See this article by Jim Bartoszewicz as it appeared in The State Journal.

Whether by design or by accident, 401(k) plans are about to become America’s primary source of retirement income. Evolving over 25 years, 401(k) plans, and retirement savings in general, have been influenced significantly by investment industry, political lobbying, and the shrinking number of defined benefit plans. Although initially intended as secondary savings, 401(k) plans have been continually redesigned to take a more prominent role. To implement 401(k) plans successfully today, we will need a cultural shift in how we think about saving for retirement.

The Old Definition

When section 401(k) of the Internal Revenue Code was first written in the late 1970s, the tax-free savings provided by section 401(k) were intended to be supplemental to defined benefit pensions (DB plans). Back then, and for a decreasing number today, retirees could rely on a pension check, a social security check, plus personal savings from a 401(k) plan or some other bank or brokerage account. This was once thought of as the three-legged stool for retirement income.

Today, for many unfortunate retirees, the stool is about to collapse. Due to rising administrative costs, longer life spans, unforgiving accounting rules, and new regulatory and legislative changes, scores of DB plans have been terminated, leaving many to rely on inadequate Social Security benefits. But, can retirees survive on Social Security and a “supplemental” plan?

A New 401(k) Definition

The answer is yes, but only if people change how they look at 401(k) plans. The New Definition of 401(k) plans requires three critical mandates: participate, contribute enough, and invest appropriately.

As a supplemental plan, participationwas barely a concern. If only 70% of employees participated, one simply assumed that the remaining 30% were satisfied with their DB plan pension and Social Security. But without DB plans, these retirees will be stuck with the low standard of living afforded by Social Security.

But participation will not guarantee a comfortable retirement if employees do not contribute enough. If a worker starts saving when they are 40 years old, a 5% contribution would provide about 20% of what they would need for a comfortable retirement, not bad as a supplement to a guaranteed pension check. However, remove that pension check and he must contribute 25% until the age of 65 to maintain his pre-retirement lifestyle. A young worker can avoid the large contribution by starting with their first paycheck. A 21 year old need only contribute 10% to retire at age 65.

The most significant shift in the new definition of 401(k) plans and most difficult concept to communicate to employees is appropriate investing. Fear of market volatility often causes 401(k) participants to choose “safe,” low-return investments. But “safe” investments fail to earn enough money over the life of an account. The previous examples assume a modest annual investment return of 7%. However, if that 21 year old contributed to a
guaranteed investment earning only 3%, she would retire with less than half of what she would need to live comfortably. That “safe” guaranteed investment requires a 30% contribution (instead of 10%) from age 21 to age 65!

The “Expert” Participant?

In most cases, 401(k) plan participants are not equipped with the knowledge necessary to make the right investment decisions. Far too few people understand how to invest
their moneys, and even if they’ve saved enough there often isn’t sufficient data on available investment to make informed decisions. Worse, an alarming number of workers neglect to take the time to perform necessary adjustments in their investments over time.

This outcome is predictable. Consider that in most cases participants are provided with a one hour meeting where they are expected to learn the benefits of tax-deferred savings, the features of their particular plan, and sound investment theory. Then these new “expert” participants are asked how they want to participate in the plan. Is it any wonder that contribution rates are inadequate or that the average participant receives an investment return of about 3% less than the overall market?

A Remedy?

Fortunately, some answers to the problems of plan investments are included in the recently passed Pension Protection Act of 2006. Separate provisions of that law encourage appropriate default investments and provide relief to plan sponsors who make professional advisors available to participants.

Under the new regulations, when the least savvy and laziest plan participants fail to provide investment instructions, their money goes into a Default Fund. Concerned with
losing the principal from these investments, plan sponsors often use a guaranteed account or money market fund as the default. But these investments result in a very low return. In response to the Pension Protection Act, the Department of Labor has issued guidelines on how default funds can take advantage of the equities market to receive a better return.

Although this is a step to help 401(k) participants who cannot or will not become expert investors, the best approach is to offer or provide professional advice to each plan participant. The Pension Protection Act offers assurances that the sponsor company will not be liable for potential investment losses if they pick an appropriate investment advisor and periodically check to see if that advisor is still appropriate.

Professional investment advice may appear a dramatic approach, but, in reality, it is merely a return to what every DB plan participant indirectly enjoyed.

Will it work?

Will the 401(k) fill American’s retirement needs? It can! However, for many it will not. But tools like automatic enrollment, scheduled contribution increases and participant advice make it possible for 401(k) plans to fill that need for those responsible enough to save.

Every employer should contribute to a retirement plan. Keep in mind: not too long ago the full burden to fund a retirement plan was on the employer. And the retirement industry must begin to educate workers about what is important – saving enough and investing
properly. Fees need to be disclosed more clearly and conflicts of interest should be eliminated. Every advisor to a 401(k) plan should be held to the same fiduciary standards as the plan sponsor – to act in the sole interest of the plan participant.

Unfortunately, it may take a generation of disappointed retirees without DB plans whose 401(k) plans are grossly under-funded to bring the urgency of this issue to light. But plan sponsors and participants who take their responsibility seriously can make a huge difference in better equipping the next generations of retirees.