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3 Modest Proposals For Improving The 401(k)

Laura Shin
Retire Scrabble Tiles

Saving for retirement was once a lot easier than it is now.

Your employer offered you a pension, which guaranteed you a certain amount of income in retirement.

Now, your employer offers you a 401(k) plan -- if you’re lucky. Or maybe "lucky" isn't quite the word, considering it comes along with an obstacle course of retirement challenges: getting around to setting aside your own money, figuring out how much you need to put away, and choosing the best investments for it. Then, once you’ve reach retirement, you get burdened with another monumental task: figuring out how to turn that into enough income in retirement that you will be able to live comfortably but not so comfortably that you deplete your savings in your lifetime — an easy feat, since we all know our own expiration date, right? And if you don’t do all that correctly, then tough luck.

Now that the shift from pensions to 401(k)s is nearly complete, and now that baby boomers are starting to retire — 10,000 will turn 65 every day for the next 17 years — and especially because they are retiring just a few years after many saw their portfolios fall precipitously, the deficiencies of the 401(k) are becoming readily apparent.

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According to the LIMRA Secure Retirement Institute, while 49% of those 80 and older had a pension, only 7% of workers under age 30 have one, and in between is a steady drop-off. And now the current state of affairs is bleak: “Less than half of all workers have a retirement plan at work, and even the typical near-retirement worker with a 401(k) plan only has enough money in their retirement accounts to provide a monthly check of $575—nowhere near enough money for a secure retirement,” according to American Retirement Savings Could Be Much Better, an August report by the Center for American Progress. While many workers can also expect some money from Social Security and Individual Retirement Accounts, the vast majority are still woefully unprepared to support themselves in their golden years.

“The 401(k) has worked for some people but for most it’s been a failure,” says David Madland, director of the American Worker Progress and author of the CAP report. “Most people don’t accumulate enough money to retire and maintain they standard of living. The system has so many holes, it makes it unreasonably hard for someone to make it to a secure retirement. We’ve stacked the deck against someone for no reason except that we’ve designed a poor system that happens to benefit some people on Wall Street.”

The Government Accountability Office recently released a study of other nations’ 401(k)-like systems, noting that they offer several options of how to take your nest egg besides the lump sum and have higher standards for financial advisors, among other advantages.

But that is how those other countries are tackling the problems of 401(k)-like retirement vehicles. What are some American ideas on how to improve our 401(k) mess? Here is one innovative program already in effect, along with two proposals.

I. Dimensional Fund Advisors’ Managed DC

So, while the 401(k)’s flaws are fairly clear, what hasn’t yet been mentioned is why it supplanted the pension. The reason is not trifling: Pensions required companies to make a certain payout even if the underlying investments didn’t perform that well, which isn’t exactly a sustainable setup. But even though the 401(k) trumps the pension in this regard, its drawbacks, as shown above, now far outweigh this benefit.

For that reason, Dimensional Fund Advisors, the exclusive money management and mutual fund company that inspires such a passionate following among its clients that it is often compared to a cult, has come up with a retirement plan that assists participants in one of the main challenges of the common 401(k): turning the lump sum into a steady stream of income in retirement.

The back end of this SmartNest plan is an investment strategy meant to improve returns over time that focuses on small-cap stocks, low price-to-book stocks (which can sometimes signal a stock is underpriced), and stocks of companies with higher operating profits.

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On the front end (dubbed “Managed DC”), participants get a radically different experience from that provided in most 401(k) plans today. In retirement planning, the conventional wisdom is that you need to know “your number” — the total nest egg you need to amass by a certain date in order to have enough to live on the rest of your life.

Managed DC ditches all that and goes straight to the income calculation. In other words, participants experience it as a pension. Well, sort of.

What they actually get is a Web interface that allows them to manipulate sliders to see how their retirement income would be affected if they changed one of four variables: “a desired income target, which might default to 50% of one’s preretirement income and the probably of achieving it; a conservative income target, which by default has a 96% probably of success; pretax contributions; and retirement age,” as described by Forbes’ Matt Schifrin.

Sliders are provided that let you perform what-if scenarios. If you want to change your desired income from $5,000 per month to $6,000, the probability of you achieving that might drop from 75% to 35%. The only way to get back up to 75% would be to move the slider for pretax contributions from 4% up to 8% or slide your retirement age from, say, 65 to 70.

