Money & Policy

Put Your 401(k) to the Test

See if your retirement plan has the best and latest features

The debate continues to rage over which is better: a traditional (defined-benefit) pension plan or a defined-contribution plan, such as a 401(k) or 403(b).

In reality, fewer and fewer workers are likely to have a pension plan — which many view as the most "efficient" type of retirement plan — and more and more people will have a defined-contribution plan.
So the better debate to have would be about which features a best-in-class 401(k) should have. After all, if you're going to have a 401(k) plan, it might as well be a good one. OK, which features should it have?

(MORE: The Downside of a Popular 401(k) Feature)

What a Best-in-Class 401(k) Looks Like

Well, according to at least one firm, it's a bit of a mashup: the best of what a defined-benefit plan has combined with the best of what a defined-contribution should offer.

"If you design a defined-contribution plan that uses the same factors that make defined-benefit plans efficient, you get an efficient defined-contribution plan," said Donald Fuerst, a senior pension fellow at the American Academy of Actuaries.

According to a new report from the TIAA-CREF Institute, "Equivalent Cost for Equivalent Benefits: Primary DC Plans in the Public Sector," the following elements make up a "best-practice, risk-managed" 401(k)/defined contribution plan:

These features — perhaps with the exception of annuitized benefit payments and limited or no borrowing — are in line with what other groups and plan sponsors say make up a great 401(k) plan. "They have it substantially right," said Fuerst.

(MORE: Fighting to Make 401(k)s Last a Lifetime)

Disagreement Over What's Best

But before you head down to your human resource/employee benefit department demanding that your plan add these features, there are at least two things you should know. One, not everyone seems to agree with the elements on the list. And two, not everyone wants what's on the list.

While it's possible to design what the TIAA-CREF Institute views as an ideal 401(k) plan, Fuerst says he doesn't see many of them. "This is not the type of plan that (employers) or employees seem to want," he said. "(Employees) want investment control and lump sums."

What Everyone Seems to Agree On

In the main, experts seem to agree that 401(k) plans, best-in-class or not, ought to have mandatory participation or automatic enrollment and adequate contribution rates.

(MORE: The Most Important Thing to Know About Your 401(k))

At the moment, however, that's not the case. For instance, just 67 percent workers with a 401(k) plan that doesn't have automatic enrollment contribute to their plan, according to a report from the Center for Retirement Research at Boston College.
What's more, 401(k) participants save, on average, just 6.8 percent of pay, according to 56th Annual Profit Sharing and 401(k) Survey from the Plan Sponsor Council of America (PSCA).
Plan sponsors and plan providers are moving in the right direction, but it's still less than ideal.

At the moment, 47 percent of plans now have an automatic enrollment feature and employees who participate in plans with automatic enrollment generally begin contributing at 3 percent of pay.

Ron Gebhardtsbauer, a professor at Pennsylvania State University, said enrolling workers at just 3 percent of pay is a disservice to employees, especially if they get stuck at the very-inadequate 3 percent of pay and don't even get the full employer match. "If employers are concerned about the cost of a higher default contribution, they can stretch their match by going to, say, 30 percent or 40 percent of the first 10 percent of pay," he said.

Aggressive Auto-Escalation Is Needed

And so what's needed in a best-in-class 401(k) is an aggressive auto-escalation feature, advisers say. Currently, 58 percent of plans automatically increase the default deferral rates over time, according to the PSCA.
"If other private sector employers are shy about requiring employees to contribute enough, I'd use not only automatic enrollment, but also automatic escalation of the contribution up a percent or two of pay, when employees get pay increases," said Gebhardtsbauer.
Others agree that workers need to save more than the default deferral.

"The single most important issue in retirement savings today is that participants are not saving enough," said Mike Alfred, the co-founder and CEO of BrightScope, a retirement plan analytical firm. "It isn't that they're not investing well, although that may be the case in a lot of plans. So, I think any feature that drives more participation and higher savings rates should be seriously considered."

What's an Adequate Savings Rate? 

To be sure, advisers might quibble over what an adequate savings rate might be. It is likely to be different based on one's age, savings goal, assets accumulated and the like. "But for most participants today, 'adequate' probably means the maximum contribution, rather than 10 percent, because most people are way behind where they need to be," said Alfred.
Experts also seem to agree that best-in-class defined contribution plans should offer plan participants low-cost pooled investments (such as target-date funds) as a qualified default investment alternative, as well as education and advice.
But at least one expert doesn't think all plan providers share that point of view when it comes to low-cost pooled investments. "The investment community would also rather have people in higher-cost funds because they will get such superior returns," said Fuerst.
For the record, plans offer participants an average of 19 funds and the funds most commonly offered are those with relatively high expense ratios, such as actively-managed domestic equity funds (86 percent of plans), actively-managed international equity funds (83 percent), indexed domestic equity funds (80 percent) and actively-managed domestic bond funds (77 percent), according to the PSCA.
Meanwhile, here's what we know about the current state of affairs for default investments, education and advice, according to the PSCA:
  • Roughly two-thirds of plans, some 64 percent, offer a target-date fund (it's the most popular default investment)
  • 16 percent of plans offer a comprehensive financial wellness program, beyond a standard 401(k) education program
  • 35 percent of plans offer investment advice

What's Needed: Advice on How Much to Contribute

"Education/advice is also important, but it needs to be on more than just on the investing side," said Gebhardtsbauer. "Employees need to know how much to contribute."

