Why 401(k) Plans Finally Work

NEW YORK (TheStreet) -- After years of frustrating trial and error, there is good news to report about 401(k)s. The savings system is beginning to work effectively.

Most employees are now tucking substantial amounts into their accounts and the portfolios are properly diversified. The improvements are too late to help many older workers who have inadequate savings to support their retirements. But recent changes should go a long way toward ensuring retirement security for people in their 20s and 30s.

The positive outlook represents a dramatic shift from the picture that appeared only a decade ago. At the time, the 401(k) system appeared badly flawed. All too many employees were investing in the wrong things -- or not saving at all.

Recognizing the problems, companies introduced a series of reforms, including automatic enrollment and balanced funds that made it easy to build diversified portfolios. In recent years, the reforms have begun producing dramatic gains.

The roots of the 401(k) crisis can be traced to developments of the 1980s when many companies were eliminating their traditional defined benefit pension plans. To replace the old retirement plans, a growing number of employers introduced 401(k)s. But there were key differences between traditional pensions and 401(k)s.


The pensions promised fixed monthly payments to retirees. To fund the monthly checks, employers put aside cash and hired professional managers to oversee it.

From the employees' point of view, the system worked automatically. Individual workers did not have to worry about whether their retirement plans were managed properly. If pensions faced a shortfall, employers had to make up the difference.

Under the 401(k) system, employees had to decide whether or not to save at all. If they did elect to save, the plan participants had to select where to invest the money. Employers could supplement the savings. But if the retirement plans produced skimpy nest eggs, that was the employees' problem.

In retrospect, the entire 401(k) strategy was shaky. The system assumed that janitors and clerks could make complicated investment decisions. However, it soon became apparent that even many employees with business degrees lacked the ability or motivation to save enough and invest it properly.

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.

Besides offering target funds, some employers are also hiring financial advisors who help employees invest their assets. Both approaches are helping to boost returns. According to consultant Aon Hewitt, employees who use target funds or receive advice get higher investment returns than people who must make decisions on their own.

When target funds are combined with automatic enrollment, employees can enjoy a sound retirement strategy. In many respects the new 401(k) plans now resemble the old days when employees enjoyed the security of traditional pensions.

Make no mistake, even the best 401(k)s are not as good as typical pensions. If the stock market stagnates for years, today's savers could be disappointed at retirement time. But the new reforms have improved the odds that 401(k)s will provide solid retirement income.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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