Commentary: Issues with 401(k)s

Fretting over your 401(k) lately? For all the current turbulence in these retirement plans – from their rocky recent market performance to asset managers’ politicization of their investments through the “environment, social and governance” agenda – the main problem lies in their flawed design decades ago, a range of retirement experts say.  

They say many retirees – particularly the less well-off – are losing out because the tax-advantaged accounts favor the well-compensated who are better able to save; also, because of the plans’ temptingly relaxed borrowing rules, typically high fees, complexity, and a presumption of investing competence on the part of ordinary workers.  

“This system works fine for the top third of income earners, but not well for the middle-  and lower-income earners,” says Alicia Munnell, director of the Center for Retirement Research at Boston College.  

Yet as traditional monthly pensions have largely disappeared for private sector workers, American retirement security more than ever hinges on 401(k)s. In an illustration of how they’re failing, Deloitte Global, the accounting and consulting firm, estimates the retirement savings shortfall for Americans at nearly $4 trillion, as relatively few employees are able or inclined to fully exploit these optional savings vehicles. 

Worse yet, few plans offer much, if any, protection against market declines, as any 401(k) investor can attest this year. There are no retirement income guarantees in the 401(k) world. And in the face of such uncertainties, the guarantee of a modest monthly federal Social Security check, the other leg of retirement finance, is cold comfort for many indeed. 

An Accident of History 

Investment experts explain how we arrived at this pass starting with an accident of history. 401(k)s were never intended as a mainstream retirement vehicle. What happened was that a benefits consultant named Ted Benna in the late 1970s discovered an obscure section of the U.S. tax code that allowed employers to offer an extra fringe “defined contribution” retirement savings benefit, mostly aimed at higher-income employees who could afford to put aside significant savings and avail themselves of employers’ matching contributions and expert investment advice.  

During the 1980s, only 8% of American workers had 401(k)s. But over the decades they have grown into a $7 trillion industry as many companies embraced Benna’s insight, concluding that they were cheaper and easier to manage than defined-benefit pension plans. Now some 43% of U.S. employees are offered 401(k) or similar plans, as pensions have virtually disappeared.  

Federal legislation compounded the bias toward higher earners. Professor Michael Doran of the University of Virginia Law School faults Congress for expanding 401(k)s by offering higher contribution limits and more generous tax breaks for those who don’t really need them. His recent paper “The Great American Retirement Fraud” contends that despite “reforms costing the government tens of billions of dollars that began in 1995, retirement savings have remained flat for middle-income households and even decreased for lower-income households, after accounting for inflation.” 

Although overall 401(k) savings have climbed in recent years, the bulk of the gains went to the upper tiers of income, Doran found. In defined-contribution plans such as 401(k)s, 403(b)s, and 457s, employees are rewarded when they make contributions along with any internal gains in the plans, both of which are tax-free until eventual withdrawal. The more you contribute, the greater the tax break upfront – a big incentive to reduce taxable income for high earners. It was easy for Congress to tweak laws to allow people to contribute more without creating better plans for middle- and low-income workers who could less afford to save.  

“The legislation has repeatedly raised the statutory limits on contributions and benefits,” Doran found, “all to the benefit of affluent workers and the financial-services companies and retirement-plan service providers that collect fees from retirement plans and retirement savings. The result has been spectacular growth in the retirement accounts of higher-income earners but modest or even negative growth in the accounts of middle-income and lower-income earners.” 

Not Features, but Bugs 

Along the way, Congress created 401(k) features that have actually proved to be bugs in the retirement ointment. It made it easier to borrow or withdraw funds from the 401(k) kitty – an obvious disincentive to saving (in contrast with old-style pensions, which couldn’t be tapped before retirement). In doing so, account holders often face steep federal income tax penalties. 

