A Perplexing Tale About 401(k)s

Henry David Thoreau, the author whose book Walden provided the inspiration for Morningstar's name, wrote that, "We are always paid for our suspicion by finding what we suspect." By that, Thoreau meant that we tend to find what we set out to find. When it comes to 401(k)s, Teresa Ghilarducci, the influential economist at the New School for Social Research, suspects that they cause lots of bad stuff--and, unsurprisingly and with great regularity, she finds it.

A partial, though far from complete, list of the maladies of the 401(k), according to Ghilarducci: She believes that defined-contribution plans make recessions worse, they increase income inequality, and they will bring an end to retirement as we know it.

I am beginning to think that she does not like 401(k)s.

But wouldn't even Ghilarducci acknowledge that the robust markets of recent years, in which equity indexes have tripled off their lows, have produced exceptional gains for retirement investors? Nope. In fact, in a column posted in The Atlantic, she suggests just the opposite. The deck for the column claims: "Most people think IRAs and 401(k)s have pretty much recovered from deep losses in 2008. They haven't."

In fact, 401(k) balances have recovered nicely in recent years. The owner of the largest database of 401(k) data available, the Employee Benefit Research Institute, reports that between 2007 and 2013, the most recent year for which its data are available, the average 401(k) balance grew at a compound annual rate of 10.9%. Note that the EBRI calculation includes equity markets' sharp losses in 2008--and still shows a dramatic increase in the average account balance. The increase in value was much larger for the "consistent contributors"--participants who made additional 401(k) contributions throughout the period.

So, how does Ghilarducci support her claim that retirement balances have not recovered? In her column, she says she and a colleague examined retirement account balances for 51- to 59-year-olds between the spring of 2009 and the fall of 2011. According to Ghilarducci, a significant minority of workers—nearly half--saw their account balances fall during this very short time frame. Note that this study incorporates returns for the third quarter of 2011, in which the U.S. stock market declined about 15%, but not for the fourth quarter of that year, when the market rebounded 12%.

The gist of Ghilarducci’s argument, then, is that 401(k)s are excessively risky because, over an 18-month period, some people saw declines in their retirement account balances. In the column, Ghilarducci does not report how many participants were in her sample, whether they continued to contribute to their retirement accounts, or even whether they withdrew money from them.

Whatever the flaws in Ghilarducci's research, her investment advice is even worse. When the market declines, Ghilarducci says that it should not be considered a buying or even rebalancing opportunity. Indeed, “rational people do not and should not buy more stocks with their retirement funds when their previous investments lost a significant percentage of its [sic] value.”

To the contrary, all other things being equal, if an investment gets cheaper, you probably want to own more of it. Morningstar's global head of research, Haywood Kelly, says: “After an asset class falls, that’s typically the best time to invest in it. Being a contrarian pays off.” In short, it is better to buy low and sell high, rather than doing the opposite.

So, is Ghilarducci’s entire argument a sham? No. To be fair to Ghilarducci, in various writings she does also raise legitimate concerns about defined-contribution retirement plans--especially the fact that many people do not have access to them at their workplaces and that people’s financial prospects may be diminished by sustained, adverse market returns when they near retirement. (This latter risk may be particularly acute now, given how stretched market valuations are.) In short, 401(k)s are far from perfect.

The good news is that there are potential fixes for many of these real and potential shortcomings of the defined-contribution system. Several members of Congress have introduced legislation to make it easier for smaller employers to form 401(k) plans. A number of U.S. states are considering or have enacted legislation that requires employers without workplace retirement plans to auto-enroll their employees in Roth IRAs. And last year the Department of Labor took tentative steps to make it easier for workers to annuitize a portion of their defined-contribution balances, reducing their exposure to market risk and simplifying the process of extracting income from a portfolio.

And beyond potential legislative and regulatory initiatives, there have already been improvements in the 401(k) space. In part because of more widespread adoption of auto-enrollment, Vanguard found that younger workers are participating in retirement plans at a materially higher rate than they were just a few years ago. Alicia Munnell, who runs the Center for Retirement Research at Boston College, has found--to her surprise--that the switch from defined-benefit to defined-contribution plans has not resulted in people accumulating less pension wealth. And as I have written elsewhere, the long-term trend for 401(k)s has simply been one of improvement.

In short, if you extend your time horizon past the third quarter of 2011, 401(k)s have a lot to recommend them. Returning to Thoreau, he wrote that, “the sun is but a morning star,” an expression meant to convey a sense of hope and optimism about a new day. It is not quite a new day in the 401(k) space, but maybe it could be if we all focused on improving 401(k)s instead of conjuring ways to tear them down.

Scott Cooley is Morningstar's director of policy research and formerly served as the company's chief financial officer. He is also a doctoral student in the Department of Political Science at the University of Chicago. Unless specifically indicated otherwise, the views that he expresses in this column are his own.