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Reforming the 401(k)

Robert Hiltonsmith

One of the many parts of the financial sector that the crisis exposed as desperately in need of reform was the 401(k) industry. In 2008 alone, the securities industry lost over $2 trillion in workers’ hard-earned 401(k) and IRA savings. This loss was problematic enough for the millions of American families who watched their balances plunge in horror, but the number that really drives home the need for reform is the more than $120 billion that the industry took home in compensation and commissions the same year it lost $2 trillion in savers’ wealth.

Clearly, there must be something wrong with the rules and incentives for the securities industry for it to be able to pay itself so much while simultaneously performing so poorly. There are, however, several relatively simple rules that could be implemented to insure that the industry responsible for millions of Americans’ retirement works to help them retire comfortably -- as opposed to simply lining its own pockets at their expense.

One rule would be to require the securities industry to act in the best interests of investors. Right now, none of the players in the securities industry—financial advisors, investment firms, etc.—are legally required to act in the best interest of savers; their only duty is to maximize their own profits or salaries, a goal which is often at odds with maximizing savers’ returns. So, for example, when you go to your financial advisor for investment advice, your advisor is not legally bound to recommend investments that will give you the highest returns; instead, they’re incentivized to recommend funds that give them the largest “kickback” payments. To try to fix these perverse incentives, the Department of Labor has proposed a rule that would require investment advisors to be “fiduciaries”; i.e. to have the best interests of their clients in mind.

Another important reform would be to reform 401(k) fees. Though most retirement savers don’t realize that they pay fees, the securities firms that manage retirement plans actually charge savers a wide range of fees to administer and invest their retirement savings. And these fees can have a serious effect on savers’ returns. According to our recent study on 401(k) fees, they reduce the size of retirement nest eggs by an average of 30 percent. Funds are able to charge such high fees largely because of the incredible complexity of the retirement investment market: savers and employers who sponsor retirement plans often don’t know how much fees end up costing, and are simply unable to determine which funds will deliver the highest returns at the lowest cost. 

The Department of Labor’s new fee disclosure rules, which are just beginning to take effect, require more transparent disclosure of fees, but have been falling short in their goal of reducing fees, because, one, the disclosures still don’t show fees’ lifetime impact and, two, disclosure can only do so much to reduce costs in a market as opaque as the retirement savings market. To reduce fees to a reasonable level, we need to change the way in which the industry is compensated: because securities firms levy fees as a percentage of the total balance of savers’ accounts, they have little incentive to reduce costs, since, as the numbers from 2008 show, the firms still make out quite handsomely even in years where they perform abysmally. If fees were, instead, charged as a share of returns, savers would see both lower costs and higher returns.

However, even if both of these reforms together would not come close to fixing what, in reality, is a completely broken individual retirement system. 401(k)s expose retirement savers to a wide range of risks, and charge them too much while doing so. And these risks and costs are in fact a fundamental part of the 401(k) system that no amount of regulation or enforcement will fix. It’s clear that the 401(k) is not serving the needs of retirement savers. If we believe, then, that hardworking Americans should be able to retire with some comfort, we’re going to need to create a new retirement system

This entry is part of the series New Rules for Wall Street, where Demos analysts and members of the Coalition for Sensible Safeguards make the case for what should be on the financial-reform agenda in the next four years. Read all the entries here.