(Bloomberg Gadfly) – Ted Benna, the man widely regarded as the father of the 401(k) plan, recently reflected on his creation – and he wasn't happy. Benna laments that 401(k)s have become so complicated and so expensive and so rife with opportunities for mistakes.
As we know, 401(k)s and other defined contribution plans have become the go-to retirement plans for private sector workers. According to the Employee Benefit Research Institute, 84% of private sector workers who participated in an employment-based retirement plan were enrolled in a traditional pension in 1979. By 2011, 93% were enrolled in a 401(k) or other defined contribution plan. (401(k)s are the largest and most common type of defined contribution plan).
4Amid such heady growth, we should also acknowledge that 401(k)s aren't serving their beneficiaries well and start thinking seriously about how to fix their many problems.
First, they’re too complicated. There are too many investment options. Does anyone really need ten different U.S. large cap mutual fund options? It’s also not obvious how to assemble various options into a sound portfolio, particularly for workers who are first-time investors.
Second, 401(k)s are too expensive. A typical 401(k) is a clown car of high-priced actively managed funds. Even the odd index fund is more expensive in a 401(k) plan than it is outside of the plan. Fees and others costs also aren't very transparent for participants.
Third, too little information is available to employees. Typically, the only information available about investment options is past performance. But if past performance isn’t indicative of future results, as we all know, then why is that the only information available to employees? This set up practically begs employees to chase high-flying investments that might swoon.
Fourth, participation rates in 401(k)s are too low. Enrollment isn’t automatic in most plans.
No one wants to own these problems. Employers say that they can’t afford the liability that may come with making investment recommendations to employees, or even offering a curated menu of investment options. Mutual fund companies say they have to charge more for 401(k)s to compensate for higher legal and regulatory burdens. Regulators say that strict rules are necessary to protect workers.
Under-performing 401(k) plan? Maybe it's where you live. Judy Diamond Associates reviewed more than half a million 401(k) plans throughout the country to determine which states had the highest amount of under-performing plans. Rankings are based on rate of return, participation and employee contributions.
This mess is a far cry from what Benna first had in mind. His original 401(k) “could be explained to employees in just a minute.” Benna recalls that “There were two options, a guaranteed fund and an equity fund,” and that “Most people would split their contributions 50-50 between the two.”
Benna had it right the first time. We can cure most of 401(k)’s ills by going back to his original concept, and we wouldn’t need to wipe out the current system to do so.
Here’s what I propose: The federal government should offer a fund that is 50% stocks (say, S&P 500) and 50% bonds (say, U.S. aggregate bonds). This Federal Fund, let’s call it, is admittedly not the perfect portfolio, but it has other important virtues: It’s intuitively appealing and easy to understand, and it would be simple and cheap to operate.
All 401(k)s would be required to offer the Federal Fund as an investment option, and employees would be automatically enrolled in the Federal Fund unless they chose something else.
How much money's here?
At least $4.4 trillion
Oh, and the Federal Fund would be totally free – that’s right, a zero expense ratio. We could easily pay for it by assessing a miniscule tax on all other 401(k) investment options of, say, one-eighth of one basis point (0.00125%) on the assets they manage. According to the Investment Company Institute, 401(k)s held an estimated $4.4 trillion in 2014 (that number is almost certainly higher today), which would generate $55 million annually – many multiples of what would likely be required to operate the humble Federal Fund.
Even if the Federal Fund proved to be insanely popular and gobbled up all the 401(k) assets – which in reality will never happen – the worst case is that it would have to charge a small expense ratio. The cheapest exchange traded fund charges just 0.03%, and the Federal Fund could be offered at least that cheaply, which would still be a huge improvement on what 401(k) participants currently pay.
In one fell swoop, the Federal Fund would plug all the holes in 401(k) plans.
In the meantime, there are simple steps employers can take to drastically improve 401(k) plans. First, the default should be opt-in rather than opt-out. Employers could set different contribution levels commensurate with employees’ salaries.
Second, cost should be the first disclosure to appear alongside each investment option. Cost should also be shown in dollars over an entire career rather than just as an expense ratio. My Bloomberg View colleague Noah Smith artfully demonstrated how this might be done.
Finally, every 401(k) plan should have ready-made portfolios labeled “conservative” and “moderate” and “aggressive” so that employees can quickly and easily choose an investment option.
Those simple steps are a good start, but they won’t be enough. If we really want to realize the potential of 401(k)s, we’ll need to channel our inner Benna.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
