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Rekenthaler Report

Jason Zweig's Proposal to Scrap 401(k)s

Strictly speaking, destruction may not be necessary, but the suggested improvements certainly are.

Brave New World?
Two weeks ago, The Wall Street Journal’s Jason Zweig published “Forget the 401(k). Let's Invent a New Retirement Plan.” The article neatly connects several of this column’s recurring themes, albeit sometimes in bolder fashion, because while this space--and Morningstar’s retirement research in general--tend to suggest incremental improvements, Zweig's commentary proposes an overhaul.

Improving Accessibility
The 401(k) system’s original designer, Ted Benna, has long been frustrated that 401(k)s are not ubiquitous. To be sure, they increased from nothing to common, but then their progress stalled. As Zweig points out, over the past 20 years the percentage of American workers who have access to employer-sponsored retirement plans has barely grown. Benna believes that the marketplace can take his invention no further; it’s time for regulations to play their part.

He (and thus Zweig) propose that all businesses with 10 or more employees be required to offer a retirement plan. New hires would be defaulted automatically into the plan, with their contribution rate raised periodically, until it reaches at least 6% of pay. Although this scheme would be mandatory for companies, it would not be so for workers, who could opt out after the initial enrollment if they chose. (They could also adjust their contribution rates.)

I see no need to stop at 10. Make the mandate apply to any and all employees, including the self-employed. But painlessly. That means:

1) No company below a certain size (and perhaps no companies at all) would be required to select, monitor, and pay for a retirement plan. Employees at such firms would bypass the company entirely, by being enrolled into a national system. (Zweig briefly touches on a similar proposal later in his article.)

2) The enrollment process would be highly transparent, so that the employee would know exactly what occurred, and the opt-out procedure would be simple. No employee should feel entrapped. Encouraged, yes, but not railroaded.

Protecting Retirement Income
Accumulating a nest egg is an essential first step, but there remains a second: how to convert the assets into income, with safety? One approach is to receive professional help, but for retirees who would prefer another path, today’s 401(k)s are deficient. They offer few solutions save for the occasional calculator. They are of little help to investors who wish to make their own income decisions.

For example, many investors would benefit by having longevity insurance, through a deferred annuity that pays its benefits in the future. Perhaps, writes Zweig, at age 85. That way, the person who retires at age 65 can plan for a fixed, 20-year horizon--a simpler process than budgeting for an uncertain life span--with the knowledge that if fortune is generous, in that retiree outlives the time horizon, that new income will be forthcoming.

Such deferred annuities are available today, through various insurers, but adoption has been slow. It is one thing to make an option available; it is quite another to convince the investment public of its merits. Thus, Zweig advocates that companies divert a small portion (perhaps as low as 0.5% of salary) of their employees’ contribution rates into an annuity pool. When an employee retires, those monies would be used to purchase a deferred annuity, thereby protecting against the danger of the investor outliving her money.

This is but one possibility for helping retirees turn their assets into income. Zweig does not suggest that it is the only such path, nor would I. Ideally (at least in my view), the government will nudge plan sponsors toward offering more assistance with income, and then the marketplace will arrive at the best solutions.

Taking It (Easily) With You
This recommendation is the simplest, and the least objectionable. Company retirement plans should be seamlessly portable, so that the retirement assets automatically follow the employee, wherever he works, throughout his career.

I can see no credible counterargument. There is no advantage to the current, helter-skelter approach, whereby one employee owns a 403(b) plan, another has a 401(a), and a third worker has investments spread across three plan sponsors. These are inefficiencies, created because the retirement system was assembled bric-a-brac, from a tax regulation that intended otherwise. The best way to eliminate the wasted efforts is to fix the problem from the top down, through new and better regulations.

(For those readers who dislike federal legislation--there are many of you--it’s important to note that existing company retirement plans aren’t without rules. On the contrary, they are over-regulated. Those rules need to be streamlined.)

Staying the Course
Frequently, 401(k) plans are criticized for leaking assets, because employees withdraw monies before they retire. This, writes Zweig, is very much the case. According to figures from the Federal Reserve and IRS, over the seven-year period from 2004 through 2010, on average taxpayers under the age of 55 removed between $0.29 and $0.41 on each dollar they owned of retirement assets. (The estimate has a wide range, presumably because of data limitations.)

That is a great deal. Zweig counsels that 401(k)s should protect investors better against their own worst instincts, by being more difficult to pillage. Initially, that idea bothered me. Unlike his previous three recommendations, this seemed to remove control from employees, rather than empowering them. However, his specific suggestion, courtesy of Brigham Young’s Brigette Madrian, seems reasonable.

Concede to the reality: Many workers, particularly the young, have little savings, and therefore are ill-positioned to respond to sudden financial needs. Address this problem by investing an employee’s early retirement-plan contributions into a “rainy-day fund,” which they could access, without tax penalty, for emergency spending. (Presumably, if they do not tap into their rainy-day fund, it would eventually be folded into the retirement pool.)

Of course, other solutions are possible. Madrian will be testing a pilot program in the United Kingdom, but hers is far from the only reasonable approach.

Wrapping Up
Although Zweig presents his program as a “New Retirement Plan”--the successor to the 401(k) platform--his proposals seem to be achievable within the current framework. There’s nothing radical about requiring that companies with at least 10 employees offer a retirement plan; improving the 401(k) system’s portability; and establishing retirement-income options and rainy-day funds. Those are sensible ideas that, at least for me, improve 401(k)s without changing their fundamental nature.

If I am wrong in that belief, that is OK, too. The legal structure for retirement plans, ultimately, is unimportant. What counts are their features.

 

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.