401(k) Plans: Too Risky for Retirement Security?

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As the nation’s economic troubles deepen, the most popular retirement savings plan for American workers is coming under increasing scrutiny for its inability to weather the current financial storm. The question is, will it remain viable for the future?

In the last 14 months, nearly $3 trillion has been erased from U.S. employees’ 401(k) plans and Individual Retirement Arrangements as market turmoil wiped out years of gains. With no end in sight, policymakers and financial experts are questioning whether such plans are too flawed or too risky to be one of the most relied-upon sources for retirement security.

During a hearing on the financial crisis in October, Rep. George Miller, D-Calif., chairman of the House Education and Labor Committee, expressed misgivings about the future of the 401(k). The retirement plan hasn’t been as secure as Americans expected, he said, nor has it “provided the returns … or level of savings that we want it to.” He described it as “failing on several fronts.”

Miller called for a serious reassessment of the 401(k) structure and said hearings would resume in 2009.

“The biggest issue is the losses that have occurred in the market and the need for policymakers to address that,” says Reid Cramer, a research director at the New America Foundation, a think tank in Washington. “This is compounded by pressures on employers to maintain and contribute to these plans in an economic downturn.”

Many companies that in previous years have contributed a “match” to their employees’ 401(k) accounts are, in fact, suspending or trimming their contributions.

In a survey of some 5,500 companies earlier this year, 63 percent said they offered a 401(k) plan with an employer contribution—down from about 80 percent last year and from every year since 2004, according to CompData Surveys, a consulting firm in the human resources industry.

“It’s the first time in 20 years where we’ve seen a drop like this,” says Amy Kaminski, a marketing programs manager for CompData Surveys. “The economy is not great and there are tough decisions for employers to make—whether to do layoffs or cut back on benefits. And cutting back on benefits is an easy way to affect their bottom line.”

At the same time, many workers have stopped contributing to their plans or cashed out completely. According to an AARP survey released in October, one in five Americans age 45 and up stopped putting money into a 401(k) or other retirement plan in the last year. Though they know such a move may imperil their future retirement, they are distraught over losses and, said one woman, “can’t stand throwing good money after bad.”

When the market tanks, not much can be done to mitigate those losses. But Cramer suggests a few measures to prop up 401(k)s, including stronger investor protections by plan providers—for instance, using a pay raise to automatically trigger increased contributions; offering well-diversified investment choices; and automatically moving investors into target date life cycle funds, which offer them less risky investments as they age.

About 50 percent of U.S. workers—an estimated 50 million people—have 401(k)s, which have gradually replaced traditional, employer-funded pensions. Among their advantages, the 401(k) and the similar 403(b) and 457(b) plans (which cover educators, some nonprofit workers and others) provide tax-sheltered retirement savings. They’re also portable, meaning they can be rolled into another retirement savings plan without penalty when employees change jobs. And they allow individuals the flexibility to choose their own investments.

At the same time, the risks and responsibilities of investing in the market are placed squarely on the shoulders of employees themselves, unlike in traditional company pension plans, which guarantee lifetime payments based on salary and years of service. As a result, those who make poor 401(k) investment decisions or save too little or take withdrawals may not have enough at retirement to last a lifetime.

Even when things are done right, there’s no guarantee of a reliable retirement income stream. Because the plans are tied to the market, workers who have had the misfortune to retire during a downturn could outlive their savings—a signal failing of a retirement system.

Teresa Ghilarducci, a professor of economics at the New School for Social Research in New York, believes the market downturn has shown that 401(k)s may not be the best approach to retirement saving. It’s time to retire the 401(k), she says, and make people save through a mandatory, universal savings plan on top of Social Security.

Testifying before the House Education and Labor Committee, Ghilarducci presented a bold alternative: Create a government-run pension program that would offer retirees a guaranteed, inflation-adjusted 3 percent return. And pay for it by eliminating $80 billion in annual tax breaks currently applied to 401(k)s.

In contrast to Social Security’s pay-as-you-go system, the accounts would be fully funded so that contributions would be credited to an individual’s account and not used to pay for current retirees’ benefits. Also, she says, account holders would be prohibited from tapping into their funds, to prevent what she calls one of the biggest flaws of the system—potential depletion of savings before retirement.

“People just want a guaranteed return for their retirement,” she told AARP Bulletin Today. “The essential feature of my proposal is that people and employers would be relieved of being tied to the financial market.”

The financial crisis and the effect of fluctuating market conditions on 401(k)s have emphasized, for many, the value of Social Security. Henry Aaron, a senior fellow at the Brookings Institution, says it’s become especially important for government to “maintain the adequacy” of Social Security benefits for retirees.

For all of its recent problems, however, the 401(k) still has many supporters. Among them is Chicagoan David Wray, president of the Profit Sharing/401k Council of America, who maintains the 401(k) is here to stay. Losses from the downturn will eventually be recovered, he says, so workers should keep contributing to their plans.

“The flexibility of the [401(k)] program is one of the reasons why it’s been successfully implemented all over the country,” he says. “It will continue to be the backbone of retirement savings.”

Carole Fleck is a senior editor at the AARP Bulletin.