Thank Serendipity, but Don’t Depend on It

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The government official who drafted an obscure add-on to the Internal Revenue Tax Code back in the 1970s could have had no inkling regarding the consequences.

Although it's true that the one-page addition attracted little notice at the time, it ultimately kicked off the era of make-your-own retirement.

That addendum is, of course, the famous "k" tacked onto section 401 of the Revenue Act of 1978. The irony is that lawmakers were trying to limit executives at some companies from having too much access to cash-deferred plans. Their attempts to rein in a perk created an opportunity that has since become a cornerstone of US private retirement provision.

The 401(k) is a positive unintended consequence that has enabled 52 million Americans to actively prepare for retirement. It was also an early experiment in behavioral finance. Faced with the choice of saving a portion of their wages in exchange for similar contributions from employers, workers clearly embraced this incentive and, in the intervening decades, have accumulated an estimated $4.4 trillion in assets—plus more than $5 trillion in individual retirement accounts, much of which comes from 401(k) rollovers—for their retirement, according to the Investment Company Institute.

The development of 401(k) is serendipity in action, a happy occurrence made by chance. Yet, my fear is that for all the good achieved with the 401(k), we are expecting one small loophole to carry a heavy burden. Much more work needs to be done to adequately prepare people for a dignified retirement.

Coverage Falls Well Short
First, there is a coverage problem: Many small firms do not offer 401(k) plans. According to Government Accountability Office figures, only 14% of small companies with fewer than 100 employees sponsor a plan in which workers can save for retirement. The result is that 53% of the working population has no 401(k). As less than 10% of workers still have a regular pension, large segments of Americans will be left depending solely on Social Security when they retire.

There are movements in states from California to Maine to extend pension plans for private-sector workers into small businesses. In all, 16 states have passed or are considering such plans. As an industry, we should support efforts to extend retirement preparation. However, these state-run proposals are unlikely to have much impact, because they do not require a match (or vesting schedule) and contribution limits are low. For the same reason, they will also be a poor tool for employers seeking to attract, retain and motivate (ARM) employees.

There are good reasons why small companies don't offer 401(k) plans, and cost is one of them. Small businesses are fighting to establish themselves, so they often can't afford such benefits until they are financially secure. Plans also add an unknown business risk, and many companies don't want the unwanted hassle of yet more paperwork to administer.

Cheapest Doesn't Equal Best
What is driving fee costs? One factor often overlooked is government involvement. In discussions about the new small-business retirement plans, it is often said that it would be better to include these types of plans in public-sector plans, which have lower costs. Now, I don't accept the argument that cheapest means best when it comes to retirement planning. But leaving that aside, the question is, why do such plans have lower costs?

The reason 401(k) fees are high often has little to do with fund selection—it's more of a function of government oversight. Public-sector plans are not subject to government-mandated regulations covering compliance, record keeping and non-discrimination testing. Such regulations strive to serve a noble purpose of ensuring that highly compensated employees don't have an unfair savings advantage. However, they have also had the unintended consequences of driving the cost of such plans out of reach for most small employers (fewer than 25 employees).

In turn, this has left many Americans without access to a 401(k) plan. A simple fix would be to eliminate all government-mandated compliance testing and filings for employers with 25 or fewer employees, and require these employers to offer a plan. A more competitive retirement-plan model would streamline the number of bureaucrats involved. This would reduce fees for all plans and enable the private sector to compete with state systems, to the benefit of savers.

Addressing fees is only one of many tasks ahead. Americans still don’t save enough, and their 3% average contribution rate is among the lowest in the advanced world. We also need to educate people about decumulation, that is, how they spend their money in retirement to ensure they don’t outlive their savings. Another overlooked danger is transition risk, which is when investors shift from accumulation to income at an unfavorable point in time, under unfavorable market conditions.

Many of us got lucky when Ted Benna, the man who identified the 401(k), outlined the loophole’s potential. But we as individuals can’t assume that fortune will always be so kind when it comes to retirement planning, nor can we as a nation expect the 401(k) in its current state to do all the heavy lifting to solve our growing retirement crisis.

This article was originally published in Project M, an Allianz SE International Pensions publication featuring unique perspectives on investments and retirement.

Glenn Dial is Head of Retirement Strategy in the US with Allianz Global Investors, which he joined in 2011. He has 23 years of defined contribution experience. Mr. Dial is a co-inventor of the method and system for evaluating target-date funds, and is also credited with developing the target-date fund category system known as “to vs. through.”

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