5 critical fixes for 401(k) plans

Americans are terrible at saving for retirement, and 401(k)s make big mistakes all too easy. The solution? Make screwing them up harder to do.

By Liz Pulliam Weston

Most Americans are doing a lousy job of saving for their golden years, and retirement expert Alicia Munnell blames the 401(k).

Its not that 401(k)s are necessarily a bad way to save. Munnell, director of Boston Colleges Center for Retirement Research, found that theoretically a 401(k) can provide a richer retirement than a traditional defined benefit pension plan.

The problem is that real people, not theoretical ones, use 401(k)s -- or dont use them, which is worse. These voluntary workplace retirement plans offer novice investors plenty of opportunities to mess up, and millions are availing themselves of those opportunities. Among the issues Munnell and fellow Boston College economist Annika Sunden identify in their new book Coming Up Short: The Challenge of 401(k) Plans:

One out of four workers simply fails to sign up.
Only one in 10 contributes the maximum allowed.
Nearly half dont contribute enough to get the full company match.
Many take too much or too little risk, and most fail to rebalance their accounts to manage their risk.
About half cash out when they change jobs. (Admittedly, this is a squishy statistic. Hewitt Associates research says its 42%; Munnells research says 55%.)

As a result, many people are falling far short of what they need to save for retirement. The latest Retirement Confidence Survey, conducted by the Employee Benefit Research Institute, finds that many people arent saving at all (4 out of 10); that most have no clue how much they need to save (6 in 10 dont); that savings rates are woefully inadequate.

Four out of 10 people aged 55 or older, for example, have less than $100,000 saved. But someone making $50,000 a year at retirement, Munnell found, probably needs at least $350,000 to adequately supplement Social Security checks.

Currently, Social Security replaces 41% of pay for workers who make average incomes over their lifetime, and 56% of pay for low-income workers.

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But those replacement rates are scheduled to drop over time. Because of tax laws already in place, Munnell expects that by 2030 replacement rates will fall to 27% and 49% respectively. If and when Congress gets serious about fixing the Social Security mess, the replacement rate may drop even lower.

Which only makes the role of the 401(k) more crucial by the day. Most people who have any kind of workplace retirement plan have only a 401(k), and the money they save there will become critically important in how comfortable a retirement they can expect.

Can't we just go back to the good ol' days?
Many people would like to see a return to the days when traditional pensions were the rule and companies had to make all the investment decisions and suffer all the investment risk. Thats just not going to happen. Companies are unwilling to take on that burden, and lawmakers are unlikely to force it on them.

Besides, as Ive said, 401(k)s properly used could provide a richer retirement for todays job-hopping workers than a defined-benefit plan. That was particularly true the more often a worker changed jobs, Munnell and Sunden found, but 401(k)s still had the edge even if an employee stays at the same company for life -- the situation in which defined-benefit plans tend to provide the best results. In the researchers analysis, a defined-benefit plan would replace 50% of the one-company workers pay at retirement, while the 401(k) could replace 59%.

The analysis, however, made lots of assumptions:

The worker would start contributing to the 401(k) at age 30 and continue to age 62 (the typical retirement year).
The worker would contribute 6% of his or her salary, with the company matching half that, for a total contribution rate of 9%.
Half the 401(k) would be invested in bonds and half in stocks, with annual rebalancing, to attain an average annual return of 7.6%.

If the worker puts off contributing, contributes too little, overdoses on company stock or puts everything in a money market account -- all common behaviors, as I wrote about in 7 most common 401(k) blunders, theyre likely to fall far short.

So whats the solution? Lots of pundits call for more education for the masses, but Munnell says thats a waste of effort.

I really dont believe this problem will be solved by making each person into a mini-investment guru, Munnell said, nor do I think thats a good use of our national treasure, which is peoples time.

Many people are better off reading books to their kids, playing tennis, living their lives, than spending hours trying to figure out their risk tolerance, follow the gyrations of the Nasdaq or understand the subtleties of asset allocation.

The solution? Put laziness to work
The solution Munnell and Sunden propose is strikingly simple: put peoples laziness to work for them. Stop requiring the average worker to make retirement decisions that can be daunting for investment novices -- whether to contribute, how much to contribute, how to invest, what to do with plan money when you leave. Give them defaults that put them back on track. Such as:

Automatic enrollments.

Set contributions to get the full company match.

Set an automatic asset allocation.

Roll balances of departing employees into an IRA.

Roll the final balance into a low-cost annuity.

Workers would always have the chance to opt out of any of these defaults, but the automatic options would be there for the vast majority who need a steady hand to guide them into doing the right thing.

For these suggestions to work, companies would need more legal cover than they have now. Simply put, employers would need some protection from employee lawsuits if, say, the market takes a dive and workers decide to blame their companies for their declining 401(k) balances.

The IRS, the Labor Department and Congress have all created such safe harbors on other retirement issues. They can, and should, do so again. The 401(k) has become too important for us not to curb the rampant misuse, abuse and non-use that are threatening Americans financial futures.

Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.

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