Is It Time to Reform the 401(k)?

Last month, PBS’s Frontline aired a blockbuster episode on America’s retirement system. You can watch the whole thing free online.

It features some of my heroes, like Vanguard’s John C. Bogle, and some of my favorite financial writers like Helaine Olenand Jason Zweig.

The show argued that America’s self-directed retirement system—the 401(k) and similar products—is complicated, expensive, and rife with conflicts of interest.

I agree, and I’ve written extensively about how 401(k)s charge hidden fees, offer bad investment options, and are generally incomprehensible.

But in discussing the show with some of my favorite financial thinkers, I realized that while everyone seems to agree that the system needs to be fixed, there’s a major philosophical divide about how to fix it.

Forgetting about political feasibility for the moment, the question is this: Should we reform the 401(k) or get rid of it and replace it with something else?

Small steps

Allan Roth, a Utah-based certified financial planner and blogger for CBS News, says we should give every worker access to the federal government’s Thrift Savings Plan (TSP).

“Personally, I’d love to roll my IRAs to the TSP to both get access to the G fund and lower cost stock funds,” says Roth.

The TSP is the model for what every 401(k) should be like: its only investment options are ultra-low-cost index funds, plus the G fund, a government bond fund that never loses principal.

“Americans need to save more and the best way to get them to do this is to force them to affirmatively opt out of saving,” says Dave O’Brien, a certified financial planner in Midlothian, Virginia.

O’Brien sees the 401(k) system from both sides: he advises clients who are saving for retirement and also companies who want to design a better 401(k) for their employees.

All too often, O’Brien sees people taking 401(k) loans for foreseeable emergency expenses. “Participants should be encouraged to save into an FDIC-insured emergency fund account before saving into their qualified plan in order to be eligible for a loan,” he says.

He continues, “Far too many people borrow from their 401(k) because they have no cash saved to pay for the new transmission, etc.”

I’d love to see Roth and O’Brien’s reforms implemented. I’m eager to roll my IRA into the TSP without having to get a federal job, too.

But as much as I rail against bad funds and high 401(k) fees, I’ve become increasingly skeptical that any voluntary approach to retirement saving will produce the result we presumably want from our retirement system: allowing people to retire at a reasonable age and preserve (at least approximately) their pre-retirement standard of living.

Why we fall behind

Here’s a thought experiment:

Let’s say all mortgages were structured as a 30-year loan with no monthly payments and a 100% balloon payment due at the end. The homebuyer would be responsible for setting aside, say, $300,000 over the course of 30 years then handing it over to the mortgage holder as a lump sum.

How many people would keep up with their mortgage payments under this system? That is: after 20 years, what percentage of homeowners would have $200,000 saved, and how many would be behind?

The answer is obvious, right?

Practically everyone would be behind. It’s not because they’re lacking in personal responsibility; it’s because the rules of the game are dumb.

What’s the difference between this hypothetical and saving for retirement? Basically nothing, except that in the real world, you get punished in the short-term for not making your mortgage payment but get punished in the long-term for failing to save for retirement.

And psychologically, it’s much harder to change your behavior to avoid long-term pain than short-term pain. Long-term consequences just don’t feel real, and this is a fact of human psychology.

And saving for retirement is much more complicated than paying off a mortgage, so all the more reason to weasel out of it.

Tess Vigeland, the former host of American Public Media’s Marketplace Money and now a freelance writer and voiceover artist, says, “Based on the emails and calls I fielded in six years hosting Marketplace Money.”

“I don’t see how we can expect people to parse 401k options and statements when they (a) have trouble balancing their checkbooks and (b) don’t understand how CDs work,” she says

The role of financial literacy

It’s easy to respond to this line of reasoning by saying, okay, fine: we need to do a better job of teaching people that saving for retirement is important and how to use the tools they have available.

“As for the argument that we need more education and advice, how much more could there be?” asks Vigeland.

She says, “There are thousands of financial advisers. There are hundreds of websites with all kinds of information to read and try to understand. There are even great radio shows that try their best to clarify and help out. And yet, we still have this problem. So clearly it’s not working.”

One obvious (and politically impossible) approach is to expand Social Security or supplement it with a similar pension-like program.

The program would be mandatory, would reward work because the payout would be based on paycheck deductions, and would be regularly reviewed and modified to keep it solvent.

That’s pie-in-the-sky. But what about a hybrid system that would keep investment decisions in the loop? Keep the 401(k). Make the TSP available to any employees who don’t have a 401(k) at work or have a lousy one.

Now, make two little tweaks:

• Make minimum contributions mandatory. Send 10% of every paycheck to a worker’s 401(k) by law, the same way we require payroll deduction for Social Security and income tax. People would be allowed to save more, but not less.

• End 401(k) loans and early withdrawals. Once you put the money in, you can’t get it out until retirement age. Special rules could apply to situations like total disability.

These aren’t crazy ideas. They already apply to Social Security: you can’t choose not to participate, and you can’t crack into the money early.

But this supplemental system wouldn’t be at risk of insolvency, because there’s no promised payout; it’s based on the actual investment performance of the account.

Yeah, I’m a dreamer. But as long as we have a retirement system that resembles a 30-year mortgage with a balloon payment, most Americans will undersave.

What’s crazier: trying to change the law of the land, or the laws of human behavior?

Matthew Amster-Burton is a personal finance columnist at Mint.com. His new book, Pretty Good Number One: An American Family Eats Tokyo, is available now. Find him on Twitter @Mint_Mamster.