Can You Afford to Retire?

401(k)s: the new retirement plan, for better or worse

401(k) was originally an arcane sub-paragraph in the U.S. tax code. But it became a revolution in retirement savings after the IRS ruled in 1981 that the 401(k) clause allowed workers to use tax-deferred salary money to build a retirement savings account. Since then, trillions of dollars have poured into 401(k) retirement plans, most administered by mutual fund companies. Below, inudstry insiders and other experts talk about the origins of the 401(k) law, the explosive growth of 401(k) plans and the mutual fund industry, the problems with 401(k)s and whether they will provide enough money for retired workers to maintain their standard of living. These comments are drawn from FRONTLINE's extended interviews for this report.

BIRTH OF 401(k)s

Elizabeth Warren
Professor, Harvard Law School

Much of the law governing 401(k)s, and much of the push toward 401(k)s, was not driven by ordinary workers looking for a way to set a few dollars aside for their retirements. It was driven by CEOs looking for tax protection in order to maximize the value of their retirements. ... If you read the legislative history ... of the 401(k), it's clear this was a little tax break for the folks who made lots and lots of money. ... That's the irony. What it was designed for and what it's being put to use for are totally different from each other. ...

David Wray
President, Profit Sharing/401k Council of America

In the Technical Corrections Act of 197[9], a one-line new provision was added [to the tax code], 401(k), and it said employee contributions could be tax-deferred. ... In 1981, the Internal Revenue Service interpreted that to mean any kind of employee contribution, so any kind of W-2 earnings that were deferred into a profit-sharing trust would receive special tax treatment. And boom -- the race was on.

Alicia Munnell
Director, Boston College Center for Retirement Research

No one thought this out. The 401(k) plans were originally introduced as supplemental plans. No one ever said, "Oh, let's end these traditional pensions and replace them with 401(k) plans." What happened was these 401(k) plans came in at the same time the stock market took off. People liked them because they liked having their own accounts that they could look at, and they liked being able to control their investments, particularly in an environment where stocks go up every year. And employers liked these plans because they didn't have to worry about the risk and what it might do to their earnings. ...

At the same time, these [lifetime pension] defined benefit plans became less useful tools for managing people. ... You have a much more mobile workforce, and so with a more mobile workforce, young people looked at these defined benefit plans and said to themselves, "I'm probably not going to be here 20, 30 years down the road, so it really doesn't mean anything to me, and I really prefer these 401(k)s." [On] both the employee and employer side, you had this easing from one system to another without anybody ever thinking, is this a good way to arrange people's retirement income?

Brooks Hamilton
Benefits consultant, Brooks Hamilton & Partners

In my experience, the old formal pension plan costs the average company somewhere between 6 and 8 percent of payroll. If you had a $100 million payroll and had a formal pension plan, ... you were paying $6 million or $8 million a year. ... That was the pension industry before 401(k).

And in 401(k)?

The company's contribution generally was structured to be a match based on whatever the employee put in. They might say, "You put in a dollar, we'll put in 50 cents." Well, suddenly the company had a great deal to gain if not 100 percent of the people joined the 401(k) plan. Let's say only half the people joined and put in 4 percent of pay. Well, the company matched 50 cents on the dollar, so the company would be putting in 2 percent of payroll for half the people. That's 1 percent of payroll. ...

David Wray
President, Profit Sharing/401k Council of America

By 1984, there were about 9 million people in these programs, and the reason for that was there was already an infrastructure in place, so that these weren't brand-new programs. ... A whole lot of companies already ... had what were called thrift savings profit-sharing plans, and they immediately converted their plans over to [401(k)s]. ... All you had to do was make relatively minor changes to an already-existing structure, and people who before hadn't been able to save on a tax-deferred basis could do so almost immediately. ...



Brooks Hamilton
Benefits consultant, Brooks Hamilton & Partners

It was a wildfire, and one of the sparks bounced over and landed in the mutual fund industry. ... The 401(k) plans and the mutual fund industry are joined at the hip; they're the same thing. ... In fact, an interesting number is that in 1990, only 5 percent of the 401(k) money was in mutual funds. In the year 2000, it was half.