Layoffs and other disruptions of the pandemic accelerated withdrawals from 401(k)s, when Congress allowed workers to withdraw up to $100,000 from retirement accounts without being subject to the 10% early-withdrawal penalty. Reacting to the pandemic’s numerous financial challenges, some 92% of employers allowed “hardship” withdrawals from 401(k)s, up from 78% in 2019, reports the Plan Council Sponsor of America (PSCA), which has been doing employer retirement surveys for the past 64 years.  

As a result, more than half of those surveyed by Bankrate said they are behind on their retirement savings.  

Even before that, federal law was already flexible on accessing 401(k) funds: Workers can spend 401(k) funds to buy a first home, pay medical bills, and avert foreclosure through hardship withdrawals. A recent study suggested that 401(k) balances may be drained by as much as 31% at age 60.  

Moreover, nearly 50,000 businesses slashed their 401(k) matching contributions during the pandemic, although many have since restored their match. Some 86% of plans surveyed offer a matching contribution as of last year, the PSCA notes. Small businesses were most likely to make the cuts. All told, although estimates vary widely, some 22% of workers surveyed said they tapped their 401(k)s during the pandemic, according to the Transamerica Center for Retirement Studies. 

401(k)s Cost Too Much 

Then there are the expenses of 401(k)s, widely viewed by financial advisers to be unnecessarily high with few exceptions.  

Defined-contribution plans are managed by financial services companies – primarily through mutual funds – and that means layers of fees mostly charged to employees. Be they managers mutual funds, insurance companies, brokerage firms, or banks, their expenses are buried in annual percentages of assets under management called “expense ratios,” even though the U.S. Department of Labor requires that employers disclose fees. 

Meantime, personal portfolio and risk management is left to individual account holders, who, research shows, consistently make money-losing decisions (see “Encouraging Money-Losing Decisions” below).  

Overpriced, inferior funds will actually eat up total retirement savings over time because workers don’t have the option of choosing funds in their employer’s 401(k) – they are limited by their employer’s selection of funds. 

The simple math on how much the high fees can eat into retirement savings is indisputable and dramatic: An increase of 1% in your 401(k) plan fees and charges could reduce your retirement earnings by 28%, according to FINRA, the federal regulator of the U.S. securities industry. 

Let’s say you invested $100,000 in a large-stock fund over 30 years. At a 7% annual return, you’d have $483,727 after three decades if you left your money invested for that period of time in a fund charging 1.5% in annual expenses.  

Lower your annual fund expense ratio to 0.5% and your final balance would be almost $655,000. Expenses still ate up $100,000 of your contributions – even in the low-cost fund – so you can see how lucrative 401(k)s are for financial services firms. That was cash that was not invested and compounding in your retirement kitty.  

By comparison, the high-cost option took more than $250,000 in fees and lost opportunity cost, that is, money that couldn’t return a dime for you because it went to a third party and wasn’t invested. (Do the math yourself online with Bankrate.com’s mutual fund fees calculator.)  

The good news is that, due to intense competition in the money management business, you – and your employer – can find rock-bottom expenses on nearly every kind of fund. But here’s a catch: Some of the big asset managers offering ultra-low-cost exchange-traded and mutual funds – including BlackRock and Vanguard – are also advocates of controversial “environmental, social and governance” investing favoring broader social goals over traditional shareholder value. Such political activism is opposed by many investors and regulators in conservative states. Investors willing to do the painstaking research required could find themselves conflicted, facing appealingly low expenses on the one hand and a political investing approach with which they disagree on the other.  

There are 10 funds that charge no management expenses for their exchange-traded stock funds. You can find bond-index funds for as little as 0.03% annually, according to the ETF database. Generally, low-cost, static, big-basket index funds don’t trade their holdings and can perform better over time than actively traded funds. The performance difference is largely due to lower fees and avoiding active-trading losses.  

But finding these cheaper funds on your own doesn’t mean that your employer will offer them in your 401(k). They are usually limited by what a single financial service company will provide (usually the company’s own “proprietary” funds). These may even load up extra layers of fees through “fund classes” or other poorly disclosed expenses such as “revenue sharing” that will erode your retirement savings. Unless employers absorb fund expenses – most do not – they have little financial incentive to shop for low-fee funds. 