A great help for this is the Labor Department's push for employers to provide personal projections of what size annuity each employee will get at retirement. (You can find out more about that Lifetime Income Calculator on the Labor Department's website.)

Advisers, meanwhile, tend to dislike 401(k) loans, but that's not reflected in plans today. According to PSCA, 88 percent of 401(k) plans permit loans.
Lump-Sum vs. Annuitized Benefits
While experts tend to agree on most of the elements that could make up a best-in-class 401(k) plan, there is some debate over the issue of annuitized benefit payments (monthly income for life).
At the moment, nearly all 401(k) plans offer a lump-sum payout to participants when they retire or leave their employer and just 11 percent offer an annuity.
That is not the case with defined-benefit plan participants. Those folks typically get a specified monthly benefit for life.

To be sure, experts say that giving defined contribution participants a monthly benefit for life could make defined-contributions plans as "efficient" as defined-benefit plans. But it might be a while before 401(k) plan participants are offered that feature, if ever. There is just too much debate and too little agreement.
"The toughest one will be annuitization," said Gebhardtsbauer. "Most non-academics in defined-contribution plans are not annuitizing, and the problems will hit us when retirees run out of money at their life expectancies. Not only will it be a problem for the retirees, but it will cost the U.S. a lot, as they will fall on welfare. Thus, the U.S. has an incentive to encourage these good practices."
Others agree that getting 401(k) plans to offer annuitized benefits as a matter of course won't be easy. "It's an evolving issue that is fraught with potential risks for plan sponsors from a liability and regulatory perspective," said Alfred.

Government Agencies Propose Changes

At the moment, the Labor Department is proposing that retirement plan participant statements show lifetime income projections. Plus, the U.S. Treasury Department and the Internal Revenue Service have proposals intended to encourage retirees to invest some of the proceeds of their retirement accounts in annuities.
But all that is a work in progress and it's hard to guess whether or not annuitized benefit payments will ever become a part of the best 401(k) plans. "The Labor Department has said that it plans to address the issue head-on, but we're still waiting to see specific guidance," said Alfred.
Questions over how much of one's 401(k) plan should be annuitized must be answered, though. For instance, Fuerst, who wrote a paper on the subject, isn't fond of a 100 percent annuity payout for money in a 401(k) plan. "I chose 50 percent because I feel people need some liquid savings also," he said.
When Annuitization Is Efficient

And still others have a different perspective on the issue of annuitized benefits. "To me, the debate on 'efficiency' of defined contribution plan design seems to hinge around the issue of annuitization," said Stephen Utkus, a principal with the Vanguard Center for Retirement Research. "Actuaries and actuarially-oriented firms define retirement efficiency as the provision of life-contingent fixed-payment streams. If you define efficiency as annuitized benefits, then any system allowing partial or full lump sums is inherently inefficient."

But if you define "efficiency" as combining regular lifetime income streams for predictable spending and lump-sum savings for erratic savings and/or for long-term care expenses, then a system that is fully annuitized is inefficient and one combining annuity payments (whether from the defined-contribution plan or from Social Security and lump-sum savings) is "efficient," said Utkus.
"This is, I think, the essential tension," said Utkus. "For some the only valid form of 'retirement income' is a lifetime annuity stream and thus 'efficiency' requires 100 percent lifetime annuitized benefits. To me the question is not either/or, but finding the optimal combination of instruments providing lifetime income streams and instruments providing liquidity and flexible savings. Saying everything must be annuitized dodges the hard question: What fraction ought to be, and which not? And who decides? And for what reasons?"

No One-Size-Fits-All Plan

Ultimately, advisers also say that what makes sense for one type of industry or profession might not make sense for another. Then again, some think TIAA-CREF's plan, by and large, works for most people.
"Basically the TIAA-CREF idea makes the defined-contribution plan as much like the defined-benefit plan as possible, which I like," said Gebhardtsbauer. "It can still have higher expenses than a large defined-benefit plan, because it has to maintain everyone's account. In addition, some employees will negatively elect out of enrollment, or out of the contribution escalations, or out of annuitization. But hopefully it will be better than current experience."

Robert Powell is a MarketWatch Retirement columnist. He has been a journalist covering personal finance issues for more than 20 years. Follow him on Twitter @RJPIII.

By Robert Powell
Robert Powell writes about retirement issues for MarketWatch.com and produces the Retirement Weekly subscription newsletter.@RJPIII

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