They went from 5 percent to 50 percent in 10 years?

Ten years, from 1990 to the year 2000, it went from 5 percent to half. It's the greatest market penetration, to my knowledge, ever. Can you imagine starting a business and having 5 percent of the market and 10 years later having half of it? ... I think it's the most brilliant marketing strategy and the most aggressively implemented marketing strategy in the history of capitalism. It is absolutely breathtaking what was done. ... Frankly, it's a chicken-and-egg deal that gave rise to the greatest bull market in history. ...

David Wray
President, Profit Sharing/401k Council of America

The growth in the assets has been unbelievable. If you look at all of the different kinds of programs, what you see is in the private 401(k) marketplace, it's about $2 trillion, and it's another half trillion dollars from all the other sources. So it's probably $2.5 trillion at least, and that's up from virtually nothing 25 years ago.

John C. Bogle
Founder, Vanguard mutual fund firm

... When I came into this business, there were relatively small, privately held companies, ... and these companies were run by investment professionals. Today that has changed in every single respect. These are giant companies. They are not privately held anymore. They are owned by giant financial conglomerates. ...

When I came into it, it was a profession with elements of business. Now it's become a business with elements of profession, and not nearly enough elements of a profession in it. We've become a marketing business, and that's where you get all these choices [of investment options]. If the world wants something -- new toothpaste, new beer, better bread -- we give it to them in our consumer society. That's not the right way to run a business concerned with other people's money. That's a sacred trust; it's not a marketing game.



Brooks Hamilton
Benefits consultant, Brooks Hamilton & Partners

So in the mid-1990s, you are working ... as a record keeper, looking at a dozen, 15 large companies. What do you see happening over a period of several years with the 401(k) plans?

I was slow to see it. I should have seen it sooner, but my gut told me that forcing novices ... to direct their own investments was not really a good thing to do. I used to ask the CEO, CFO of my major clients, ... often in a conference room [after] some young employee would bring in coffee, and as they would be leaving, I would ask the CEO, "Would you allow that employee to direct the investment of your account in the 401(k) plan?" They always thought I was some kind of idiot: "Of course not. I wouldn't let them touch my account with a 10-foot pole." And I said, "But you force them to manage their own!" And they are running their money into the ground.

... We decided to look at the top 20 percent and the bottom 20 percent [of 401(k) participants, based on annual rate of return]. ... The same story [was] repeated over and over. The top 20 percent [of plan participants] always did anywhere between five and six times the annual investment rate of return of the bottom 20 percent. If the bottom 20 percent, say, had a 4 percent return, ... the top 20 percent might have had a 25, 26 percent return. ...

I label[ed] this yield disparity. I just coined the term. I thought, we have a yield disparity that is a financial cancer in our great, beautiful 401(k) movement. I had never seen it before, but it was everywhere I looked.

What do you mean a financial cancer?

It would destroy the opportunity for ordinary workers to retire in dignity. They couldn't get there from here. There is no way.

David Wray
President, Profit Sharing/401k Council of America

We started out with relatively few people. We had some terrific ideas. We have a great government program, but we're learning how to do this. ... There was an expectation in the late 1980s, the early 1990s, that if we gave people choices, if we built them a wonderful structure, we gave them great investments and daily evaluation and Internet access, that there would be a rush to taking advantage of these programs: "If we build it, they will come." ... I think what we have learned is if we build it, some will come, but some won't.

A lot.

A lot won't. So I think the thinking is being reappraised, and companies -- at least companies who are interested in reaching out to their employees -- are saying, "We need to actually act for the employees." ... We're moving ... to begin ... automatically enrolling people in the programs, to automatically escalating their contribution rates so that you get them to an appropriate savings level over time, to investing the money for them. ...

So it sounds to me that if you move to a system where the employer is by default, putting employees into the 401(k) plan, determining their level of participation and then managing the money, we're virtually back to a defined benefit plan, except that the employees are footing 50 percent of the bill, and they've got all the risk instead of the employer.

