Is the 401(k) a good thing?

By Felix Salmon
July 21, 2009

Mike Konczal (he’s come out now) says, plausibly enough, that the most important financial innovation of the past 30 years is the 401(k). Which is not to say, of course, that it’s a good thing.

Mike says the 401(k) is “the creation of a loophole in a tax bill”, which I think is doing it something of a disservice — the move from defined-benefit to defined-contribution pensions is a global one, and Mike’s really just using the 401(k) in particular as a proxy for defined-contribution pensions in general. Those would have taken off regardless, even if that particular tax bill hadn’t existed.

Mike’s right that such plans aren’t an obvious improvement on what went before. In fact, looking at his arguments in favor (“it’s a plus that consumers can directly manage their retirement finances”), one in general isn’t very impressed: there’s no reason to believe that consumers are particularly good at managing their retirement finances, and quite a lot of reason to believe that they can be extremely bad at it. That said, Mike’s right that there’s an air of historical inevitability to the whole thing. You might not like it, but it was bound to happen sooner or later.

There’s also however an air of historical inevitability about individuals schooling and working longer before they have families; I don’t think that the 401(k) was an important cause of that particular trend, although the hypothesis is intriguing.

In any case, Mike’s done nothing to counteract my thesis that financial innovation over the past couple of decades has been, on net, a bad thing. The 401(k) might be very important. But I’m far from convinced that Americans are better off for it.


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>> But I’m far from convinced that Americans are better off for it.

Well, of course you’re right, Felix. We are always better off when someone more intelligent and capable is looking out for our interests. We even have a name for them; we call them Democrats.

Posted by Curmudgeon | Report as abusive

Sorry, couldn’t resist.

Posted by Curmudgeon | Report as abusive

I think we’d be better off with a higher boundary for tax-free interest and dividends. Allow people to earn median income from interest and dividends tax free and the incremental incentive to save with savings accounts, money markets, and CDs explodes. The need for tax sheltered accounts with their associated management fees is reduced.

Now cynic that I am, I think that we have this crazy low boundary on interest income for two reasons: First it enables a system of managed IRAs and 401Ks which earn tremendous fees for Wall Street, and second it caters to that old populist impulse against “unearned income.”

The truth is, everyone wants unearned income by the time they retire, and our schizoid solution is a maladaption.

The question is not a good question. Could there be a better program for retirement? Sure, almost anything can be improved, especially a creation of congress. Is it better than nothing? Yes, again. Not only are all companies not capable or qualified to administer a pension plan, but as witnessed by countless cash-challenged companies, most can not be counted on to actually deliver the benefits promised by a pension plan. In fact, when push comes to shove (or when a stream of automatic profits dries up and management’s inability to figure out how to make money is exposed, pension plans are invariably tapped. Or worse, companies go out of business without having a large enough voting block to get congress to guarantee benefits.

So are Americans better off because of the 401(k)? Maybe not all, but many of them wouldn’t have had an alternative, and wouldn’t have saved anything. So, yes.

Posted by KenG | Report as abusive

It is clear to me that no one should have a defined benefit pension plan in the future as opposed to a portable defined contribution plan and most important of all, public entities at all levels cannot go bankrupt with the latter. There is also far less scope for corruption with defined contribution.

Regards, Don

Posted by Don Lloyd | Report as abusive

Of course the 401(k) is a great improvement over fixed contribution plans. It frees the worker from being tied to one company and removes their counterparty risk. Sure, the PBGC helps in some regard but I don’t think it replace 100% of the pension if the company goes BK. Returns to the investor should be roughly the same in both cases (poor individual investing vs. poor pension plan investing), but the added independence is very valuable.

Posted by A | Report as abusive

Isn’t it interesting that the growth of 401Ks has coincided with a drop in savings (to zero, until the recent uptick)?

A lot of people with 401K “savings” are actually in debt and not saving at all. This is a bonanza for the financial industry because they profit from the debt and the investing of the borrowed money.

