Are 401(k)s a good thing?

I’m beginning to wonder.

That sounds like heresy. For years, financial advisers have universally agreed that workers should put as much money as possible into these tax-deferred retirement plans. I’ve made this point myself over and over.

But now, as Democrats and Republicans wrangle over the best way to remedy 401(k) flaws revealed by last year’s Enron debacle, I’m starting to think the best solution would be to scrap the system. Participants might do better if they could take the boss out of the mix and channel 401(k)-sized contributions to old-fashioned IRAs.

The 401(k) began as little more than a legal loophole exploited two decades ago by just a handful of companies. Then employers everywhere realized 401(k)s were far better for them than traditional pension plans. With a pension, the investment risk is the boss’; with a 401(k) it’s the employee’s.

In the early years, the 401(k) was a frill. Now it is the Americans’ main retirement-funding vehicle.

Among the benefits: Money you put in is deducted from your income, providing a big income tax saving each year you participate. Any contribution by your employer is also free of tax the year it’s put in. Investment profits compound year after year again with no tax. And, of course, the 401(k) provides an investment discipline that many people otherwise lack.

Income tax must be paid when money is withdrawn in retirement. But by then, many people are in lower tax brackets, reducing the bite. And all the tax-deferral up until then allows the account to compound much faster than it would if the same contributions were made to ordinary taxable investments.

Guarding against Enron

Then came Enron, highlighting problems some experts had been worried about for some time. Enron employees had the lion’s share of their 401(k) investments in Enron stock, which was wiped out when the company went bankrupt. For one thing, their 401(k) plan was in a holding pattern during which employees were not allowed to sell their Enron shares as the company’s woes became public.

The Republican-sponsored remedy, now taking effect, requires that employees be given 30 days’ notice of “blackout periods” when they can’t make investment changes, such as when the company shifts providers. Also, corporate executives will be prohibited from selling their own shares of their companies’ stock during any periods when employees can’t do so as well.

Republicans and Democrats are still fighting over additional proposals by President Bush: to give workers the right to sell their company’s stock after three years; to give employees more reports on their plan’s performance; and to allow the brokerages or fund companies that provide plans to give employees investment advice.

This last one is a real sticking point. Democrats worry, quite reasonably, about conflicts of interest. Providers aren’t likely to tell employees that the investment options chosen by the boss and plan provider are no good.

Democrats have some proposals designed to penalize employers who provide bad advice. But this sounds like an enforcement nightmare, since even good investment advice can turn out badly.

Investing on your own

So here’s my question: Why not take the employer out of the loop?

Many perhaps most employers, are not qualified to make investment decisions, such as choosing a good plan provider or coming up with a list of investment options from which employees can choose. Bosses also may be swayed by other considerations, such as throwing the business to country-club buddies or picking providers simply because they offer the cheapest deals.

Instead, imagine a system in which workers could choose their own investments, as they do with IRAs, and have portions of their pay automatically sent in by their employers. As with today’s 401(k)s, contributions would be deductible and earnings would grow tax-deferred. There would be no account-shifting hassle when the employee changed jobs.

Most important: This retirement-investing option would be available to everyone. With a 401(k), you get it only if your employer chooses to offer it, and the plan you liked when you were job hunting can be changed whenever the boss feels like it.

Potential problems

I can hear some of the objections already.

First, that many employees aren’t equipped to decide between the tens of thousands of stocks, bonds and mutual funds in the market.

I think that can be solved. Upon taking a new job, one would automatically be enrolled in a standard plan with a set of straightforward, low-fee index funds. This would assure that participants could match the performance of the market overall. Employees who made no effort to manage their investment would thus follow the strategy that probably makes the most sense for them anyway. Everyone would be free to make changes at will or not to participate.

Since plans would not vary company-by-company as they do now, a public education campaign could promote the benefits of this sound, no-frills investing strategy.

A second objection, and perhaps the most important, is that an employer might not make matching contributions to a plan that’s not identified with the company. Some experts argue that employers match in 401(k)s to build employee loyalty.

I’m not sold on that view. It seems to me that matching contributions are made so employers can compete for good workers, just as they must offer competitive pay.

But I’d like to hear what you think. What’s wrong with the present 401(k) system, and how could it be fixed?

Drop me a note at jeff.brownphillynews.com.