Dangers that lurk in 401(k)s

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The average American with a 401(k) retirement savings account saw it grow by
8.7 per cent a year in the seven years to 2006, and held $121,202 by the end of last year.

That information, released by the Investment Com­panies Institute, the mutual fund industry trade group, makes it sound as if all may be well with 401(k) retirement plans. The plans were introduced with great fanfare as the way that individual Americans could save for their own retirement, replacing the company pension plan that still prevails in most European countries.

Sarah Holden, the ICI’s senior director of retirement and investor research, who co-authored the study, says: “The growth . . . demonstrates the impact that a regimen of regular savings can have on an individual’s ability to accumulate sizeable amounts in a 401(k) account.”

She says the period encompasses “one of the worst bear markets in equities since the Depression,” yet individuals were still able to lift their average assets.

However, there are a few other data points which somewhat dim the picture. The median account balance – the one at which half are below it and half above it – grew by 15 per cent to $66,650, only half the average level, according to the study by the ICI and the Employee Benefit Research Institute.

The study, one of the largest of its kind, tracked individuals who remained with a 401(k) plan throughout the seven-year period. The rise in assets was generated by both contributions from plan holders and increases in performance of the assets.

The data above applied only to those who held an account continuously since 1999. The average balance of all individuals with a 401(k) account – regardless of how long they had held it – was only $61,346, or half the amount of the headline.

And a crucial point is that the median account balance was $18,986 – that is, less than $20,000. This appears to indicate without much doubt that most people still have insufficient funds saved for retirement, and the 401(k) has not been the panacea for retirement savings that was originally envisaged.

The Pension Protection Act, which was signed into law last year, will allow employers automatically to enrol their employees into 401(k) plans unless any employee specifically opts out. The move, which was strongly lobbied for by the industry, is a significant one and expected to boost 401(k) membership and assets vastly.

The new law does not require an employer automatically to enrol employees, and without doubt some will not choose to do it. However, many will, and given the human tendency towards inertia, it can be expected that most employees who are automatically enrolled will stay that way.

One industry member is fond of pointing out what happened with the switch from opting in to opting out of organ donation in several European countries recently. When it was up to individ­uals to sign up for donating their organs, he says, only about 10 per cent bothered to do it. When they became automatically enrolled for donating their organs, with the option to refuse, few opted out.

The 401(k) study also found a few predictable patterns. About two-thirds of 401(k) assets were invested in stocks, through equity funds, balanced funds and company stock. That was little changed over a decade. Most 401(k) plans offer a mix of conventional mutual funds, both actively managed and indexed. Few offer exchange traded funds or exposure to property or alternative assets.

New hires were less likely to invest in company stock for their 401(k) plans, the study found. As a result, the percentage of 401(k) assets invested in the employer’s own stock dropped by 2 percentage points, to 11 per cent, over the seven years. The shift comes after several big scandals involving companies such as Enron, which got into financial trouble but continued to encourage em­ployees to buy their stock through the 401(k) plans, with disastrous results for employees.

New hires were also investing heavily in lifecycle funds, a new type of fund which shifts asset allocation according to the age of the participant. Recently hired 401(k) plan holders in their 20s had a quarter of their 401(k) money invested in lifecycle funds, the study found. This compared with only about 7 per cent in 1998.

Last year, 18 per cent of 401(k) participants had taken out a loan against their accounts. Most funds allow this.

However, the average balance levels are skewed by a handful of fairly well-off individuals. If half those with 401(k)s have less than $19,000 in them, as the data show, this should remain a big priority for public policymakers. That account balance does not even provide enough for a single year of retirement. The corporate pension plan may be dying off, but the replacement has not yet shown it will provide for the retirement needs of more than a few.

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