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The Good News About 401(k)s

There is certainly room for improvement in these plans, but the factors that matter most to 401(k) investors' success are within their control.

Jason Stipp: I'm Jason Stipp for Morningstar. 401(k)s have been in the cross hairs for a little while, but for all the noise about 401(k)s, what signals should 401(k) investors take away? Here to offer his insights is Morningstar's vice president of research, John Rekenthaler.

John, thanks for being here.

John Rekenthaler: Pleasure.

Stipp: A couple of the beefs against 401(k)s--you say first of all aren't really the biggest things investors should be focused on, but I want to talk about them first--the fees and the investment choices are what you hear why 401(k)s have been bad for investors. You really have to dig under some of those claims, though, to truly understand what's going on.

Rekenthaler: Yes, I ran an exercise to try to look at the relative importance of fees, investment choices, as well as other things that can affect how somebody can build up the assets in a 401(k) plan. This was a spreadsheet, simplified spreadsheet, of a hypothetical investor, a 42-year-old woman, and things that could happen: The company could increase her salary immediately. She could grow her salary more over time. She doesn't necessarily have control over these, right, but these are things that can happen and can improve your 401(k) plan. She could increase her contribution rate; the company could increase its match rate. She could have started to invest earlier; she could retire later. She could have better investments by moving up her investment performance or maybe just getting to a more aggressive asset allocation, or, finally, the fees in the plan could decline.

There were eight variables I looked at, and it's just one example, one spreadsheet. You can build a different case. You could change the variables by more or less, depending on the exercise you're doing. But I think pretty strongly the message that came out when I ran the numbers was--what has the biggest effect is increasing the contribution rate and starting to save earlier, and those are two things that the investor controls. I think often the 401(k) investor is portrayed as powerless--the victim of somebody who is doing something to them. It’s a bit of a victim language in the articles that criticize 401(k)s. Well--I’m not maintaining here or anywhere else that 401(k)s are perfect, and there are indeed some very bad 401(k) plans--it's also true that investors have powerful tools in their control by just very simply contributing more and contributing earlier. Those are really big items, and frankly, if you move from, say, a 6% contribution rate to an 8% contribution rate, that's going to have more of an effect on your balance probably than if your plan fees are cut to nothing and you don't pay anything in fund fees or plan fees or you don't have any fees, unless it’s a very high fee plan.

Stipp: On the flip side, if you take control of the things you can control, increase your contribution rate, for example, the fund would have to be really bad on some of these other metrics for it to not be worth investing in the 401(k) at least at some level.

Rekenthaler: I think there are very few mutual funds in 401(k) plans where you can make an argument that it's not worth investing just because the fund is some... Generally speaking, you have very mainstream funds in 401(k) plans, and mainstream fund companies are offering it. Again, somebody watching this video, if you're in a very small company, maybe served by an obscure provider with a peculiar fund in it--there are a few of those cases. But most people are served by--75% of the market--the three largest providers, and I know the funds that they're offering and those are very straightforward funds. Maybe they're not all brilliant, but they're not going to get you into trouble if you're a buy-and-hold investor.

Stipp: Certainly, as you're saying, some of the smaller plans may have less selection, some of the fees might be higher, but in general, do you think that there is a fee problem across the 401(k) marketplace, especially when you asset weight the different plans and see where are most people invested in these plans?

Rekenthaler: I don’t think there is a fee problem with large and midsize plans. I think fees will come down on those plans due to market pressure that they can and should get lower, but I won't call it a problem at least in the sense that, again, in the popular press it's portrayed as kind of a retirement crisis that's keeping people from being able to have a good retirement. In your mainstream plan where the fund fees are under 1%, cutting them from 75 basis points, 75/100s of 1%, to 25/100s improves your investment returns, for sure, but is not the difference between being able to retire in comfort and not. There are other things that are bigger and more important than that--that's what I'm trying to convey. It's hard to get that into balance, right, because people will say you're arguing against the importance of--no, I'm not. I'm just saying let's keep this in perspective. There are many aspects that go into building for a successful retirement and a successful 401(k) plan.

Small plans--that can be different. I was on a discussion recently about 401(k) plans and really the consensus was--people who are involved with 401(k)s, some of them as journalists or writers observing them, some in the industry--pretty much the consensus across the board was that we still have a lot of problems in the small plans, and when people call and have problems it tends to be with the smaller plans. Then often we answer them and say, well, look, things are good with large plans. Things are good with large plans, and most investors are in large to medium-size companies and most assets, but it's not a perfect system yet.

Stipp: It's not just the plans and the investors, but there are political voices in this debate as well, and sometimes those voices can be very loud and they can lead investors to make decisions that really aren't in investors' best interest.

Rekenthaler: I try to keep politics out of my column, and I think politics should be out of investments, but I will touch on it here because it is important. It's important to recognize that the criticism on 401(k)s tends to come from the left, which wants more of a government or corporate solution. While they have some valid criticism of what goes on in 401(k)s, there is also a political motivation that adds to that criticism, and it's not just the left. On the right you get, we've seen this, where there is a democratic President, the business press, which tends to be right, tends to exaggerate or build upon the failures or flaws or the issues or problems associated with that President. Often you get rather gloomy investment advice that maybe the stock market is going to get hurt because of the political affiliation of the President. Well, that's not helpful to anybody either. I'd say neither side, the left or the right, is very helpful when they start moving off of the investment facts and getting in viewpoints in the matter that just overwhelm the facts.

Stipp: Let's step back for one moment. You said the things that can lead to success, the biggest drivers of success, for investors in 401(k) plans are in their own hands. But socially speaking, if it’s in my own hands, is that the best kind of system that you can have, given that we know investors' psychology makes it difficult sometimes to save for the future when you have pressing needs here in the present? Is a plan that requires you, the investor, to divert some of your money today to save for the future really the best system for society to save for retirement?

Rekenthaler: Now, we are starting to get into a political discussion, which is good. I think that's an appropriate question. I don't think I am particularly geared to take on it or have a stronger ability to take on that question than someone else. That's why I try to separate the investment aspects of 401(k)s, which I can address, with maybe the psychological or implementation issues, which get into the politics of should you have a voluntary system or not voluntary system, and I don't have an expertise there.

I will say that one thing that seems easily observable is the pressure on young people to make the right decision. When you look to my hypothetical case, such a big issue was--when do you start saving in a 401(k) plan? I do think it's a legitimate question and concern to wonder if a system that is requiring 25- and 27- and 30-year-olds to get invested early and get invested meaningfully as well as to make decent investment decisions--I think that's a bit of a challenge because as we know those are the people that are least likely to be connected with investing or see the payoff with it. As people get older, it starts to make more and more sense to them, but often it is a little late by the time that they start to view this as important.

Stipp: John, 401(k) is a hot topic right now. Thanks for helping us dig into the details and key in on what really matters.

Rekenthaler: Thanks, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.