The real problems facing retirement plans.
Talk about misdiagnosing a problem. To read the press, the problems with U.S. retirement plans are threefold: 401(k) plans cost too much, they don’t have enough of their assets in index funds, and some Americans are accumulating too much money in them, spurring a call for government to cap the amount of money people can put into a tax-deferred plan. There’s much wrong with U.S. retirement plans, but surely these aren’t the most pressing issues.
The critique that plans cost too much and have too much of their assets in actively managed funds has been most recently championed by an Ivy League professor who has garnered attention by threatening to “expose” more costly 401(k) plans. His view is that with average costs of near 90 basis points and with many assets still in actively managed funds, 401(k) plans are not as efficient as they should be. In essence, he chastises 401(k) plans for resembling T. Rowe Price’s offerings when he believes they should mirror Vanguard’s.
There are two major problems with this view. First, it ignores the tremendous progress 401(k) plans have made in the past two decades. As recently as the mid-1990s, it was common to see double-digit exposure to company stock or stable-value funds in these plans—two options unlikely to chart a steady or successful path toward retirement. By focusing on cost and indexing, this critique underplays the significant progress that’s been made in asset allocation, to say nothing of the benefits that behavioral finance has brought to the usage of 401(k) plans. Moreover, jumping on the cost and indexation bandwagon now, when the decades long trend has been toward lower costs and more use of passive options, is a bit like becoming an ardent Seahawks fan in the fourth quarter of this year’s Super Bowl. The outcome is already decided; you’re just looking to share the glory.
The critique also directs attention away from the real issues facing retirement savings. One, far too many people either don’t have access or choose not to participate in retirement plans. Two, those who do participate in plans typically contribute far too little to build a suitable nest egg for retirement. Given this pressing reality, complaining about active-versus-passive investing or the need to move from low to lower costs is like rearranging the deck chairs on the Titanic. Obviously, lower costs would be better and indexes are always fine options to have in a plan, but these aren’t the most urgent issues facing retirement plans today; participation and expectations are.
Only a small percentage of Americans will accumulate $1 million in their 401(k) plans. Even at a company like Morningstar—where we have a high participation rate, great funds, free portfolio construction advice, an informed participant pool, and a generous employer match—the average participant balance for employees in their 50s is around $300,000. Many of our employees will accumulate $1 million in their 401(k) by the time they retire, but not all. At a 4% withdrawal rate, $1 million in savings will provide just $40,000 a year. That’s a nice supplement to Social Security and savings outside of the plan, but it’s unlikely to be sufficient to meet all of our employees’ spending needs in retirement—and we’re likely one of the most successful plans.
Clearly, Americans need to be saving much, much more for retirement than they are. The thinking that an employee contributes enough to get the employer match in their 401(k) plan and has, therefore, done what’s necessary to provide security in their later years needs to be shattered. Our nation’s messaging on retirement savings is all wrong. Fully using your 401(k) plan is the start of the savings process, not its conclusion. In this light, the Obama administration’s talk about capping participation in 401(k) plans is simply absurd. Perhaps Mitt Romney has more money in his retirement plans than legislators anticipated when they designed these plans, but his tax is deferred, not forgiven, and his experience is hardly common. The issue isn’t the extreme success of a tiny handful; it’s the utter failure of the masses to use these plans well. Policy should help the many, not penalize the few. It makes no sense to set limits on participation in retirement plans when the real issue is a lack of participation. We need to be talking about the need for greater thrift and saving throughout our society, not scorning those who do save successfully.
The current debate over U.S. retirement policy, with its grandstanding and political positioning, is hardly our country’s finest hour. There are real problems with the U.S. retirement system, but they’re not the ones being discussed. There’s much that we could learn by looking outside our borders to places like Australia that have focused on participation, rather than getting bogged down in the turf battles of active-versus-passive investing. It’s time for the U.S. retirement system to raise its game to the higher global standards being realized elsewhere. American citizens’ futures depend on it.