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The Invisible Hand Did Wonders for 401(k) Plans

However, now Washington's assistance is required.

John Rekenthaler, 04/25/2017

The Invisible Hand
This article reiterates a thesis advanced this past November, in "The Radical Fix for 401(k)s." This column approaches the topic from a different direction, so the argument is new, but the conclusion is not: The process that has successfully guided the growth of the 401(k) system appears to have run its course.

From the beginning, Washington has kept its distance from 401(k)s. Today's defined-contribution plans were born by accident, a side item in a 1978 tax bill. No Washington lawmaker can take credit--or blame, depending upon your perspective--for having envisioned a nationwide system of company-sponsored retirement plans, with voluntary employee participation. That … just happened.

Since then, Congress has pretty much stayed out of the way, letting the invisible hand determine 401(k) plans' development.

Three Victories
Laissez faire has fared well. Without federal prompting, the marketplace:

1) Settled on mutual funds as the standard investment.
Early rivals to mutual funds were company stock, cash, and private investment pools run by insurance companies. The first option was imprudent, the second was too conservative, and the third lacked transparency. Mutual funds deserved to win the competitive struggle--and they did.

These days, mutual funds are sometimes displaced by collective investment trusts, which are unregistered investment pools that usually (although not always) clone existing mutual funds. Also, exchange-traded funds are mounting a threat. Those investments aren't necessarily superior to the mutual funds that they seek to replace, but they are generally of a high quality, offering well-diversified, low-turnover portfolios at relatively low cost.

2) Developed default programs.
During the first two decades of 401(k) plans' existence, plan sponsors talked themselves blue in the attempt to turn their rank-and-file employees into enthusiastic investors. That attempt failed. With enough effort, and favorable demographics (wealthier, college-educated workers), companies could sometimes generate high participation rates. However, even then, many employees had unacceptably low contribution rates, and most disliked making the investment decisions.

Realizing that leading the horse to water was insufficient, plan providers and sponsors began to offer default programs that simplified employees' decisions. The first was automatic enrollment, which placed workers into 401(k) plans and selected the initial fund for them. That fixed the problems of nonparticipation and poor investment selection. Then, after automatic enrollment was established, the marketplace introduced auto-escalation programs, which addressed the remaining issue of low contribution rates.

is vice president of research for Morningstar.

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