoescalation programs.

As concerns go, that is not a bad one, because
it is relative rather than absolute. Research
didn't find that automated programs failed their
goals. Instead, it learned that the status
quo was better than advertised. Education was
a stronger path than I and other critics
believed. It might not succeed initially, but over
time, employees become more receptive as their
retirement dates near.

My confidence was misplaced. Four academics
have compiled disconcerting news about
the effectiveness of automated 401(k) services.
At the 2020 AEA/AFA Joint Luncheon, one
of those researchers, David Laibson (the other
three being John Beshears, James Choi,
and Brigitte Madrian), argued that automated
programs are not the panacea that I, and many
others, had believed.

The other finding, though, is a serious
problem. Whether participants are auto-enrolled
or not, leakage from 401(k) accounts, caused
by early withdrawals, is substantial. One paper
shows that for households under the age
of 55, average 401(k) outflows equal 40% of the
inflows. Another study, by Laibson's coresearcher Beshears, estimates that, within
the first four years, 25% of the benefits
of automated-enrollment programs are consumed
by early withdrawals.

It's not that the claims for automated programs
are false. When companies adopt auto-enrollment
features, their plan-participation rates immediately skyrocket. Laibson provides the
before-and-after results for four 401(k) plans that
added automatic enrollments. Collectively,
the participation rates for employees with 12
months of tenure averaged just over 50%
before the firms enacted automatic enrollment and
more than 80% afterward.
The contribution rates also rose. That improvement
was less dramatic, because sometimes
employees who voluntarily establish 401(k)
accounts select contribution rates that are above
the company's initial auto-enrollment rate,
but the direction was nonetheless positive. Also,
employees mostly accepted their autoescalation contribution-rate increases. Inertia was
indeed their investment friend.

Tax penalties, it turns out, are insufficiently
alarming. Each year, for example, 8% of
adults under the age of 59 1/2 remove money from
their IRA accounts.
Revolution

That's enough evidence for me. I was already
troubled by the 401(k) system's failure with small
companies. Thirty years after defined-contribution
plans hit the large-company mainstream,
they still are only sporadically available at smaller
firms. Although I have suggested some cures
for that disease, my prescriptions are not
particularly strong, because they use the existing
401(k) framework. The additional problem of
leakage closes the deal.
Those problems cannot be fixed incrementally.
Morningstar's policy analysts have diligently

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15


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Morningstar - Q2 2020

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Morningstar - Q2 2020 - Cover1
Morningstar - Q2 2020 - Cover2
Morningstar - Q2 2020 - 1
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Morningstar - Q2 2020 - Contents
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