Posted by Max | Report as abusive

By the way, a good reform would be to eliminate all interest tax deductions for people who contribute to 401Ks (or IRAs etc).

Posted by Max | Report as abusive

I have always thought that it would really help the current housing crisis to let people pull out money penalty free from their 401k’s in order to put a downpayment on a house that they are going to live in. That is money that people have already saved and letting them access those funds in order to put down a larger downpayment would seem to be a big help in the current situation where it will take a lot of time for people to get to the point where they can start putting 20% down on a house. Say cap the amount to be taken from the 401k to 20k and limit it to half your downpayment so that people still do need to save funds on their own.

Posted by spotatl | Report as abusive

Anything that provides freedom of choice is a good thing.

The problem is mutual funds(probably run by HBS alumni)marketing the investments as safe in “blue chips” to naive 9-5 consumers.

Posted by dvictr | Report as abusive

The alternative to the 401k is a pension plan. The problem with that is that you are tied to one company for the rest of your life. That may be fine for some, but not for others.

Posted by john | Report as abusive

@John: The problem is that I know of only a few companies that have outlasted my career, and I have worked for none of them. Further, I have no idea why, on an economic basis, the auto industry pensions continue to survive (although I do on a political basis). Companies simply don\’t survive for any given career these days. To even offer the option of a pension based on a lifetime with one company seems criminal. The only option is for all of us to work exclusively for the government.

Posted by Curmudgeon | Report as abusive

@Max: We already do that; we call it a Roth IRA. The problem is that you have to offer some incentive for people to save in a defined contribution plan. It is probably better to make that incentive immediate rather than deferred, but I don’t feel strongly either way (even though I understand that the Roth is a better incentive in the long run).

Posted by Curmudgeon | Report as abusive

I’m writing from the Investment Company Institute, the national association for mutual funds. More than 40 percent of the assets in 401(k) plans and individual retirement accounts are in mutual funds, so we take a strong interest in retirement issues.

401(k) plans have a remarkable track record of success in providing Americans incentives to save, invest, and think long-term. Consider the numbers. Even though 401(k)s have been around for less than 30 years—not even a full working career—Americans have accumulated $2.4 trillion in these plans. And that doesn’t count hundreds of billions of dollars saved in 401(k)s and rolled over into IRAs.

Assessing the significance of that accumulation, economists James Poterba of MIT, Steven Venti of Dartmouth, and David Wise of Harvard conducted a detailed study of 401(k)s in 2007. They concluded: “Our projections suggest that the advent of personal account saving will increase wealth at retirement for future retirees across the lifetime earnings spectrum.” The Employee Benefit Research Institute and the Investment Company Institute got similar results in 2002, when they projected what 401(k)s could accumulate across a full career under a range of participant behaviors and scenarios—including modeling various long-term market returns that included significant historical market downturns (e.g., 1931, 1937, 1974). That study found that 401(k) assets could replace at least half of pre-retirement income for more than 60 percent of 401(k) participants reaching the age of 65 between 2030 and 2039. Add in Social Security, and median replacement rates range from 106 percent of pre-retirement income for the lowest income group to 84 percent for the highest.

We think Americans are well-served by 401(k)s and that we can build on their success. We should preserve the best attributes of 401(k)s: portable benefits, fiduciary standards for plan decisionmakers, diversification opportunities, and the ability to take advantage of catch-up contributions and employer matches. We should also improve disclosure, encourage more employers to offer plans, and make financial literacy a national priority.

Thanks for the chance to comment – Ianthe Zabel, Investment Company Institute

I think that one of the perverse consequences of the 401k is that everybody wants shares to go up, because that makes them richer.

Therefore everybody prefers lower interest rates and the end result after 15 years of cutting rates is a colossal misallocation of capital and now collapse.

Essentially the 401k has co-opted the man on the street , and has convinced him that he as well can be rich through stock ownership. Its the old popular capitalism idea of Maggie Thatcher.

However owners of all these 401k do not see that they are actually poorer in relative terms , even if their account shows healthy rises.

