By Mark Miller
(Reuters) – 401(k) accounts are far from perfect as a retirement benefit, but they are getting better, and more improvements are on the way.
For better or worse, private-sector employers have almost completely substituted the 401(k) for the good old-fashioned defined-benefit pension in recent decades. Not all workers had traditional pensions even in their peak years, but those who did benefited from automatic participation, professional investment management and a guaranteed lifetime income stream when they retired. With a 401(k), you’ve got an employer-managed, tax-deferred retirement account that allows you to invest part of your salary in a variety of mutual funds. The risk and responsibility is all yours, and translating whatever you have saved into income is challenging.
The most significant improvements to these plans over the past couple of decades have added more automatic processes and decision-making. Since the U.S. Congress passed the Pension Protection Act of 2006, a majority of plan sponsors have made enrollment automatic for workers when they start new jobs. Another improvement is the dominance of target-date funds, which automatically adjust the allocation of equities and fixed income as retirement draws near.
The changes have improved investor behavior. Vanguard this week issued its annual report on workplace plan trends, based on data from 5 million workers participating in plans that the company administers. It finds that a record-high 59% of plans offered automatic enrollment last year. The percentage of employees participating in plans stood at 82%, a figure that has improved from 75% in 2013.
Nearly all the plans studied (96%) offered target-date funds – and 83% of participants used them. Impressively, 70% of target-date investors had their entire account invested in a single target-date fund; that means their portfolios are on autopilot, which helps people avoid the harmful practice of trading in a reactive way to economic news. Vanguard reported that only 1% of investors who invested exclusively in a single target-date fund executed trades last year.
Many plans also have adopted auto-escalation, a feature that automatically escalates worker contributions each year. And the report finds that average 401(k) participant deferral rates stood at a record high of 7.4% last year – and that total savings rates hit a record high of 11.7%, when employer contributions are included.
NEEDED: WIDER COVERAGE, BETTER PROTECTIONS
That’s the good news. The flip side of this coin is a huge coverage problem. Only about half of private-sector U.S. workers are covered by a workplace plan at any given time, and most of them work for larger firms that tend to have well-run, low-cost plans that keep more money in the pockets of savers.
What’s more, the value of the two most important incentives to save are skewed to the highest-income workers. One is the ability to defer income taxes on contributions – a study published earlier this year found that the 59% of tax deferral benefits the top fifth of earners, compared with just 3.7% for the bottom 40% of earners. Another is the employer matching contribution. Research by Vanguard found that nearly half of the dollars plan sponsors contribute to employee 401(k) accounts goes to the top 20% of earners, exacerbating pay inequity.
These skewed incentives are one reason why nearly all of the savings are accumulated by high earners – and they help explain the large gaps in savings by race and ethnicity. Black households hold only 14% as much as white households, and Hispanic households just 20%.
More improvements are on the way. Starting in 2027, low-income workers can benefit from what amounts to a government matching contribution to their savings in workplace plans or individual retirement accounts. The Secure 2.0 legislation passed in 2022 upgraded an existing “saver’s credit” to a refundable “saver’s match” of 50% up to $1,000 that will be deposited directly into the saver’s account.
Secure 2.0 also includes several changes to the treatment of orphan 401(k)s that get left behind when workers change jobs. This is no small problem – one study estimated about $1.65 trillion is sitting in abandoned accounts, representing the savings of 30 million workers.
But the biggest change would extend the legal protections found in workplace plans to funds that you roll over to IRAs when you retire. Federal law provides fiduciary protections to money you save at work – that is, the plan sponsor must act in your best interest.
The U.S. Department of Labor recently finalized a rule that requires more financial professionals to act as fiduciaries when they advise people on investments that roll over from workplace plans to IRAs. A “best interest” regulation adopted in 2019 by the U.S. Securities and Exchange Commission already covers retail securities investment; this new rule would cover investments in commodities, real estate and annuities offered by insurance companies.
Going forward, the big challenge will be improving coverage. There is no doubt that automatic payroll deductions, coupled with an employer match, are the most effective way to save for retirement. Seventeen U.S. states have created “auto-IRA” programs to enroll earners lacking workplace coverage, and similar ideas have been proposed at the federal level – so far, to no effect.
A bolder federal solution is to expand Social Security benefits, with a focus on middle- and lower-income workers. The question is whether we have the political will to make that happen.
The opinions expressed here are those of the author, a columnist for Reuters.