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Annette Nellen

401(k) Concerns and Ideas

The current financial crisis has brought renewed attention to whether
401(k) retirement plans are adequately serving workers.

November 20, 2008
by Annette Nellen, CPA/Esq.

The current financial crisis has caused some older workers to postpone retirement due to a drop in the value of their retirement accounts. It has also led to renewed attention to some limitations of 401(k) plans and ideas on how to make them stronger retirement vehicles.

This article summarizes concerns raised by the House Committee on Education and Labor at two hearings held in October 2008 on 401(k) plans and retirement security. Some of the suggestions from these hearings and elsewhere are summarized as well (for IRS information on 401(k) plans, see Tax Topic 424 and 401(k) Resource Guide).

401(k) Data

A 2008 report of the General Accountability Office (GAO) found that for 2004, 26 percent of households participated in a 401(k) plan compared to 29 percent owning an IRA. About 10 percent of households had both an IRA and 401(k) plan. Contributions to 401(k) plans exceeded those to IRAs by about 400 percent (GAO, Individual Retirement Accounts (PDF), June 2008).

Financial Troubles

Per Congressman George Miller, chair of the Committee on Education and Labor: “Over the past 12 months, more than a half trillion dollars have evaporated from 401(k) plans as a direct result of the crisis in the markets.” (October 2008 statement (PDF)).

In October 2008, the Congressional Budget Office (CBO) estimated that defined benefit (DB) plans experienced a 15 percent decline in the value of plan assets over the past year. The CBO also estimated that because defined contribution (DC) plans, such as 401(k) plans, tend to have more stock investments than do DB plans, they may have experienced a greater decline in value. The CBO also observes that because households tend to view DC plans as part of household savings, the drop in value could result in decreased spending as well as delayed retirement. (CBO testimony (PDF), October 2008.)

401(k) Concerns

While 401(k) plans have enabled many workers to save for retirement, a variety of concerns over their effectiveness have been raised. Many of these concerns are highlighted when DC plans are compared to DB plans. Some of the concerns workers, employers and the government have with 401(k) plans as ideal retirement savings vehicles include:

  • Not all workers are covered because their employer offers no plan, they are not automatically enrolled or they chose not to enroll.
  • Participation and contribution levels differ among income and age groups.
  • Early withdrawals for hardship are not restored.
  • Benefits are not guaranteed or protected from inflation.
  • There is no protection should a person outlive their retirement savings.
  • Workers may not have the financial knowledge to create an effective contribution and investment strategy.
  • Management fees and other costs may be high and are not always transparent to the participant.

Suggestions for Improving 401(k) Plans

Following is an overview to various proposals that have been offered to improve 401(k) plans. Financial crisis relief: The current financial crisis has generated a variety of proposals to help retirees preserve their accounts. For example, one suggestion is to grant relief to retirees who prefer not to take a required minimum distribution (RMD) if doing so would require selling assets at a loss. In October 2008, Congressmen Miller and Andrews requested that Treasury take action on this suggestion (see October 2008 press release).

H.R. 7242 proposes various pension plan changes including that no penalty be assessed for failure to make a distribution if the aggregate value of a taxpayer’s individual retirement plans is $200,000 or less.

Both presidential candidates called for variations on limited fund withdrawals beyond the current hardship rules (Geisel, “McCain, Obama Spar Over 401(k) Proposals,” Financial Week, October 2008).

Greater transparency and access to information: H.R. 3185 requires greater disclosure of information on services and associated fees. In September 2008, the Senate Committee on Health, Education, and Labor & Pensions held a hearing on 401(k) fee disclosure.

In summer 2008, the Department of Labor (DOL) issued two sets of proposed regulations on 401(k) plans. The regulations issued in July call for fee, expense and investment option information for participants using a comparative chart. The regulations issued in August propose requirements that aim to improve accessibility of investment advice for plan participants.

Financial literacy: The House passed resolutions supporting Financial Literacy Month (April). H. Res. 273 notes a 2004 survey which found that only 42 percent of workers have calculated how much money they must save for retirement. In addition, 37 percent of workers acknowledge that, at present, they are not saving for retirement.

Wider participation: Over the past few years, various proposals have been suggested that aim to increase participation and modify current government subsidies. Two plans that have received wide attention are Guaranteed Retirement Accounts (GRA) and a universal 401(k) plan. These plans differ in terms of how workers obtain coverage and the government’s technique for supporting the plan (such as through tax benefits or specified contributions).

Professor Teresa Ghilarducci of The New School for Social Research in New York proposes the GRA plan under which workers not covered by a DB plan would have an account established by the government. Each year, the government would deposit $600 into the account with that amount adjusted annually for inflation. Workers would also have five percent of their earnings deposited into their GRA. The government would pay a guaranteed return that would be adjusted for inflation.

Professor Ghilarducci posits that this five percent contribution and three percent inflation-adjusted return would enable workers to supplement their Social Security benefit such that they would “achieve a 70 percent replacement rate at retirement.” (October 2008 testimony (PDF) before the Committee on Education and Labor.)

Professor Ghilarducci suggests that her plan could be funded through the elimination of poorly targeted subsidies in the current 401(k) system. She notes that today, about 50 percent of the federal budget subsidy for 401(k) plans benefits six percent of workers with incomes over $100,000. For additional information on GRAs see Professor Ghilarducci’s 2007 paper for The Economic Policy Institute.

The universal 401(k) plan has been offered in varying formats. During the presidential campaign, Senator Hillary Clinton, D-NY, proposed a portable, universal 401(k) plan for all workers that would provide limited matching grants from the government.

Gene Sperling of the Center for American Progress has proposed a universal 401(k) plan that provides funds for low and middle income workers (Sperling, A Progressive Framework for Social Security Reform, 2005). His rationale is to reverse today’s retirement tax subsidies that provide greater benefits to higher income individuals due to their higher tax rate. Sperling calls for limited matching contributions and a refundable credit for the accounts. Portability and automatic enrollment would also be elements of the plan. The New America Foundation (PDF) has also proposed a universal 401(k) plan.

Outlook

Growing responsibility over one’s retirement savings, increasing longevity and low financial literacy pose challenges to effective use of 401(k) plans. These factors, in addition to the adverse effect of the current financial crisis on retirement savings and talk of federal tax reform, all make for a perfect opportunity to thoughtfully review current retirement tools to ensure they best serve the needs of all workers. We’ll likely see that the hearings and proposals of 2008 were just the opening act.

View a list of links to recent congressional hearings on retirement savings.

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Annette Nellen, CPA/Esq., is a tax professor and Director of the MST Program at San José State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the AICPA and ABA. She has several reports on federal and state tax reform and a blog.