The Argument for Mandatory 401(k) Participation

Turning Nudge Into Insistence
The pendulum is swinging hard.

Fifteen years ago, amid the optimism of the New Era, more was almost universally regarded as better for 401(k) plans. If investors benefited from being able to pick and choose from thousands of mutual funds in their other accounts, then why restrict them to a mere handful of funds in their 401(k) plans? Such was the sentiment. Plan sponsors responded by bulking up fund lineups and, in some cases, opening brokerage windows.

That mindset is now but a memory. The current trend in 401(k) plans is to limit choice, or at least the appearance thereof. Cut the number of investment options. Steer investors toward the single option of target-date funds. If they don't enroll on their own, default them into the plan--and hope they don't realize that they can promptly opt out. As for brokerage windows, the Department of Labor is now considering banning them altogether.

Which leads to the big question. The mother of all 401(k) questions. If 401(k) investors are best served by paternalism (to mix my parental metaphors), then why not follow that logic to its conclusion? Stop with the nudge, and move to insistence. With defined-benefit plans being phased out of existence, and most people unable to fund their retirements in another fashion, the American retirement system has but two legs: Social Security and 401(k) accounts. To leave the latter at an employee's whim seems irresponsible.

So goes the argument--and for the first time, I have some sympathy for the idea. Previously, I have categorically shied away from proposals to make 401(k) participation compulsory. After all, there are plenty of laws on the books already, and plenty of restrictions on how Americans are permitted to lead their lives. I am in no hurry to embrace new rules and further limitations.

However, I am adjusting my thoughts in response to new research that crossed my path. This research does not concern the common claim that the United States is in the midst of a "retirement crisis." That is not a claim that I believe. From Doug Short, contributing to Advisor Perspectives:

The orange line has enjoyed an excellent run. For the foreseeable future, retiree income will be the best-performing segment of American household income since 1970. That does not strike me as a crisis.

I do believe, however, that Washington could make matters worse. To ease the strain on the federal budget and, ironically, to ostensibly improve the quality of American retirements, politicians have floated that the age for the maximum benefit paid by Social Security might be pushed to 68 years, or possibly even 70. These proposals temporarily are dormant, but in a different political climate could be revived.

If Social Security benefits are cut, I do not believe that American workers and companies will change their habits significantly. Americans will not retire at a later age than they do today. They merely will receive lower Social Security benefits. Then, perhaps, the U.S. will indeed have its predicted retirement crisis.

I write this after reading through a 187-page survey entitled 2013 Risks and Process of Retirement Survey--Report of Findings, prepared by Mathew Greenwald & Associates and sponsored by the Society of Actuaries. The authors conducted 2,000 interviews, half of which were with workers who have not yet retired, and half of which were with retirees. By taking such an approach, the authors were able to contract pre- and post-retirement viewpoints. If the two sets of responses matched, then workers had a pretty good sense of what awaited them. If not, then they were in for a surprise.

And the largest mismatch of all was … retirement age. On average, the workers expected to retire at age 65. The 65-year-old figure wasn't a plug given by 20-somethings who hadn't given the subject any thought. The survey only was given to those who were at least 45 years of age, so that was the answer from mid- to late-career employees. However, when retirees were asked that same question, they responded that they had retired at an average age of 58--seven years earlier.

To an extent, this discrepancy can be interpreted as being part of the reported retirement crisis: The previous generation had the luxury of retiring earlier, presumably because it had access to a defined-benefit pension while the newer generation is stuck with a 401(k) plan, while the upcoming generation must work several more years. However, upon further reflection, this explanation seems faulty.

For one, the survey doesn't fall neatly along generational lines. One third of the retirees were relatively young, being between 45 and 59, and another third were in their 60s. Effectively, those groups belong to the same generation as the pre-retirees. Also, baseline numbers don't change that fast. It is highly unlikely, to say the least, that a survey group that is only a few years younger will dramatically change its habits and work for seven years longer. Two years would be a large move indeed.

For another, the results don't appear to be affected by the availability of a defined-benefit pension rather than a 401(k) plan. When asked if they received defined-benefit or defined-contribution (i.e. 401(k)) income, retirees who answered no to either question did indeed retire at a later date. However, those who answered yes to either question had almost identical aggregate retirement statistics. For example, 27% of those who reported defined-benefit income retired aged 55 to 59, and 27% of those who reported defined-contribution income did the same.

Finally, there are the reasons for retirement. Nearly 18% of retirees reported being forced into early retirement by ill health or company actions--a significantly higher percentage than expected by those who were working. Even among those who were not pushed out the door, about one third of those who retired did so because they no longer found the working environment to be comfortable, or because they feared that they would lose their job. In short, they didn't feel wanted.

It seems unlikely that raising the age for maximum Social Security benefits will make workers feel more wanted at their companies. Nor will such an action improve their health so that they can stay longer on the job, or make corporations less responsive to Wall Street demands that they improve efficiencies by reducing labor costs (meaning relatively highly paid older employees). Raising the age, in short, will hurt retirement readiness by reducing income, without an attendant benefit. In such a case, it may be prudent to make 401(k) participation mandatory, to strengthen the 401(k) pillar even as the Social Security pillar is weakened.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.