The Future of 401(k)s

The New Breed of 401(k)
Vanguard just published a nifty little 95-page document entitled "How America Saves 2013: A report on Vanguard 2012 defined contribution plan data." Light reading the document is not; there's a reason why it took Vanguard until June to release its 2012 edition. However, the paper is a great source of data not only on where the 401(k) industry stands today, but also on where it is heading.

(It's true that Vanguard is atypical among 401(k) suppliers, as the company features much lower costs and more index investing than do its competitors. However, with $500 billion of the defined-contribution market's $4 trillion, Vanguard is large as anomalies go. It's not the tiny exception that proves the rule. Also, while Vanguard tends to be off by its lonesome with costs and indexing, it is 401(k) mainstream in other aspects. If Vanguard is experiencing a trend, you can bet that the rest of the industry is experiencing it, too.)

Four items in particular struck me:

1) Low Trading Activity
For the full year of 2012, only 12% of Vanguard's defined-contribution participants made a trade. The 88% made no change to their allocations.

Vanguard participants likely trade less often than the typical 401(k) investor because of the company's emphasis on long-term strategic asset allocation. However, there's no doubt that 401(k) investors as a breed are inactive. In the late 1990s, many stock-market strategists warned that panicked 401(k) investors would turn the next bear market into a rout. Quite the opposite. When the New Era stocks splattered, 401(k) investors were highly patient. Rather than being fuel for a downturn, 401(k) assets helped to stabilize the markets.

2) Less Company Stock
Company stock remains a problem with 401(k)s. Among Vanguard plan sponsors that offer company stock to employees, 31% of participants had stock positions that exceeded 20% of their total 401(k) assets. Not all of those stakes should be considered rash, as in some cases the investor's outside assets would have adequately diversified the portfolio. Most of them, though, are mistakes. (Writes the man whose largest investment is Morningstar (MORN)! However, I do not own the stock through the company's 401(k) plan.)

Fortunately, only 10% of Vanguard funds offer company stock. (Unfortunately, those tend to be among Vanguard's larger plan sponsors.) This percentage has declined slightly over the past five years, as has the percentage of investors who choose concentrated positions. Overall, 9% of Vanguard participants held more than 20% of assets in company stock, as opposed to 12% in 2007. Not a number to celebrate--but the direction is correct.

3) More Automatic Enrollment
Half of Vanguard's large plans permit employees to be automatically enrolled, up from 40% in 2007. The percentage of total plans is lower at 32%, as 401(k) enhancements generally trickle down from the bigger plans to the smaller ones. Of the plans that have automatic enrollment programs, 70% also offer automated savings increases, whereby the participant's deferral rate is gradually increased over time.

4) More Target-Date Investing
This is the big number. The really, really big number, as Ed Sullivan would say. Target-date funds have won the field. Almost unanimously, plan sponsors are selecting target-date funds as the repository for automatically enrolled monies (at Vanguard, the figure is 90%). With those assets growing, and target dates remaining popular with investors who make active investment choices, target-date funds are becoming very popular indeed.

Half of Vanguard's participants use target-date funds in some fashion. Many own either multiple target-date funds or a target-date fund plus other types of funds, which isn't how target dates were designed to be used but is mostly harmless. (Having several target-date funds makes for a blurry picture, but the performance tends to be pretty much like that of the middle fund in the series.) The other half, or 27% in total, own nothing but a single target-date fund. In 2007, that figure was 13%.

The growth of target-date funds means that 401(k) investors will become even less active in the future. Of Vanguard investors who hold only a single target-date fund, only 2% (two percent!) made a trade during 2012.

In short, 401(k)s are improving. Their already low trading activity is moving even lower; the use of company stock is gradually declining; through the use of automatic enrollment programs, default options, and automated spending options, the plans require less effort from the employee; and the growth in target-date funds leads to better diversification. 

I Picked the Wrong Week to Stop Sniffing Glue
Thanks for all the great comments about yesterday's column on "The Retirement Gamble." There is much to be said in response. Unfortunately, I picked the wrong week to write a column that requires follow-through, because now is the time of Morningstar's annual investment conference. Thus, I'll address most of the issues next week.

Two brief items, though. First, many people view the pre-401(k) era as being better for everyday Americans because of company pensions. That was not my experience. The golden era of pensions was great for my uncle who worked at Boeing for 35 years, or for my grandfather who spent his career at the post office, or for my aunt who worked at the same college library for 30 years. It was not great for any of my extended family. My other relatives moved around a lot or worked in industries that didn't much offer pensions. They were hurting.

So, when debating about whether 401(k) plans are bad, we sometimes disagree on the premise. I see even flawed 401(k) plans as an improvement. Others do not.

Second, I fully agree with those who criticize 401(k) plans as being designed for the wealthy, not for the everyday investor. Yes, that is correct. The defined-contribution plan wasn't launched to make Americans financially safe. They were started as tax dodges for business owners and senior executives, and financial-services companies were interested by and large because they wanted to get their collective hands on the assets of the business owners and senior executives. The rest of the employees were an afterthought; taking care of them was a necessary evil.

However, that was then and this is now. The 401(k) has gone mass, and in doing so it's been changing its stripes. Look at the industry's current trends. None of them are for the senior executives. The 401(k) isn't adding brokerage windows, or exotic asset classes, or enhanced trading features. Instead, it's improving its appeal to the smaller, less involved, less financially sophisticated investor by getting those investors into the game via automated default programs. And for the bigger plans and major 401(k) providers, the default programs land in a pretty good place. Not cash, not a specialized fund, not high-cost options, but rather medium- to low-cost target-date funds that these investors hold through thick and thin, while rarely trading. 

I call that progress. Not perfection, to be sure, but progress.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.