Your 401(k) Has Probably Gotten Better
401(k)s are not perfect, but it is amazing how much they have improved.
It is pretty easy to focus on what is wrong with our defined-contribution retirement system. Lots of employees still do not have access to workplace retirement plans. Fees can be too high, especially for workers at smaller firms. Sometimes employees face making complex decisions with relatively little guidance. Many of us do not save as much as we should for retirement. All of these things are true.
But there is a more positive side to the 401(k) story. Over the past few decades, 401(k)s have simply gotten a whole lot better. Insights from behavioral economics have led to the development of retirement plan features that have encouraged greater employee participation and higher deferral rates. The industry has developed investment options that simplify decision-making. 401(k) plan assets are much better diversified than they were in the past.
In my mind, the real debate has shifted from a discussion of whether 401(k)s can work for employees--they definitely can--to a debate about the best way to maximize the benefits of defined-contribution plans and to bring them to a greater number of workers.
Here are a few of the signature developments that have significantly improved the retirement system.
Improvements in 401(k)s
Autoenrollment and autoescalation. The Pension Protection Act of 2006 (PPA) made it much easier for employers to autoenroll their employees in 401(k)s, by providing relief from some costly regulations. In 2006, 12% of 401(k) plans provided by Vanguard offered autoenrollment; by 2014, that had risen to 36%. According to Jeanne Thompson, a VP at Fidelity Investments, 70% of very large plans currently offer autoenrollment. Bank of America (BAC) has found that plans with autoenrollment have achieved participation rates that are 32% higher than for plans that do not have such a provision. A solid majority of employers that offer autoenrollment also autoescalate their employees' contribution levels. Among plans administered by Fidelity, Thompson said that 38% of increases in employee deferrals last year resulted from autoescalation.
Target-date funds and other professionally managed options. Plans that autoenroll employees now typically default them into target-date funds or managed account programs. Prior to passage of the PPA, some plans defaulted employees into money market or stable-value funds, which are poor options for long-term investors. In 2014, Vanguard reported that about 41% of employee contributions went to target-date funds, a near doubling of the proportion in 2010. The data show that by using these relatively simple-to-understand investment options--target-date funds and managed accounts--workers can achieve solid investor returns without needing to become investment experts.
Immediate eligibility. Not all that long ago, a majority of 401(k) sponsors enforced a waiting period before employees could participate in their workplace retirement plans. Jim Smith, a VP of Client Solutions in Morningstar's retirement business, said that approach tended to depress 401(k) participation rates, as it gave workers an opportunity to procrastinate about signing up for the 401(k)--and also forced HR departments to "reengage" with employees months after they had started work. Now, more than three fourths of plan sponsors provide immediate retirement plan eligibility for their employees, according to Aon (AON), so the 401(k) signup has become part of new employees' orientation procedures. Especially for employees who change jobs many times over the course of their careers, immediate eligibility for 401(k)s should materially improve their retirement security.
Reduced amounts of company stock in plans. Financial advisors generally recommend that workers limit their holdings of company stock, as employees are already exposed to the vicissitudes of their employers' business fortunes. At times, overexposure to company stock has led to disastrous results, as was the case for Enron employees who saw their life savings wiped out when their employer declared bankruptcy. Nevertheless, a couple of decades ago, it was still quite common for employers to provide 401(k) matches in the form of company stock. Companies also had a habit of encouraging workers to buy company stock in their retirement plans. As a result, Aon says that more than 30% of employee assets were invested in company stock in 1997. By 2014, just 11% of assets were invested in company stock--still too high, but the trend is moving in the right direction.
Simplification of options. Behavioral research from Richard Thaler and others has shown that when people face making complex decisions, they often procrastinate. Many 401(k) providers have responded by simplifying the enrollment process. Bank of America found that by "minimizing upfront choices," it could achieve a nearly 40% increase in the percentage of employees who enroll in a 401(k). One small change was to ask employees to pick from among three deferral rates, rather than asking them to make up their own. Indeed, B of A found that employees most often chose the first deferral rate listed, which suggests that employers have a lot of opportunities to "nudge" people to make optimal retirement-savings decisions. Thompson reports that Fidelity has also achieved meaningful increases in participation rates with a streamlined enrollment process, including cutting down on the number of deferral choices.
The Good Old Days
None of these 401(k) improvements will keep some people from pining for the good old days when (allegedly) everyone had a defined-benefit, or DB, pension plan. Of course, the good old days weren't that good: Even during the heyday of DB plans, they were a lot less widespread than people often think. According to the Employee Benefit Research Institute, in the late 1970s--before the widespread adoption of 401(k)s--only 38% of employees worked for a company with a DB plan. And naturally, the percentage who actually earned a decent DB benefit was lower, as many of those 38% did not accrue enough time with any employer to earn a decent pension benefit. At least with 401(k) and other defined-contribution plans, when employees change jobs, their retirement savings are portable, allowing them to build a meaningful retirement nest egg even if they frequently change jobs.
It's hard to imagine DB plans making a significant comeback. As Bruce Springsteen wrote about factory jobs in "My Hometown," DB plans "are going, boys, and they ain't coming back." Nearly everywhere around the world, companies have moved to defined-contribution plans to limit risk to their balance sheets and P&Ls and to better meet the needs of a mobile workforce. Over time, the financial-services industry has moved to develop investment options that help people better navigate this defined-contribution world. Although there is much criticism of Wall Street, it is worth noting that in the retirement business, there is a lot of innovation that has helped workers prepare for their golden years. Instead of relitigating a decision that has already been made--the shift from DB to defined-contribution plans--we would be much better off spending our time figuring out how to extend the benefits of 401(k) plans to the millions of workers who lack access to them.
As you may (or may not!) have noticed, we have moved to a less frequent publication schedule for this column. I have decided to resume full-time graduate studies, working toward a Ph.D. in political science, so rather than writing a weekly column I will weigh in on investor-related policy issues as they arise. I really appreciate the feedback on the columns and look forward to continuing to engage with you, albeit on a more occasional basis.
Scott Cooley is Morningstar's director of policy research and formerly served in a variety of analyst and management roles at the firm. He is also a graduate student at the University of Chicago, focusing on political science. Unless specifically indicated otherwise, the views that he expresses in this column are his own.
Scott Cooley does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.