Insiders make much more money in this game of inflating share prices. Either people who work in the companies( through option schemes and scams) or people who owned companies and floated them.

People that are fundamentally workers ( meaning that their main source of income is their working hours) have accepted to have much lower wages , because they believe that with their 401ks they will partake in the spoils of capitalism.

Sadly they end up with a much smaller part of they pie, but oh how they are happy!!!

Posted by Fred Engels | Report as abusive

What good is a 401K ? I’ll educate all of those who think you buy, put away, and forget about stocks… is called investing for your future.

Say for one moment your 401K is representative of the Dow Jones Industrial Avg. The investment I am thinking of would have required 45 of them to buy one basket of the DJ 30 stocks in 1997. Today, in spite of a run in 2007 to record high of 14,198, I can buy a basket of DJ 30 for only 9 of them. Based on what I am thinking of, you’ve lost 60% on your money over a 12 year period. Me? I’m prepared to make more. What do I own ? You can’t own it in your 401K …Ha ha ha !

Posted by John P. Crowley | Report as abusive

Retirement planning is an unexpectedly subtle discipline. Even if someone knows how to calculate a present value or future value—surely a small proportion of the population, in my experience—they are unlikely to (a) discount the accumulated values by inflation to get the “true” dollars that this will purchase, (b) will overstate the risk equity premium and view that return as an absolute value rather than the most likely single value (c) will underestimate their own life span. Pension actuaries don’t do that, and defined benefit plans in general do a good job in providing a benefit (both by doing the planning and making sure that the normal form of the distribution is an annuity).

By contrast, a 401(k) is a salary reduction plan—the participant’s current income is reduced to fund the plan. These plans were first popular with high-tech firms, which paid pretty good wages but couldn’t afford the pensions that some of their employees were clamoring for. Note that when every company offers a 401(k) that salaries are inherently overstated and savings for retirement is a hidden, personal choice—which is exactly what you don’t want in public policy.

As for being portable—a defined benefit plan could also be portable, if vesting were immediate. The real difference is that defined benefit plans inherently favor the older members of the work force.

My own personal hobby-horse: annuitization is largely underpracticed in retirements. Permit cash “opt-ins” to social security that would provide a life annuity, inflation-adjusted, with extremely low expenses (two of the reasons annuitization is so low is the administrative expense and credit risk of insurance companies).

Posted by Richard | Report as abusive

Better off than what? Defined contribution beats defined benefit hands down.

That said- most mutual funds aren’t a great deal. I rollover my 401(k) plans into IRAs as soon as I can for investment flexibility. The best plan would be to switch everything to Roth style accounts- post tax, free growth.

Posted by mattmc | Report as abusive

The best thing about the 401(k) is that it shifts the taxes paid by middle and upper income Americans from when they are high earners and low users of government services, to when they are low earners and high users of government services.

From that viewpoint, the advent and expansion of the Roth IRA and Roth 401(k) were gad things, as they shifted federal tax income forward rather than delaying it.

Posted by MattJ | Report as abusive

I don’t think Mike was trying to suggest that 401(k) has been a positive development, just significant (as in affects a lot of people, involves a lot of money).

Posted by ang | Report as abusive

\”Well, of course you’re right, Felix. We are always better off when someone more intelligent and capable is looking out for our interests. We even have a name for them; we call them Democrats\”

As everybody knows, we are the best to decide what is best for ourselves. That way, we get health insurance that covers what we do not need and pushes us towards bankruptcy, invest in retirement having no idea of the risks involved, buy \”explosive cars\’ (a.k.a. Ford Pintos) and so on.
Of course, as we are left in the hook for the whole bill others make fortunes out of it
We even have a name for those who predate on others\’ ignorance and make tons of money out of it: Republicans.

Prof. Zvi Bodie wrote quite a bit against making financial experts out of the average Joe; but if you believe otherwise, I suggest following Bodie\’s advice: next time you need surgery just get a pamphlet of what the surgery is about and operate yourself. Sounds idiotic? Well, it is what most of 401(k) holders do.

Posted by targetpredators | Report as abusive