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Case Closed: The 401(k) is a Failure

David Callahan

The big stock market slide of the past month has been bad news for the over 50 million Americans with 401(k) plans. Many of these investors have yet to recover from the 2008 crash and have been counting on a market upswing to make up for lost ground.

Yet even if stocks do rebound, the truth is that most 401(k) holders will never accumulate enough money in these accounts for a secure retirement. Few workers and their employers contribute at the level needed to build up a serious nest egg, and the median balance in a 401(k) for people approaching 65 is under $100,000, according to recent study by my colleague at Demos, Robert Hiltonsmith. On top of that, 401(k)s have been battered by two major stock market crashes in the past 12 years and, further, many Americans have withdrawn money from their 401(k)s to cover emergency expenses. Experts on retirement forecast that millions of middle class baby boomers will fall into poverty, or near poverty, in old age - thanks to the failure of the 401(k) experiment.

Why has the 401(k) been such a flop? Five reasons stand out.

First, the 401(k) system of individualized accounts is inherently inefficient. While traditional pension funds invest worker contributions in large pools, keeping administrative costs low, each 401(k) holder pays fees to the firms that manage their individual accounts. Those fees can add up big time and chisel away at savings. According a recent Demos report, 401(k) nest eggs end up nearly 30 percent lower over a lifetime of saving thanks to fees.

Second, the 401(k) system has never covered all workers. Some 40 percent of employees do not have access to a 401(k) plan, and many workers with this option choose not to participate or contribute negligible amounts. Given such huge gaps in who is covered by 401(k)s, it's wrong to see this system as the primary private supplement to Social Security.

Third, 401(k)s expose individuals to too much risk. While investment firms always tout long-term "historical returns" of the stock market, real-life individuals can be in big trouble if they need to retire during a prolonged slump in stocks. Pooled pension funds, in contrast, can better manage such downturns and buffer individuals. Such funds are also managed professionally, while the 401(k) lets ordinary Americans decide how their money is invested. Yet many workers are clueless about how to allocate their savings among the menu of investment options that most 401(k) plans offer and often don't revisit their choices even as market conditions change.

Fourth, the 401(k) system depends on the financial industry acting in the best interests of investors - which, too often, it doesn't do. Research has found that the fees charged by 401(k) plans and mutual funds are often excessive, far beyond the actual costs of managing investments. Financial firms have a bottom-line interest in pushing these fees as high as the market will bear - an interest in conflict with the needs of investors. Investment advisors and firms have historically not had a legal fiduciary responsibility to act in the best interests of 401(k) holders. And while the Dodd-Frank Wall Street reform empowered the SEC to write rules that could impose such a responsibility, it has not yet done so.

Fifth, consumer choice does not offset the failures of the 401(k) system. In a truly competitive marketplace, educated consumers would shop for 401(k) plans with the lowest fees and switch to those plans. But surveys have found that most Americans don't have a clue about the fees associated with their 401(k)s. And switching plans can be difficult for individuals, since employers choose the plans. In turn, employers can find it time consuming to move to a new plan. Wall Street charges such high fees for 401(k)s because they can in the face of consumer ignorance and high barriers to switching plans.

It is easy to forget that 401(k) plans have only been around for three decades. We have learned a lot in that period, and the jury is now in: The 401(k) experiment has failed. This system does a better job of enriching the financial sector than in providing retirement security to Americans.

It's time for a new approach. One idea, offered by economist and Demos Senior Fellow Teresa is the Guaranteed Retirement Account (GRA), which would supplement Social Security and be a universal system of individual accounts where investments are managed in pooled savings with low fees and buffers for individuals who retire during turn downs in the stock market.

The 401(k) system emerged after elected leaders changed the tax code in 1978. There is no reason we have to live with  this mistake forever.