BlackRock CEO Larry Fink: 401(k)s Have Failed. Time for Mandatory Savings

BlackRock, Inc., is the largest asset management company in the world, with nearly $4 trillion under management. It is also a major player in the 401(k) business. So it's worth paying attention to the fact that yesterday, BlackRock's CEO, Larry Fink, gave a speech at NYU in which he declared that the 401(k) system is basically a failure.

Fink noted that the move away from defined-benefit pension plans to defined-contribution plans was "a seismic shift from collective responsibility for retirement to individual responsibility."

But we never sufficiently warned people about this new responsibility – and we never educated them about how to meet it. As a result, the defined contribution system simply isn’t doing the job. As of 2011, only about half of private-sector workers were covered by an employer-sponsored retirement plan of any kind – and less than 40 percent participated. That means the majority of private sector workers aren’t participating in this vital part of our nation’s retirement system. And even where employers offer plans, less than seven percent of eligible employees maxed out their 401(k)s in 2010 despite the benefits to doing so.

Fink could have gone on and said more about why 401(k)s are such a failure, such as the tendency of people to borrow against their plans and the ways in which administrative fees undermine nest eggs over time. These are all points that Demos has made in its studies on the failed 401(k) experiment. Instead, though, Fink offered a different and also very important explanation of why leaving individuals to manage their own retirement accounts is a bad idea: Most of us don't know what we're doing and, among other things, don't take enough risk.

When individuals manage their own retirement savings – whether in 401(k)s or taxable accounts – we see that they invest much more in traditional fixed income than pension fund managers do. But in today’s environment, that isn’t going to deliver the returns they need. So why aren’t people taking the steps needed to plan for their retirement? Part of the answer is investor psychology. As behavioral economist Daniel Kahneman has found, people’s investment behavior is not as rational as most economic theories assume.

Investors feel more pain when they lose money than pleasure when they gain. So they often underinvest or do nothing at all when left to their own devices.

All very true.

Fink's solution is to mandate that employers contribute to the retirement accounts of their workers and that workers have a chance to make contributions on top of that. Fink cites Australia's superannuation system, which compels employers to contribute 9 percent of an employee's salary for their retirement -- a figure set to gradually rise to 12 percent in coming years. Workers can contribute on top of that and get a tax benefit for doing so.

All this money gets invested in so-called superannuation funds, which are similar to 401(k) funds and therefore not optimal, in that there is wide variation in fees and returns -- although individuals seem to have fewer chances to screw things up compared to U.S. 401(k)s. Still, as Fink points out, Australians now have a huge pool of retirement savings in these funds -- $1.6 trillion -- twenty years after superannuation was introduced, which has dramatically improved retirement security in that nation.

Fink also points to the U.K. for inspiration, which has created the National Employment Savings Trust, a non-profit pension entity that any employer in the U.K. can use to contribute to an employee's pension -- with very low administrative fees.

One way to easily get something similar to NEST in the U.S., Fink suggests, would be to allow all American employers and workers to participate in the defined-contribution program for federal workers, the Thrift Savings Plan. This is a hugely successful program that operates a lot like a 401(k) plan, but with lower administrative fees. An even better idea is for states to offer guaranteed retirement accounts, leveraging the existing infrastructure of their public pension systems -- as argued in a Demos paper last year.

One key to any successful system -- and Fink should have stressed this more -- is that investments are managed in pooled funds to sidestep all the administrative costs of millions of individual accounts. Such pooled accounts can also smooth out losses over time and guarantee a certain level of retirement income to individuals, which is how defined-benefit plans work. The Demos plan for state GRAs incorporates such features.

Just to be clear: Fink is not suggesting that the U.S. gradually shift employer contributions for retirement away from Social Security and to some new system. Rather, he sees a new mandatory retirement contribution as coming on top of what Social Security already requires of employers. He suggests that this be phased in gradually, so it doesn't hurt the economy, which is what Australia did.

Let's hope Fink's ideas get a hearing.