Is the 401(k) Ready for Change?

Kristi Mitchem, Head of Defined Contribution, Barclays Global Investors, noted that participant balances had been significantly impact by the recent downturn, citing data from Hewitt Associates that said the average 401(k) participant balance was down 28% through December 31, 2008 from the year before.

However, despite the dramatic market sell-off, Mitchem, speaking at BGI’s 2009 Retirement Breakfast Briefing, noted that a return to normalcy would bring a quick recovery for most investors. Specifically, citing data from the Employee Benefit Research Institute (EBRI), she noted that younger participants (who have smaller balances, on average), could recover in as little as two years, and that even older savers could recover in five years.

That said, Mitchem said that a comparison of the current 401(k) model to that kind of benefits/security provided by a defined benefit plan illustrated some stark differences, and some room for improvement(s).

A 401(k) “Makeover”

Noting that contributions to defined benefit (DB) plans were mandated, that the investments of those programs were typically institutionally priced, that there were significant vesting/accumulation periods, and that a “lifetime income” option was “always offered”, and sometimes mandated in those programs, she made a case for “making over” the 401(k). She noted that the Pension Protection Act (PPA) had done much to strengthen and streamline the 401(k) contribution structure, through the use of automatic enrollment and contribution acceleration (both of which are experience an uptick in usage since the PPA’s passage), as well as the availability of qualified default investment alternatives (QDIA).

Mitchem noted, in fact, that more than half of the largest 1,000 employers currently use automatic enrollment, and indicated that about a third of all plans currently do. Furthermore, she noted studies that indicate that automatically enrolled participants tend to stay where you default them, and cited the findings of a Harvard research team that participants defaulted at a deferral rate as high as 9% (the “default comfort zone”) were unlikely to exodus from that rate.

She also noted that rollover options were increasingly available, though not mandatory, in 401(k)s, and that the prominence of lump-sum availability contributed to a significant "leakage" from the retirement savings system, particularly among those with smaller account balances.

In fact, those distribution "defaults" meant that, according to a 2007 Hewitt Associates study, that 40% of those participants eligible for a distribution take it in cash (25% roll directly to an IRA, while the remaining 25% stay in the plan). Of those taking a cash distribution, 27% "consume" it, while 62% reinvest the money in an IRA or other employer plan, and 10% invest the funds.

As for ways to address those problems, Mitchem suggested:

• Making plan-to-plan transfers more seamless
• Encouraging participants to remain in the plan
• Offering plan sponsors an incentive to accept contributions, and
• Requiring that participants roll over their balances prior to liquidation

Mitchem noted that the issue of retirement income looms large, both because people underestimate their chances of outliving their income, and that they overestimate their ability to "self-insure" their retirement income needs. However she noted that lifetime income options were not currently offered in most plans. She suggested that a legislative "nudge" could serve to break down the barriers to annuitization, but that changes in public policy, sponsor education, and participant acceptance were also needed.