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Money & Policy

7 Fatal Flaws in 401(k) Plans

The employer match is insufficient, plus six other problems that need fixing


(This article appeared previously on MarketWatch.com.)

Nearly a third of American households have nothing at all saved for retirement. It's also widely known that the other two-thirds of households have inadequate savings.

 
This is an awful state of affairs — and not just for future retirees. When a large, growing segment of the population is just scraping by, they collectively put a big strain on our common resources.

(MORE: 4 Ways to Fix the U.S. Retirement System)

 
Here are seven ways that America’s 401(k) plans are failing workers:
 
1. Restricted access to the best investment choices This is the biggest flaw in 401(k) plans. Workers should be able to put their money into the asset classes that are most likely to make their money work well for them over the long run.

I believe every plan's menu of choices should include nine equity asset classes plus a short-term and intermediate-term bond fund — and each one should be available through a low-cost index fund.

 
These nine equity asset classes are: U.S. large-cap stocks, U.S. large-cap value stocks, U.S. small-cap stocks, U.S. small-cap value stocks, international large-cap stocks, international large-cap value stocks, international small-cap stocks, international small-cap value stocks and emerging markets stocks.
 
Every one of these asset classes is available for employee retirement plans through low-cost, institutional index funds.

(MORE: Do You Know What's Wrong With Your 401(k)?)

 
2. Participation is not required I believe that many American households, with nothing saved for retirement, are headed by employed breadwinners who could participate in a 401(k) retirement plan. If I'm right, it means that millions of people who desperately need the benefits of retirement plans aren't taking advantage of them.

There are probably many reasons for that. But at the root of all those reasons is this fact: Workers don't have to participate.

 
Many employers, perhaps the majority, have established waiting periods before a new employee is even allowed to start making contributions. But that opportunity comes only after the employee has become accustomed to a paycheck that's a bit fatter than it will be if he or she chooses to join the 401(k) plan.
 
How's that for an incentive?
 
I think there's a better way that would still preserve each employee's freedom to choose. At the beginning of the employment period, automatically sign up each new worker unless he or she specifically opts out by signing a form legally acknowledging the choice to do without the retirement plan.

(MORE: Are Americans Able to Manage Their 401(k) Plans?)

 
Some employers will insist on a waiting period so they don't have to pay for the expenses of establishing an account for somebody who will be gone in a few months. That's legitimate. But they can deduct 6 percent of the employee's pay anyway and put it in a bank account. When the waiting period is over, the employee can either take that money in cash or have it all invested as a start in the 401(k).
 
3. Insufficient employer match I also think employers should be required to match at least a quarter of what each employee contributes — after the waiting period, of course.

Employers may squawk that this increases their labor costs. But this could be seen as essentially another form of pay. If all employers had to do this, none would be at a competitive disadvantage because of it.

 
Mandatory matching would provide a powerful incentive for employees to save for their future. Companies that want to provide financial incentives in recruiting and retaining employees, could obligate themselves to match up to 100 percent of employee contributions after particularly profitable years.
 
This is a variation on the bonuses companies give to their top executives.
 
4. Employees bear the costs Top executives commonly get perks like life insurance policies, financial planning, and other company-provided services. Do they have to pay the cost of those things out of their generous salaries? Of course not!
 
And yet many employers make their workers pay the costs of administering a 401(k) plan, which should be treated as an employee benefit that's paid for by the company. In far too many cases, the costs paid by employees are hidden in the form of higher fees for investment funds.
 
Even worse, some plans offer load funds that charge sales commissions levied on every employee contribution. This may be technically legal, but it's a gross injustice to the workers, who after all are a “captive audience.”
 
I can't see any justification for making the employees pay a commission when high performing no-load funds are available.
 
5. No Rollover IRA option Federal law allows — but doesn't require — employers to let employees move part or all of their 401(k) balances into a Rollover IRA while continuing to contribute to the company plan. All workers should have this option, which gives them access to virtually unlimited investment choices. But relatively few employers offer this.

I suspect part of the reason is that 401(k) plan administrators or managers don't want to lose the asset-based fees they collect from workers. The law should make this option standard in all retirement plans.

 
6. Too much company stock Corporate 401(k) plans often encourage participants to load up on company stock. There's probably no way to stop this short of a federal law, because employers with publicly-traded stock love the steady market that's created for their shares every payday.
 
I have nothing against corporate loyalty, but it's too easy for employees to gloss over the very real added risk that goes along with owning an individual stock — especially stock in a company they are already counting on for wages and benefits.
 
7. Default options are too safe Too many plans steer contributions to low-performance investments. It's bad enough that the employee's default option in many plans is simply not to participate. But for those who do sign up, it's equally wrong to have a default option of a stable value fund that virtually guarantees the employee will gradually lose some of the purchasing power of their savings.
 
I think the default asset allocation should be something that's likely to make sense for most participants. Obviously a default choice should not be very risky. But a 50/50 mix of stock funds and bond funds should be easy for most employees to stomach.
 
I'm suggesting that only as a default option for those who don't want to be bothered making decisions — or who are too busy with new jobs to focus on their investments. Most workers can and should do better.
 
In fact I think the most important choices that participants make is how their investment assets are allocated. In my next article I will give specific recommendations about this.
 
Paul Merriman is founder of Merriman Wealth Management, a Seattle-based investment advisory firm, and president of The Merriman Financial Education Foundation. Paul writes a weekly column for MarketWatch's The RetireMentors and records a weekly podcast, Sound InvestingHe has authored numerous books on investing including Financial Fitness Forever, Live It Up Without Outliving Your Money and the new How To Invest series available for free at PaulMerriman.com. Follow Paul on Twitter @SavvyInvestorPM.

Richard Buck contributed to this article. 

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