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Why 401(k) Plans Finally Work

Baffled by the complicated decisions, many employees threw out their 401(k) application forms and saved nothing. Other participants made unsound investments, putting all their holdings in low-yielding cash or in the stock of their employers.

To strengthen the system, the simplest approach would have been to throw out 401(k)s and return to traditional pensions. But companies were not willing to do that because old-fashioned pensions are expensive. Instead, employers have instituted a series of reforms. What has resulted is a system that has replicated many of the advantages of traditional pensions.

The Reforms

To ensure that most workers save, employers have installed automatic enrollment. Under this approach, money is automatically deducted from paychecks and invested in 401(k) accounts. If employees decide not to participate, they must take a positive action, filling out a form.

This is very different from the voluntary approach that was used in the past. Under the voluntary system, employees had to fill out forms in order to have their contributions deducted from paychecks.

The automatic system has produced dramatic results. According to a study by Vanguard, 72% of employees under 25 save when they are in automatic plans. When companies don't offer automatic plans, only 18% of young employees elect to have money deducted from paychecks.

To ensure that employees diversify their holdings, companies have introduced target-date funds. Holding diversified collections of stocks and bonds, the target funds are designed for savers who will retire around a certain year such as 2020 or 2040.

The funds start with heavy stock allocations and gradually shift to bonds as the savers approach the retirement age. At many plans, the target funds are default options; if savers do nothing, their money goes into an appropriate target-date fund.

With the increasing use of target funds, fewer young employees are putting all their assets in fixed income. Instead, new employees are investing heavily in stocks, an appropriate choice for savers who need to maximize growth over decades.

According to Vanguard, savers in their early 20s had 41% of assets in stocks in 2003. By 2010, the stock allocation had climbed to 85% as the use of target funds spread.

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