The reason smaller plans charge employees high fees comes down to profit. Your 401(k) plan’s average account balance may impact the fees you pay. Joseph Valletta, publisher of the 401k Averages Book, says “our data finds that average account balance is one of the key drivers of 401(k) plan costs.”  

“Plans with larger average account balances will be able to generate more revenue per participant than a plan with a smaller average account balance,” he explains. “For example, a $5 million plan with $50,000 average account balance costs 1.19%, which translates to $595 [in revenue] per participant, while a $5 million plan with $10,000 average account balance costs 1.48%, which translates to $148 per participant.”    

Ironically, on the expense issue, Congress has taken care of itself and federal employees through its Thrift Savings Plan (TSP), a giant defined-contribution plan. The TSP not only clearly discloses and explains all expenses; the total fees on their funds range from only 0.043% to 0.053%. Note where the decimal point is. These funds are a super bargain for federal employees, although private plans are generally charging exponentially more.  

Small plans, typically under $5 million in assets, typically extract high fees from employees. According to 401ksource.com, which tracks plan fees, a plan with $500,000 in assets, for example, may have an average annual expense ratio of 2.23%, which is an onerous internal tax on participants. Broken down, 1.59% goes to investment managers and recordkeepers and 1.06% to “revenue sharing,” a hidden cost that is an incentive for intermediaries to place funds within a plan. 

While fund fees have declined overall in recent years, usually the larger the plan in terms of assets, the lower the expenses. A plan with $50 million in assets and 1,000 participants will pay an average 0.88% annually, 401ksource reported. Someone who has invested $100,000 over 30 years and is investing $1,000 monthly at 7% annual return would have an ending balance of about $1.2 million in the more expensive, smaller plan, compared with nearly $1.6 million in the larger one.  

Litigation Blossoms  

Not surprisingly, there’s been pushback on high 401(k) fees by employees in recent years. 

Employers have faced multiple lawsuits over high fees and poor performance. In legal parlance, litigators representing employees argue that employers have often violated their “fiduciary duty” under federal law to select managers to prudently manage employee funds at a reasonable cost.  

More than 90 lawsuits against employers for faulty 401(k)s were filed in 2020 alone. The suits alleged that employers “breached” their fiduciary duty by offering high-cost, low-performing funds. The litigation has also cited inclusion of company stock in 401(k)s, an ultra-risky investment – particularly if the company’s shares tank. The once-giant retailer Sears, for example, was sued in 2017 “for allegedly encouraging participants in its 401(k) plan to buy company stock despite well-publicized struggles that have battered Sears shares since 2014,” according to The Wall Street Journal.  

Employers have also been sued for conflicts of interest within plans, such as “self-dealing,” where the benefit of fund managers is placed above employees, and excessive third-party administrative fees and record-keeping, typically the least transparent expense. 

It’s no surprise that 401(k) suits have come in waves, usually after major market or economic declines, since defined-contribution returns are directly linked to markets. When stock and bond markets fail to provide consistent returns, high fees sting employees even more since 401(k)s don’t guarantee returns in volatile market environments. More than 100 new 401(k) suits were filed in 2016 and 2017, following an earlier wave in 2008 and 2009 in the wake of the market meltdown and recession in those years.   

Many of the suits target investment choices, which are loaded with extraneous fees, conflicts of interest, and often higher risk. To address that issue, fund complexes have offered “lifestyle” or “target-date” funds (TDFs), which are baskets of pre-packaged funds designed to offer a “glide path” to retirement at given years. All of these funds, however, impose two layers of fees that erode returns. They may even come up short on performance and vary widely in risk profiles. 

“Excessive risk lawsuits should be the next wave (of lawsuits),” says Ron Surz, a long-time critic of mainstream TDFs and president of Target Date Solutions.