But what makes it much easier for participants is that moving the sliders then readjusts the investments in the background; the consumer is relieved of the burden of all the complicated calculations necessary to make their desired changes happen. (Currently, Managed DC is only available at a few companies.)

II. The SAFE Retirement Plan
The second way to improve the 401(k) that we’ll outline is the proposal from the CAP report. According to Madland, who wrote the report along with Rowland Davis, the current 401(k) system has four main problems, and here is how they propose to solve each:

1. Increase Access

“You only have about half of workers having access to their 401(k) plan in the workplace,” says Madland. To address this issue, the SAFE proposal would automatically enroll people in their retirement plans, instead of requiring employees to sign up for their employers’ plans. It would also make 401(k)s available to everyone, including those not full-time employed, such as freelancers. To make them available to everyone, a marketplace would offer options, much like the health care exchanges, and everyone would be able to take their 401(k) with them, even when they switch employers.

2. Lower The Cost And Improve The Quality Of Investments

“Most [401(k)s] have high fees and not the best investment options,” Madland says. To address these problems, the SAFE plan would require the assets to be invested in index funds that don’t try to outperform the market, but instead meet it. (Find out here why trying to outperform the market actually leads investors to  underperform it.)

3. Professional Management

Third, they posit that individuals will be the best long-term planners of their money, which would be true only in an ideal world. The solution? Require the money to be professionally managed. (Find out the 10 questions you should ask when evaluating a potential financial advisor.)

4. Lower Risk

And lastly, “[401(k)s] expose individuals to lots of risks — of the market falling right before they retire, or that they’ll outlive their assets in retirement,” says Madland. To ensure that individuals don’t outlive their savings, the SAFE plan would offer an inflation-adjusted lifetime payout, which would be accomplished by having a collar on the return so that when the market is especially good, participants get a little bit less than what their investments actually earned, and they later receive that overage when the investments underperform the collar.

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III. The Highly Regulated Option

The third plan, offered by Teresa Ghilarducci, chair of the economics department of The New School for Social Research, who often speaks on retirement issues, is more extreme than the proposals outlined above.

“My suggestion — and it’s going to go beyond any American suggestion but it very much piggybacks on the successful experimentations in Europe — is for 401(k)s that are very highly regulated,” she says. Here are her proposed solutions:

1. A Mandate

“Over half of middle and low income workers have no vehicle at all to accumulate savings for retirement,” she says. Her fix? A mandate for workers to have a 401(k) — as long as it’s an improved 401(k) system than our current one. (More on that below.)

2. More Choice And A Public Option

“The second problem is that when people do have a 401(k) they only have a commercial option,” she says, “and these are inadequate and inefficient, so they need more choice.” Her suggestion is essentially a public option — for workers to be able to have their 401(k) money managed by a state or non-profit entity.

This idea essentially copies legislation in California to study something called the Secure Choice Plan managed by the state pension system. “They’re not for profit and only have allegiance to participants, not shareholders. That would change everything. Everything,” says Ghilarducci.

3. Safeguard Against Predatory 401(k)s

Bad investment options, high fees and bad advice are the next big problems she sees, costing a median-income, two-earner family $155,000 in fees and lost returns, according to The Retirement Savings Drain, an investigation into the hidden fees of 401(k)s by Robert Hiltonsmith. To address those, she proposes that fund managers be fiduciaries who are required to act in the best financial interest of their clients, and won’t make a commission from selling them specific investments. “Don’t have investments mixed up with a [fund manager’s] profit motive,” she says.

4. Prohibit Early Withdrawal

A third of people withdraw money from their retirement accounts early, says Ghilarducci. She proposes that 401(k)s no longer have an early withdrawal option — that once money is put away, it is kept out of reach until retirement. Ghilarducci acknowledges that many people withdraw from their retirement accounts for emergencies, but she says, “[People] should have savings for non-retirement problems. We all know retirement happens so we all have to save for that. So don’t mix your 'life happens' with 'retirement happens.'”

“I would like to reform 401(k)s by following the vision of health care reform — everyone should have pensions and there should be a public option managed by a not for profit company — you know, single payer mandate,” says Ghilarducci.

She summarizes her proposal this way: “God help me if I had to solve the health care cost issue. But this is easy. Mandate savings, put it in a safe place with low fees and keep it there till you retire. Don’t have investment mixed up with a profit motive, and third, withdraw it in a way that you have money for the rest of your life.”

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Photo: 401(k)2013/Flickr