It's very interesting to look at where the system is going. ... We're really going back to where the retirement system as a whole was based prior to 1980, which is back to that it's an employer-driven system. ...

Brooks Hamilton
Benefits consultant, Brooks Hamilton & Partners

So the answer now that's being put forward is, "OK, we will give you the option of turning it over to Fidelity or one of the other mutual funds." Is that going to work? Will that fix it?

You must save more, earn more, work longer. Those are the three things we control. Fidelity managing my account is not part of that equation, so I don't see that as part of the answer. If Fidelity manages my account, does that mean I save more? Not at all. Does it mean I work longer? Not at all. Does it mean I earn more? Probably not.


It's fees and expenses, and unfortunately most fees and expenses are not even revealed.

But you may get a better return on your investment with professionals doing it.

... [John Bogle] testified before the Senate in November of 2003. ... He basically said ... from [1984] to 2002, when the [stock] market did [a] 12 percent [annual] return, the mutual fund industry credited 9 percent. ... The average investor [in mutual funds], according to [mutual fund data collector] DALBAR, did 2.7 percent. ...

That's 2.7 percent growth per year.

Per year, yeah. ... So now the solution is to turn it over to them? I thought that's where we had been.

And it hasn't worked too well.

It hasn't worked too well.

John C. Bogle
Founder, Vanguard mutual fund firm

Investors should realize [they] don't get the market return. In a 9 percent market, we all share 9 percent before we pay the cost of financial intermediation, and after we pay those costs, which are about 2.5 percent a year, we get 6.5 percent on a 9 percent market.

So if I do your average, what percentage of my net growth is going to fees in a 401(k) plan?

Well, it's awesome. Let me give you a little longer-term example: ... an individual who is 20 years old today starting to accumulate for retirement. That person has about 45 years to go before retirement -- 20 to 65 -- and then, if you believe the actuarial tables, another 20 years to go before death mercifully brings his or her life to a close. So that's 65 years of investing. If you invest $1,000 at the beginning of that time and earn 8 percent, that $1,000 will grow ... to around $140,000.

Now, the financial system -- the mutual fund system in this case -- will take about two and a half percentage points out of that return, so you will have ... a net return of 5.5 percent, and your $1,000 will grow to approximately $30,000. One hundred ten thousand dollars goes to the financial system and $30,000 to you, the investor. Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return, and you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That is a financial system that is failing investors because of those costs of financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed.

I've got to unscramble what you just said. You said that in the case of the $1,000 invested for 65 years, the financial system is taking 80 percent of the money. But most of us aren't doing that. In the first place, at 20 we're out spending it; we're not putting it away. But set that aside. We're really talking about people who are probably saving from 35 or 40 or 45 at best for retirement at 55, 60 or 65. and they are plunking the money away into 401(k)s. I'm just asking you, in that system, roughly what chunk of it are people getting back themselves out of their gains, and what chunk of that is going to go to the financial system for managing their money?

Well, in the long run, it's 80 percent to the financial system, 20 percent to you. In a given year, it's about 80 percent to you and 20 percent to the financial system, so if you look at 10 years or 15 years, you're probably talking about 60 percent to you and 40 percent to the financial system maybe over 20 years, something like that. But the longer the period, the greater the impact of that tyranny of compounding costs is.

How do you get costs out of the system? ...

Easy. You own [a market index fund]: the entire U.S. stock market or maybe 25 percent international, the entire U.S. bond market, or just simply go to government intermediate-term bonds and don't pay anybody for those services. ... It is all you need to pay to own the market.

David Wray
President, Profit Sharing/401k Council of America

I agree with Mr. Bogle. ... Fees can eat up a lot of your gains. In the 401(k) system, if you're in larger companies, the fees are much lower than any other investable program. The 401(k) is actually the very best way to invest your money that an individual could have. [For] small companies, the fees are going to be retail, but at least the employees are getting the employer match, and the match is certainly offsetting the fees. Employees have more money than they would have if they didn't save at all, but certainly they're not in as advantageous a position as someone who can have an S&P [Standard & Poor's] 500 index fund. ...



