The Invisible Hand Did Wonders for 401(k) Plans

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.

3) Invented target-date funds. The most-enthusiastic of target-date supporters say that target-date funds differ from the rest of the industry's offerings because they bundle "advice" into their service. That is a substantial exaggeration, given that target dates, as with all mutual funds, deliver but a single size to every shareholder. Also overstated is the importance of the funds' changing asset allocations; those positions move slowly over time. Practically speaking, owning a target-date fund is like holding a garden-variety allocation fund.

But that is plenty good enough. Quibbling about the investment details of target-date funds is to miss the point, which is that they are suitable, well-diversified holdings that make for a better portfolio than what most employees would assemble on their own. Plus, people like target dates; defining funds by their intended time horizons, rather than what they own, is intuitively appealing.

From the Bottom In 2006, Congress supported the marketplace's innovations with the Pension Protection Act. That legislation addressed the second and third of the above points, by removing legal concerns about default programs, and by sanctioning target-date funds (among other investments) as being appropriate selections. With these rules, Washington followed rather than led; rather than create a new path for 401(k) plans, the Pension Protection Act smoothed one that had already been trodden.

Score one major success for invention that bubbled up from the bottom, rather than being created from the top by fiat. One can certainly quarrel with the disappearance of traditional pension plans and argue that current corporate employees have worse retirement prospects than those of previous generations, but that is a separate issue. For the direct question of whether today's 401(k) plans are better than their predecessors, the answer clearly is Yes.

A New Era However, the marketplace's era appears to be waning. The 401(k) industry now faces three challenges that are unlikely to be resolved without Washington's assistance.

One is the difficulty of signing up smaller companies. While estimates of 401(k) market penetration vary widely, there's no doubt that while essentially all midsize and larger businesses offer some sort of defined-contribution plan, that millions of small companies, representing tens of millions of workers, do not. It's all very well to laud the virtues of low-cost target-date funds, owned through automatic-enrollment programs, but if the company doesn't have a 401(k) plan to start with, such benefits are only theoretical.

Another snag is the high costs paid by smaller companies that do adopt a plan. Television personality John Oliver complained that when he solicited bids for a 401(k) provider to deliver a plan to his small business, that the fund expense ratios were exorbitantly high. As his potential 401(k) provider responded, and this column detailed, there were valid reasons why the bid was so costly. Signing up plan sponsors, one minnow at a time, is an inefficient task.

The third problem lies with larger companies. They are beset by class-action lawsuits from legal firms seeking to profit from the settlements. While some of these suits have been merited, and they have spurred the positive side effects of forcing large 401(k) plan sponsors to watch their funds' expenses more carefully, the process of legislating through the courtroom is wasteful, as well as potentially unfair to 401(k) sponsors. It's one thing to punish companies for violating obvious, clearly articulated rules; it's quite another to do so because the legal interpretation of a vague statute is changing.

Political Matters All three obstacles can be resolved by the same measure: Decoupling companies from defined-contribution plans. In short, permit all U.S. private-enterprise workers, whether working at a company or self-employed, the same access to 401(k) plan providers. Whoever wants Vanguard's standard plan can have it, or Fidelity's, or Schwab's. Bingo! Immediately both small-company-related problems are resolved, and the plan-sponsor lawsuits would disappear, too.

Unfortunately, Washington these days looks to be in no position to do anything very useful, particularly for an issue like retirement savings that doesn't carry obvious political benefits for the party that advances the cause. The marketplace inspires far more confidence; it is motivated to seek change when change is required, and it's not hobbled by partisanship. But I don't see how market forces can accomplish this task alone. It needs a partner in Washington--a partner that looks to be on walkabout.

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.