In defense of the 401(k)

As the historic drop in the world’s financial markets bruises the balances of defined contribution plan participants across the country, critics are questioning the fundamental nature of such plans. Some are calling for a complete overhaul of the employer-sponsored retirement plan system. Others are questioning whether DC plans can deliver adequate retirement income.

Headlines and rhetoric aside, well-designed DC plans, including the popular 401(k) plan, have served American workers well for the past three decades — despite occasional and inevitable stock and bond market turmoil. Indeed, DC plans have been broadly embraced by American businesses and their employees. There are some 65 million active participants in DC plans holding nearly $3 trillion in assets.

Critics have compared DC plans unfavorably to defined benefit pension plans. DB plans have many positive attributes and remain a vital component of the total benefits package for a shrinking, but still significant, number of private- and public-sector employers. But the fact remains that most participants, now and in the future, will rely on defined contribution plans for their employment-based retirement savings.

Thanks to the Pension Protection Act of 2006, some of the most important characteristics of DB plans — universal participation and professional investment management — are now available to an increasing number of DC plan participants. Continued innovation by plan sponsors and providers will further enhance the DC plan as a retirement savings vehicle that is portable, secure and capable of generating sufficient retirement income.

Changes to the DC system are already having a meaningful impact:

• Automatic enrollment. The PPA endorsed an innovative plan design that harnesses the power of participants’ inertia by automatically enrolling them in a DC plan and automatically increasing their savings deferrals over time. Vanguard’s research on the early results of this design is very encouraging. For participants with incomes less than $30,000, automatic enrollment has increased the participation rate from 44% to 80%. For participants ages 25-34, automatic enrollment has increased participation from 56% to 86%.

• Qualified default investments. In another significant reform, the PPA provided fiduciary relief for plan sponsors who place participants into a qualified default investment alternative, such as a target-date or balanced fund. QDIAs help to ensure that participants are invested in well-diversified portfolios appropriate for a long-term investment horizon. This is critical, as academic studies have repeatedly demonstrated that decisions about asset mix — the percentage of stocks, bonds, and cash in a portfolio — have a far greater influence on long-term results than specific investment choices or the timing of contributions.

The adoption of QDIAs has been rapid. Virtually all Vanguard-administered plans already offer either a target-date fund or a balanced fund. And, in the brief amount of time since the QDIA regulations were finalized in May 2008, 40% of those plans have taken the steps necessary to designate an approved QDIA. More than eight in 10 of them chose a target-date fund as their QDIA. We expect the number of plans adopting approved QDIAs to grow as plan sponsors continue to adopt automatic enrollment for new hires and as others consider building on the concept by re-enrolling existing participants in a QDIA.

• Advice. The PPA also provided plan sponsors with the ability to offer investment advice to their participants without fear of increased fiduciary liability. Final regulations implementing the PPA provisions were published just as the Obama administration took office. Although these regulations are likely to be reviewed, and might be revised by the new administration, we continue to believe the PPA’s advice provisions provide participants with necessary protections and afford them much-needed access to professional advice.

Advice can have a substantial and positive impact on portfolio construction. Participants who use advice programs that customize recommendations based on input from participants can significantly improve their asset allocation. For example, 27% of participants in the Vanguard managed account program switched from an all-equity or no-equity portfolio to a balanced portfolio.

• Company stock reforms. There is legitimate concern about some participants’ overconcentration in company stock. The PPA gave all participants the right to diversify out of employer contributions made in company stock after three years of service; in our experience, most plan sponsors now permit immediate diversification.

Moreover, we have seen significant improvement in portfolio diversification in plans with company stock as an option. In Vanguard-administered plans, 68% of participants have less than 20% of their portfolio allocated to company stock.

There will always be periods when investments in the financial markets lose value. No retirement program can be designed to be completely risk-free. But it would be wise to avoid drastic policy changes while in the midst of a crisis. Let the reforms of the PPA take hold and continue to inspire the private sector to develop innovative DC plan designs. This will ultimately lead to greater retirement security for all American workers, retirees and their families.

Ann L. Combs is principal of Malvern, Pa.-based Vanguard Group Inc.’s strategic retirement consulting group. As the assistant secretary of labor for the Employee Benefits Security Administration from 2001 to 2006, she was involved in formulating the Pension Protection Act.