4 August 2020

401(k)s Will Be Considered Unthinkable

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How much money do you have saved in your 401(k)? In 50 years, no one will ask. Even better, no one will have to provide the usual answer: way too little. Our 40-year experiment with 401(k)s — tax-favored investment accounts for retirement sponsored by employers — will be seen as an unfortunate interregnum, a massive waste of taxpayer dollars to bolster the retirement security of the rich while undermining the retirement security of the rest.

Added to the tax code with little foresight in 1978, Section 401(k) cannibalized America’s public-private framework of retirement security. Prior to the regulatory authorization of 401(k)s in the early 1980s, employers couldn’t legally provide tax-favored vehicles for retirement savings in which workers themselves controlled and directed the funds.

Instead, the pension plans that were the norm among medium and large firms — offered by roughly 4 in 5 such employers — were called “defined-benefit plans”: basically a private form of Social Security where employers made most of the contributions, handled the investments, and paid out the benefits at retirement based on a formula that was legally binding.

Today, vanishingly few private employers provide a defined-benefit plan, and they’re mostly legacy offerings covering older workers. If a recently hired worker has a plan at work — and more than a third of workers still aren’t offered any plan — it’s a 401(k). Three numbers and a letter spell the future of American retirement security.

And that’s a problem. There’s a reason, it turns out, why employers didn’t hand retirement planning off to workers: 401(k)s are terrible at ensuring that those who need to save for retirement do. Indeed, over the same period in which 401(k)s expanded, the share of working-age households at risk of being financially unprepared at age 65 jumped from 31 percent (in 1983) to more than 53 percent (in 2010). Indeed, the terribleness of 401(k)s helped spark a new field of behavioral economics, which showed that voluntary plans in which people manage their own investments defy everything we know about how the brain works.

Traditional pension plans force people to save and protect them against investment mistakes, market risks, and the possibility of outliving their savings, not to mention predatory financial institutions. 401(k)s don’t, and, lo and behold, most people don’t put enough in them, make serious investment errors, and fall prey to heavy fees that crush long-term returns. Worse, because 401(k)s can be tapped into (with a penalty) before retirement and are transferred to workers when they lose or change jobs, middle-class workers often use them as rainy-day fund when times are tough, further beggaring retirement security.

Granted, 401(k)s work well for one group — the group who needs them least. For the affluent, 401(k)s are a lucrative way to manage retirement investments. They are also a great way to build up an estate and delay paying taxes. (Traditional defined-benefit plans didn’t become part of workers’ estates; like Social Security, they promised benefits for the remainder of a workers’ lives, pooling the “risk” of living longer — and potentially running out of money — across all those covered by the plan.)

Because they are subsidized through delayed taxes, 401(k)s are worth the most to households in the highest tax brackets. Moreover, higher-income workers are also more likely to be offered a plan, to have their contributions matched by their employers, and, of course, to have the financial freedom to put money in them. As a result, nearly 70 percent of the $190 billion in tax breaks for retirement and income security accrue to the top 20 percent.

To be sure, 401(k)s have served one purpose. Corporate America’s eager embrace of them showed that employers can’t or won’t play the role they once did. But we now know that individual risk management isn’t a workable alternative to corporate risk-pooling.

The obvious solution is a strengthened Social Security system, and fortunately measures to boost Social Security’s benefits are back on the national agenda (and enjoy overwhelming public support). John Larson, a Democratic representative from my home state of Connecticut, has 200 House co-sponsors for his “Social Security 2100 Act,” which would boost benefits and raise revenues to ensure the program’s solvency through, yes, 2100.

If 401(k)s were necessary to get such sensible measures a second look, then they deserve our grudging respect — at their funeral.

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