6 December 2021

The U.S. Needs Only One 401(k) Plan

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When Less Is Best 

Sometimes, competition leads to many solutions. The people don't seek a national television network. They want to choose from among hundreds of channels (albeit while continuing to complain that there's nothing to watch). At other times, though, consumers don't require variety. For example, they are content with two smartphone platforms, and but a single search engine.

The 401(k) system belongs in the latter camp. The public doesn't want more 401(k) flavors. Plan sponsors don't want more 401(k) choices. Retirement investors won't benefit from more 401(k) diversity. Quite the contrary. The more 401(k) products that exist, the greater the public confusion, the legal danger for plan sponsors, and the costs to both companies and their employees.

You needn't take it from me. The marketplace has spoken. When 401(k) plans began, in the aftermath of the Revenue Act of 1978, they were highly customized. Companies that adopted 401(k) plans used a variety of investments, including insurance-company pools, mutual funds, separate accounts, and company stock. All were actively managed. Effectively, every 401(k) plan was a tiny self-directed brokerage firm, offering a handful of options from which employees selected.

Moving Toward One 

Over the decades, the 401(k) industry has gradually standardized. Some variety remains, because sponsors tend to adjust their 401(k) plans incrementally rather than overhaul them abruptly. However, the drive toward conformity is clear:

1) Plan lineups are shrinking, as sponsors eliminate their actively run funds.

2) Almost every plan now includes index funds.

3) Ditto for target-date funds, which are usually a plan's default investment.

These trends are most pronounced with Vanguard. Last year, the company reports, 60% of its 401(k) participants owned but a single fund. Among that group, 91% did so through one of the company's target-date funds. Such investors exemplify all three of the industry's prevailing forces. They require only a limited fund lineup; they index (the method of investing for Vanguard's target-date funds); and they hold a target-date fund, which was likely selected for them.

In the fund industry, where Vanguard treads, others follow. In other words, future retirees will invest quite differently than did the early 401(k) adopters. By and large, future 401(k) participants will hold target-date funds. When they invest otherwise, they will mostly use index funds. The actively managed funds that were once the 401(k) industry's mainstream will continue to lose popularity.

The Lesson of Experience 

These developments have been driven not by dogma, or by astute marketing from index providers, but instead by experience. People want 1,000 channels because they like television. They enjoy browsing their options. However, as studies of participant behavior have amply demonstrated, they heartily dislike looking through 401(k) plan lineups. Investing gives most employees the shivers. They prefer that somebody else do the thinking for them.

They also prefer that somebody else take the action. From that desire was born the concept of a default investment, whereby, without effort, new employees are enrolled into their company's 401(k) plan, into a fund not of their own choosing. That these default investments eventually codified into target-date funds, rather than another type of broadly diversified fund, has been an accident of history. The details were not inevitable. But the existence of default investments was.

The shift toward indexing was also inevitable. Once again, the impetus has been practical, not political. Most actively managed funds, over most time periods, fail to keep pace with lower-cost index funds. Once that fact had been thoroughly demonstrated, through decades' worth of investment performance, plan sponsors changed their views. Initially, they favored active managers, but they switched to another approach after experience taught them otherwise.

Legal concerns have bolstered that decision. Last year, more than 200 class-action lawsuits were filed against 401(k) plan sponsors, with the most common complaint being excessive fees. All actively managed funds levy higher expenses than do the lowest-cost index funds, and all sometimes trail their benchmarks. Consequently, putting an actively managed fund into a plan runs a risk that using an index fund rarely does: being on the wrong end of a lawsuit.

For that reason, the recently published monograph Defined Contribution Plans by the CFA Institute--an impartial, not-for-profit organization that represents investment researchers and managers--recommends to plan sponsors that "passively managed funds" be "the default choice for their plans." Indeed, absent a strong belief to the contrary, "sponsors should make available only passively managed options." (The italics are mine.)

A Simpler Approach 

Which leads to the question: If 401(k) plans are converging toward a common structure, then why force companies to adopt their own 401(k) plans? Save them the time, expense, and hassle. Create a single national plan that all companies can access through their payroll systems. Relieve corporations from the burden of overseeing the investments for their employees' retirements. Few businesses seek such responsibility, and equally few are skilled at the task. 

The national plan would hold a default target-date series, based on underlying index funds, plus several passively managed single-asset funds. (Those interested in other investment options could open a brokerage window.) The national plan would be identical for all participants. However, it would not be a monopoly, as it would hire multiple vendors for its indexes. In that way, revenues from managing 401(k) assets would be spread among competing businesses, as they are today.

Such a structure would not prohibit corporate competition. As with today, plan sponsors could woo employees by matching a higher percentage of their 401(k) contributions. They could also enhance their plans by adding investment options. The point is not to limit the activities of ambitious plan sponsors. In fact, I propose to expand their opportunities, by protecting companies against lawsuits for selecting expensive and/or unsuccessful funds. (Since the additional investments would be viewed and presented as purely supplemental, caveat emptor.)

None of this, properly speaking, is my view. If employees were fascinated with 401(k) plans' diversity, disliked being enrolled into funds that they did not choose, and believed strongly in active portfolio management, then I would have written a different column, with different recommendations. Similarly, if most plan sponsors wished to bear the expense and fiduciary liability of running their own individual 401(k) plans, I would have arrived at another conclusion.

But none of those conditions apply. For 40 years, the 401(k) industry has conducted a public experiment to determine the best defined-contribution structure. The marketplace has answered. Broadly speaking, both employees and plan sponsors seek the same thing: simplicity and convenience. They want a solution that is easy to understand, with somebody else doing most of the work. They want a national plan.

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