The Radical Fix for 401(k)s

Not Good Enough Today's 401(k)s are much better than their predecessors. Plan providers invented target-date funds to reach workers who could not make investment decisions no matter how many education seminars were offered. They launched automatic-enrollment programs to boost participation rates, and then auto-escalation features to raise savings rates. Finally, at many companies, they have slashed fund costs by substituting index funds, institutional share classes, and collective investment trusts for their original offerings of retail-priced mutual funds.

This improvement, sadly, is beginning to look as if it has run its course. Yes, the marketplace has done its best to adjust the square peg to fit into the round hole. Legislators, too, have responded, most notably by enacting the Pension Protection Act of 2006, which green lighted auto-enrollment programs. But for all those efforts, tens of millions of working Americans remain without access to any 401(k) plan whatsoever, and tens of millions of others pay 25% or more of their expected long-term returns in the form of plan fees. Those unhappy realities don’t appear to be changing anytime soon.

That situation would be acceptable if 401(k) plans retained their original role of being a corporate perk. In 1980, adding a plan helped companies distinguish themselves when bidding for higher-salaried talent. The 401(k) was a fringe benefit, no more and no less. Nobody viewed 401(k)s as vehicles for the masses. Nobody expected that 401(k)s would replace pensions as the third leg of America’s retirement stool (the other legs being Social Security and taxable savings).

An Immodest Proposal It is one thing to be a fringe benefit; it is quite another to be a retirement pillar. The 401(k) excels at the former; however, despite its many improvements, it remains a long ways from becoming the latter. It is time, I believe, for a radical change. Whereas previously I have suggested incremental enhancements, working within the existing legal framework, I now advocate an explosion. It's time to abolish corporate sponsors' fiduciary duties.

Permit me to explain. Currently, companies that sponsor 401(k) plans have the legal requirement, under ERISA regulations, of conducting due diligence on plan providers. They must sort among potential vendors, make a prudent selection, document their decisions, and monitor results. They can be--and sometimes are--sued for negligence if they fail in these tasks.

Burdening the company sponsor with fiduciary duties made sense back in the day, when 401(k)s were supplemental features and when there were relatively few such plans. The company sponsor made the decision to add a little-known benefit. It needed to do some homework. For their part, plan providers were inventing on the fly. This was a new service; there were no rule books, and there was plenty of opportunity to make mistakes by giving employees inappropriate fund lineups.

Today, things are very different. What was an option has now become a virtual requirement. That changes the equation. Thirty years ago, a company that lacked a 401(k) plan because it didn’t wish to spend the time and money to become a fiduciary might suffer in attracting new workers. If so, bad for that firm’s business. Today, the company without a 401(k) plan prevents its workers from gaining access to one of the country’s three retirement pillars. Bad for those workers. Bad for the nation.

The situation of the plan provider has also changed, substantially. Every major provider has assembled an off-the-shelf fund lineup, with off-the-shelf services. While the very biggest and most sophisticated corporate sponsors might wish to prod the merchandise and request customizations for its tastes, most companies will have no such desires. They have businesses to run, not amateur investment management to conduct on the side.

In addition, the plan-provider business has largely become commoditized. Services are very much alike for the various vendors. Ditto for the investment lineups that consist of index funds (setting aside the issue of costs, that is, and allowing for the exception that is Dimensional Fund Advisors). Even among those providers who run actively managed funds, there is much homogeneity. They generally default employees into their target-date funds, which share similar asset allocations. Their remaining funds tend to be in core investments and managed conservatively.

In Brief There's little that is gained with current fiduciary rules and much that is lost. Better to cut the cord. Have all plan providers register a standard lineup/service with a single organization. (Whether the members of this organization come from private enterprises or government agencies is up for discussion. It matters not for this proposal.) This organization would review each application to ensure that providers meet a minimum quality standard.

The result would be a provider “buy list.” Every U.S. company with more than one employee--we’ll set government workers aside for the moment--would be required to select a provider from the buy list as its default 401(k) supplier. However, the system would open so that those who wished to use another provider could do so. Because the system is national, and the role of the company sponsor merely to act as a facilitator, plan costs would not varied. The worker at the company with two employees would have access to the same plan, with the same expenses and features, as the worker at a company of 20,000.

Companies that used this standard, off-the-shelf structure would face no legal liabilities. They would have no fiduciary duties as currently defined. Naturally, some companies would seek customization or perhaps lower-cost choices on account of the volume of assets their plans contain. They would be permitted to seek such changes, but in doing so they would assume fiduciary responsibility.

There is much, much more to be said about this scheme and several hard questions to be answered. Nonetheless, its direction feels correct. The incremental approach has taken us far. But now the bridge that must be crossed requires something more substantial.

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.