News your connection to The Boston Globe

Avoiding mistakes in your 401(k) plan

PRESIDENT BUSH has proposed a shift to an "ownership society," where individuals take increased responsibility for their health insurance and retirement income. Before embracing this initiative, it is useful to look at one example of what happens when all the responsibility is shifted to the individual -- namely, 401(k) plans. .


401(k) plans emerged without debate in the 1980s as supplements to traditional employer-defined benefit pensions. Now they are the dominant pension arrangement. Buoyed by a roaring stock market, increasingly expensive pension regulations, and a shift away from large manufacturing companies, 401(k)s will be the sole supplement to Social Security for the majority of future retirees with pension plans. But these plans are coming up short. Simulations show that the typical household in theory should end up with about $350,000 in its 401(k) account at retirement, providing an adequate income. But the reality looks different. The Federal Reserve's 2001 Survey of Consumer Finances reports that the typical household approaching retirement has only $55,000.

A critical factor in explaining these low balances is that the entire burden has shifted from the employer to the employee. The employee must decide whether or not to join the plan, how much to contribute, how to invest the contributions, and when to rebalance, what to do about company stock, whether to roll over accumulations when changing jobs, and how to withdraw the money at retirement.

Evidence indicates that at every step a significant fraction of participants make serious mistakes. A quarter of those eligible to participate in a plan choose not to. Fewer than 10 percent of those who participate contribute the maximum. Over half fail to diversify their investments, many over-invest in company stock, and almost none rebalance their portfolios in response to age or market returns. Most important, many cash out when they change jobs. And very few buy an annuity at retirement.

The problem is that making decisions about 401(k) plans is difficult. Most participants lack sufficient experience and training. The cost of understanding the options appears greater than the benefits. As a result, they simply stay put. Once employees decide to participate and have set their contribution level and asset allocation, they generally make few changes.

Public policy could greatly improve 401(k) plans by leveraging this inertia and setting the defaults in 401(k) plans to "best practice." The plan would automatically enroll all eligible participants; it would set their contributions at the level that maximizes the employer match; diversify and rebalance their portfolios as they age; restrict investments in company stock; automatically roll over lump-sum distributions; and pay out retirement benefits in the form of a joint-and-survivor inflation-indexed annuity.

These defaults would eliminate the cost for participants of trying to figure out what to do. Individuals could opt out at any stage, allowing them to make different decisions if their situation warranted. But setting good defaults would help workers avoid mistakes. With a little help from "inertia," 401(k) plans could become far more effective vehicles for retirement saving.

Creating more effective retirement saving vehicles is critical as Social Security becomes a less important source of retirement income going forward. The legislated increase in the normal retirement age from 65 to 67 is equivalent to an across-the-board benefit cut. Premiums for Medicare Part B, which are automatically deducted from government pension checks, are scheduled to increase sharply due to rising Medicare costs. Social Security benefits will also be taxed more extensively under the personal income tax, as the exemption amounts are not indexed to inflation. In addition to these already scheduled benefit cuts, further reductions are likely as part of any compromise to eliminate the program's financial deficit.

With a diminished role for Social Security and the inadequate performance thus far of 401(k) plans, Americans need more forms of collective saving, not fewer. The clear message from the 401(k) experience is that financial decisions are complicated and individuals with busy lives do not make good choices.

We need to improve the retirement income prospects for workers. But our experience with 401(k) plans should caution us about transferring even more responsibility for crucial protections to overburdened workers. We should instead consider adding a mandatory retirement savings program between our declining Social Security system and our wobbly 401(k)s. This need not be thought of as a new government program, but as a communal effort to get each of us to do what we should do, but apparently cannot do on our own.

Alicia H. Munnell is director and Annika Sunden is research associate at the Center for Retirement Research at Boston College. They are coauthors of "Coming Up Short: The Challenge of 401(k) Plans."

Globe Archives
Today (free)
Yesterday (free)
Past 30 days
Last 12 months