911 for 401(k)s

Why we’re so incredibly stupid about retirement investing.

401(k) plans are a huge success, right? According to the Employee Benefit Research Institute, 27.9 percent of workers, or about 36.6 million of them, had 401(k) plans in 2001. The Investment Company Institute fact book estimates that 401(k) assets rose from $864 billion in 1995 to $1.867 trillion in 2003.

But 401(k)s haven’t really lived up to their potential. At companies that offer them, 30 percent of employees generally fail to participate. Just 5.6 percent of 401(k) participants made the maximum allowable contribution in 2001, according to EBRI. A study released by the benefits consulting firm Hewitt Associates last week reached the kind of conclusion that causes economists to pull their hair out: Workers are effectively giving away hundreds of dollars a year by failing to take advantage of employers’ offers to match employee contributions.

According to Lori Lucas of Hewitt, most company 401(k) plans offer matches, typically 50 cents on the dollar up to 6 percent of salary. But in a survey of 621 employees at a large company, Hewitt (assisted by economists James J. Choi and David Laibson of Harvard, and Brigitte Madrian of the University of Pennsylvania) found that 39 percent didn’t participate in the 401(k) plan at all. And of those who did participate, 40 percent didn’t contribute enough to max out the employer match. When Hewitt sat down with employees in the survey and had them calculate how much they were forgoing, “it was about $1,200 per year in matching contributions” per employee, according to Lori Lucas.

Why do employees behave so foolishly? It’s not the employer’s fault. When fewer employees max out on their contributions, it does save cash for the employer. But for regulatory purposes, companies need to encourage lots of their employees to participate. And for long-term strategic purposes, companies want their workers to amass sufficient assets so that they’ll be more willing to retire when they get older and more expensive.

Companies could probably do a better job marketing 401(k) plans and encouraging employees to contribute. The same researchers who helped produce the Hewitt study have found that simply changing the default position from not contributing to a 401(k) to contributing doubled participation rates. But most of the blame should lie with the theoretically rational workers who walk around, heedless of the greenbacks lying on the floor. “Only 35 percent of non-participants were definitely aware of the fact their employer even offered a matching contribution.” The employees aren’t broke, either. More than two-thirds of those who didn’t receive the maximum company match said they could save an extra $20 per week, or $1,040 per year.

When the researchers politely grabbed people by the lapels and explained just how much money they were missing out on, 33 percent of the non-participating workers under the age of 59 1/2 said they planned to start saving. But when they checked back after two months, only 12.5 percent had actually done so.

Clearly, debt is a deterrent to saving. If offered a $500 raffle prize, the survey participants said they’d use 47 percent of the proceeds to pay down debt, save 30 percent, and spend the rest. In some circumstances, forgoing a 401(k) isn’t entirely nonsensical. You get a much higher short-term return by paying down credit card debt than investing in a 401(k). And younger workers have plenty of other demands on their cash that make it difficult to save 6 percent of their salaries.

For workers older than 59 1/2, who aren’t subject to penalties for withdrawals, maxing out in the 401(k) would yield an almost instantaneous 50 percent return, assuming a 50-cents-on-the-dollar match. “These are people for whom contributing is an absolute no-brainer,” said Madrian. “They’re staring retirement in the face, there’s a match, a risk-free return on their investment, and they can take the money out at any point in time without a penalty.” But when she and her colleagues examined the 59-1/2-and-older set at seven different companies, they found that 40 percent of them were leaving money on the table.

Perhaps the real culprit is workers’ lack of faith in their ability to invest wisely. They don’t know what to do with their 401(k)s. In the Hewitt survey, only 2 percent of workers said they are very knowledgeable about investing, while half said they were “less than knowledgeable or not at all knowledgeable.”

Employees are like smokers who know the risks of smoking, say they want to quit, and know their finances and health would improve if they did quit, but who fail to take action or continually concoct excuses as to why this isn’t the right time to quit. They know they should save, but can’t bring themselves to do it.

And this may be one of the big stumbling blocks on the road to a further broadening of President Bush’s ownership society. “Saving is no different than a lot of other things, like car repair, or legal assistance,” said Brigitte Madrian. “Some people are really good at it, and the rest of the people aren’t.” The real problem may not be a lack of information, but a lack of good advice for employees with modest net eggs. Brokerage firms and asset managers aren’t exactly falling over themselves to dispense sound advice to people with $10,000 in a 401(k). But even a mediocre investment strategy—putting the whole plan in T-bills, say—is wiser than leaving the employer match on the table.