Jack VanDerhei
Senior Research Fellow, Employee Benefits Research Institute

... As a nation, we're dependent essentially on defined contribution, and that means mainly 401(k) plans. Are major fixes needed in the 401(k) system?

I would say there are many fixes that are relatively easy to accomplish that would get much of the perceived problem taken care of almost instantaneously.

Such as?

Automatic enrollment. Automatic enrollment takes care of those low-participation-rate problems we mentioned.

The other thing is, employers have tended to put [employees' monies] into default investments which are very low risk. The problem [is], low risk means low expected return. If you're sitting in a money market fund or something similar to that on day one when your employer puts you in that, you have a tendency to stay in there. If the employers thought that they would be safe by putting employees in an age-appropriate equity position as a default investment, all the simulations we've run show that account balances for these individuals would increase substantially, especially for the low-income individuals.

The other thing -- if you want to go out to something perhaps more radical -- is ... stricter penalties for pulling monies out of the retirement system. ... Increased tax penalties, maybe even restrictions on pulling money out, I think would go a long way to curbing the leakage problem ...

Other things that you might want to consider [are], what happens at retirement age? Should, perhaps, a portion of the monies be mandated to be annuitized? ... If you look at a package of those types of revisions -- and some of those have been suggested in recent legislation, you would go a very long way to curbing the problems that many 401(k) participants today experience.

Brooks Hamilton
Benefits consultant, Brooks Hamilton & Partners

... I regret the fact that our retirement income strategy in major companies is the 401(k), because I think it may be fatally flawed. I know it's flawed; it's either fixable or it's not, and I won't pass judgment on that. I know that there's a growing number of people who feel it's not fixable. ... I look back and think, how many people are going to be worse off because their pension benefit is gone and they now have a 401(k) plan? ...

Alicia Munnell
Director, Boston College Center for Retirement Research

…The winners under the 401(k)-type arrangement are people who have mobile careers or intermittent careers. Women probably are doing better with 401(k) plans than they would have done under the old type of old-fashioned pensions, because they have an account; they can keep it with them. Whenever they go back into the labor force, they can add more to it. In the old days, if they left mid-career or got there late, they would not end up with a significant pension. It's really those type of mobile employees who have done better.

But the long-term worker who stays with his employer has really lost out. And the people who are really losing out are the people who are caught mid-career, late 40s, early 50s, when their employers freeze their pension….

John C. Bogle
Founder, Vanguard mutual fund firm

…If you were to just design the perfect retirement plan, you would own [index] the stock market or you would own the bond market. You would get all the costs or all that you possibly could out of the system. So on an annual basis, if the market went up 8 percent, you would get 7.8 or 7.9 percent.

... The federal government has a defined contribution plan, a Federal Employees' Thrift Plan. And guess what they do? They buy index funds and just a very simple line. You can actually have a government bond account or a U.S. index or an international index. So our legislators and our federal employees get these great benefits through as close to a perfect retirement plan as you can have, owning the financial markets and holding them forever. We don't do that for our regular citizenry. ... So it's not just me who is saying index the market, capture the market's return, get costs out of the system, be bored to death and have a comfortable retirement.

Elizabeth Warren
Professor, Harvard Law School

…The 401(k) experiment is coming into its own now. More and more, employees will be asked to cover it all themselves. That can be good news in a rising stock market. That can be good news if you don't get really sick when you get old. That can be good news if you don't live very long after you retire. But all of those risks [rest] on each individual worker.

The way I look at is ... that all the little boats out in the harbor were linked to each other, and if one sprung a really bad leak, the rest of them kind of held it up. That was what defined benefit pension plans were like. Now ... all those little boats have been cut loose from each other. If one sinks here and one sinks over there, ... they just sink. If you happen to be on a boat that floats, you'll do fine, but if you're not, you drown. …

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posted may 16, 2006

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