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Rekenthaler Report

Charley Ellis Foresees a 401(k) Crisis

His advice for avoiding "grievous harm."

The Prediction
This past Wednesday, Charley Ellis gave a keynote speech at Morningstar's ETF Conference. Ellis is well-known among institutional investors for his early support of index investing and for authoring perhaps the most famous investment article of the 1970s, "The Loser's Game." His argument that money managers succeed more by avoiding mistakes (including those of cost) than by finding winners was decades ahead of its time.

Let's hope that he is less prescient with 401(k) plans, because he is pessimistic indeed. He opened his presentation, "Falling Short: The Looming Problem with 401(k)s and How to Solve It," by declaring that 401(k)s represent "the most important investment challenge" that the United States has ever faced. The "demographics on this issue are undeniable," yet "millions of Americans have no idea that [the problem] is coming their way."

How We Got Here
The origins of the 401(k) plan lie with John Rockefeller's Standard Oil Company, which established a voluntary employee savings plan in the 1920s. For several decades, however, most large companies offered defined benefits, rather than sought defined contributions. Defined-benefit plans were "the best financial service that has ever been." The company assumed all investment risk, made all the contributions, paid all plan costs, and took charge of all investment decisions.

As defined-benefit plans expanded through the middle of the century, so too did the scope of Social Security. Social Security payments, initially made to only to a minority of retirees, became more widely available. And they became larger--much larger. The payout rate grew from 15% of pre-retirement income at Social Security's 1935 launch to 28% in 1950, and then again to 40% in 1972. Real wages, of course, were also ballooning. The 70s were "the golden age of retirement" for American workers.

But they didn't know that. When 401(k) plans spread during the next decade, employees were beguiled by the promise of freedom. A 401(k) plan put them in control. They could contribute at their own rate, tailor their investment portfolio, borrow against assets as needed, and take the money with them if they left the company. What was not to like?

Unfortunately, responsibility cuts both ways. The power to create is accompanied by the power to destroy. Many employees did just that. Whether simply by not participating, or through errors such as contributing too little or withdrawing assets before retirement, these workers found themselves shorthanded at the time of retirement. Today, the median balance for a 65-year-old in 401(k) assets + IRA savings is $110,000. At a 4% annual withdrawal rate, that represents only $4400 per year.

Employer Recommendations
Companies need to realize that their employees need help. They need "nudges," to use economist Richard Thaler's term, to achieve better outcomes. For 401(k) plans, this means automatically making several decisions for the employee, with in all cases the worker having the right to opt out--a right that will typically be waived.

  1. Automatic enrollment--All new employees are placed into the plan, at an initial contribution rate.
  2. Automatic match--All new employees receive some level of match.
  3. Automatic escalation--All contribution rates are steadily increased until they reach a specified limit.
  4. Automatic indexing--All assets will be placed into index funds.
  5. Automatic target-date--All these indexed assets will be in the form of target-date funds.
  6. Automatic 4% payout rate--Plan participants who are retired will receive 4% withdrawal payouts.

Also, all workers must have access to a 401(k) plan.

Employee Recommendations
The starting point for employees is to obey the defaults established by the employers. (Ellis did not directly state this, but effectively his recommendations lead to a hybrid of the old and new systems. The employee gives the company jurisdiction over the investment portfolio, savings rate, and withdrawal rate, in the manner of defined-benefit plans, but the plan is portable, funded by worker contributions, and under the final control of the employee, as with defined-contribution plans.) The finishing point is to supercharge their results through the simple mechanism of retiring later.

The benefit of working the eight years from the initial Social Security retirement age of 62 to the mandatory age of 70 is powerful:

  1. Eight fewer years of retirement need to be funded.
  2. Eight more years of savings will swell the 401(k). Indeed, stated Ellis, a worker with the median 401(k) balance of $110,000, a salary of $60,000, and a 12% annual contribution rate, should be able to more than double his 401(k) assets. Ellis estimates a gain of $150,000 during the eight additional years, boosting the overall 401(k) balance to $260,000.
  3. Deferring Social Security from age 62 to age 70 raises Social Security payouts by 76%. Calling this improvement "the spirit of '76" (and accompanying it with a slide of a Revolutionary War painting), Ellis claimed that even among those who work in financial services, only one person in 100 realizes that the Social Security reward for deferred retirement is so large.

Analysis
I will keep this section short. It was after all Ellis' keynote speech, not mine.

Certainly, the 70s were the golden age of retirement for those who worked at a single large corporation throughout their career. But for the 50% of workers who were at smaller companies that did not sponsor benefit programs, who changed employers, or were self-employed, today's imperfect system surely beats yesterday's nonsystem. The 70s had the two retirement camps of haves and have-nots. Today (setting some public pensions aside), there would seem to be a single camp of "partially have."

With that caveat, Ellis' prescriptions are to the point. Happily, several are already industry standards. The automatic features of enrollment, match, and escalation have become norms, as has the practice of defaulting to target-date funds (or something very similar). It will be a while, if ever, that defaulting to index funds becomes universal, but as active management with large-company 401(k) funds tends to come at a low cost, the performance implications are negligible. (Small-company plans remain a concern, however.)

The one concern lies with making 401(k) plans universally available. That will require a new law--a nudge will not suffice.

The advice to employees, to work until age 70, also seems unarguable. I was not the one savant among the 100. I knew that Social Security payments increase along with the retirement age, and of course there is the favorable math of a higher 401(k) balance being asked to finance fewer retirement years. However, I had not realized the potency of the effect.

But I do wonder: If every American wishes to work until age 70, will the jobs be offered? Or will they be shunted aside for younger employees?

That, I think, is the critical issue. By and large, employers are improving 401(k) plans along the lines that Ellis suggests. What is less clear is whether employees will also be permitted to implement Ellis' recommendation by working until later in life. If so, then perhaps the predicted 401(k) crisis will be averted. But that seems to be a very large "if."

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.