401(k) Pitfalls

There are four major 401(k) Plan pitfalls:

• Low Participation - A 401(k) Plan can't be an effective retirement savings tool if people aren't in it! Studies show that communication campaigns and education programs do not overcome employee inertia; employees know they should join the Plan, but many never do.
• Low Contribution Rates - Employees need to contribute at least four to six percent of their pay to a 401(k) Plan to expect a reasonable retirement income. However, many employees contribute at lower rates, and some Human Resource departments even encourage employees to "put in just a dollar or two" each week in a misguided effort to boost participation rates.
• Micro Yield Disparity - Our research using 401(k) data over several years from a number of large plans in assorted, geographically dispersed industries revealed a disturbing phenomenon we call micro yield disparity. Micro yield disparity is the remarkable difference among investment returns earned by individuals in the same plan. For example, in one plan with 2,113 participants the earnings for the plan as a whole were 18.3%; however, one person's earnings were 52.1% while another's were negative 12.8%. This disparity in earnings (yield) correlates to pay. We divided the Plan's population into five groups (quintiles) then rank ordered them by investment returns, highest to lowest. In Plan after Plan we have found that the first quintile, which of course had the highest average investment return, also had the highest average pay. The second quintile, which had the second highest average investment return, had the second highest average pay. Ditto third, ditto fourth, ditto fifth. We think this disparity in earnings has huge legal implications as lower-paid workers reach retirement without adequate savings. The Letter To The Editor from the Journal of Pension Benefits, Volume 7, Issue 1, Fall 1999 explores this issue in depth.
• Macro Yield Disparity - The big brother of micro yield disparity is macro yield disparity, which is the difference between one 401(k) Plan's investment returns and market investment returns. We discovered macro yield disparity while exploring the effectiveness of participant education programs. If these programs are effective, we hypothesized that the 401(k) Plans of firms who use them would perform better than average. To test this, we examined the 401(k) Plans of financial services firms, reasoning that employees of these firms should be the most educated about, and interested in, personal finance. After all, these are the firms who want to invest your money or educate your employees, so their money and their employees should be a shining example of their effectiveness.

We examined five Plans, Citigroup, Hewitt, Merrill Lynch, Morningstar and Prudential, for the period 1995 through 1998 (the latest year for which data are available). None of the five came close to matching the performance of the stock market, or an index of 60% stock and 40% bonds. We know that all employees of these firms aren't financial experts, but isn't it reasonable to expect they would have more investment interest and knowledge than employees at non-financial service firms?

If employees at Merrill Lynch and Morningstar can only manage below-average returns, is it reasonable to hope that most American workers, the majority of whom according to USA Today don't know the difference between a stock and a bond, will be able to properly manage the investment of their retirement funds? Reinventing Retirement Income in America, a National Center For Polcy Analysis publication co-authored by Brooks Hamilton, offers supporting data and examines this topic in more detail.