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Charley Ellis Foresees a 401(k) Crisis

His advice for avoiding "grievous harm."

John Rekenthaler, 10/02/2015

The Prediction 
This past Wednesday, Charley Ellis gave a keynote speech at Morningstar's ETF Conference. Ellis is well-known among institutional investors for his early support of index investing and for authoring perhaps the most famous investment article of the 1970s, "The Loser's Game." His argument that money managers succeed more by avoiding mistakes (including those of cost) than by finding winners was decades ahead of its time.

Let's hope that he is less prescient with 401(k) plans, because he is pessimistic indeed. He opened his presentation, "Falling Short: The Looming Problem with 401(k)s and How to Solve It," by declaring that 401(k)s represent "the most important investment challenge" that the United States has ever faced. The "demographics on this issue are undeniable," yet "millions of Americans have no idea that [the problem] is coming their way."

How We Got Here
The origins of the 401(k) plan lie with John Rockefeller's Standard Oil Company, which established a voluntary employee savings plan in the 1920s. For several decades, however, most large companies offered defined benefits, rather than sought defined contributions. Defined-benefit plans were "the best financial service that has ever been." The company assumed all investment risk, made all the contributions, paid all plan costs, and took charge of all investment decisions.

As defined-benefit plans expanded through the middle of the century, so too did the scope of Social Security. Social Security payments, initially made to only to a minority of retirees, became more widely available. And they became larger--much larger. The payout rate grew from 15% of pre-retirement income at Social Security's 1935 launch to 28% in 1950, and then again to 40% in 1972. Real wages, of course, were also ballooning. The 70s were "the golden age of retirement" for American workers.

But they didn't know that. When 401(k) plans spread during the next decade, employees were beguiled by the promise of freedom. A 401(k) plan put them in control. They could contribute at their own rate, tailor their investment portfolio, borrow against assets as needed, and take the money with them if they left the company. What was not to like?

Unfortunately, responsibility cuts both ways. The power to create is accompanied by the power to destroy. Many employees did just that. Whether simply by not participating, or through errors such as contributing too little or withdrawing assets before retirement, these workers found themselves shorthanded at the time of retirement. Today, the median balance for a 65-year-old in 401(k) assets + IRA savings is $110,000. At a 4% annual withdrawal rate, that represents only $4400 per year.

Employer Recommendations
Companies need to realize that their employees need help. They need "nudges," to use economist Richard Thaler's term, to achieve better outcomes. For 401(k) plans, this means automatically making several decisions for the employee, with in all cases the worker having the right to opt out--a right that will typically be waived.

  1. Automatic enrollment--All new employees are placed into the plan, at an initial contribution rate.
  2. Automatic match--All new employees receive some level of match.
  3. Automatic escalation--All contribution rates are steadily increased until they reach a specified limit.
  4. Automatic indexing--All assets will be placed into index funds.
  5. Automatic target-date--All these indexed assets will be in the form of target-date funds.
  6. Automatic 4% payout rate--Plan participants who are retired will receive 4% withdrawal payouts.

Also, all workers must have access to a 401(k) plan.

is vice president of research for Morningstar.

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