401(k) System Passes “Trial by Fire”

By Randy Myers

Not so long ago—the 1980s, to be precise—it was commonly argued that the self-directed, largely participant-funded 401(k) retirement system would implode if the financial markets experienced a severe crisis. Individual investors, the theory went, would not have the sophistication or the stomach to successfully negotiate a dramatic upheaval in the financial markets.

This theory was tested once in the bear market of 2000-2002 following the bursting of the dot-com stock bubble, and more dramatically in 2008-2009 when the credit crisis triggered by the mortgage-market meltdown sent both stock and bond prices plummeting. Some 401(k) investors reacted by shifting money out of stock funds and into stable value funds, but most simply left their investment strategies untouched. In 2009, stock and bond markets began to recover much of the ground they had lost, and by year-end assets in 401(k) plans totaled $3.34 trillion, up from $2.67 trillion at the end of 2008 and within striking distance of the $3.73 trillion held at the end of 2007.

“What happened is that the 401(k) system was an island of stability amid the chaos,” David Wray, president of the Profit Sharing/401(k) Council of America, told participants at the SVIA’s fifth annual Spring Seminar in April. “It was the one place in the American financial system that was stable.”

To be sure, some of that stability was earned by the hard work of the retirement plan industry, including plan sponsors and plan providers who undertook what Wray called a “tremendous educational effort” to convince plan participants not to sell at the bottom of the market. “We gave participants permission to do nothing,” Wray said. “They were as panicked as anybody else. Plan providers who have call centers were fielding hundreds of thousands of calls per day from participants wondering what they should do with their retirement portfolios. The common theme was, stay the course. And they did. They did not bail, and the system did not collapse.” Among retirement plan participants whose accounts are managed by Vanguard Group, for example, Wray said the number of workers who pulled out of their plans while still employed rose to only 3.1 percent in 2008, just slightly above the normal rate of about 2.5 percent.

Wray noted that total assets in the U.S. retirement system, including all types of defined contribution and defined benefit plans both public and private has increased over the past 15 years to $16.04 trillion from $5.91 trillion.

“There are ups and downs in there, but we are setting aside money in this country—more per capita, and in real terms, than any other society,” Wray said. “This is the most successful system in the world. It works.”

Wray dismissed the notion that defined contribution plans are a weak link in the U.S. retirement system, arguing that if people begin saving early for retirement and allow their contributions and

earnings to compound throughout their working lives, most will wind up with sufficient retirement assets. “It’s just time and arithmetic,” he said. “If you compound money for 40 years at 5 percent, you’ll have a lot of money. The key is how people live in retirement with what they have accumulated.”

While many policymakers are worried about how people will manage their savings in retirement—and worried that they won’t be able to do a good job of it—Wray said those concerns are misplaced, too. “My own personal view is that people can do it just fine,” he said. “They’re doing it now.”

Wray said defined contribution plans remain the model for the future, and noted that there is tremendous interest among policymakers outside the U.S. in transitioning their own retirement systems from the defined benefit to the defined contribution model.

Wray noted that throughout the recent financial crisis, 401(k) plan participants held the percentage of their salaries they were deferring into their 401(k) plans fairly steady. He said he suspects that once the numbers are in for 2009 they may show that deferral rates actually rose that year. “People realize they need less debt and they need to save more money,” he said. “And a 401(k) plan is a great place to save money.”

That sentiment may help to explain why hardship withdrawals from 401(k) plans increased only slightly during the financial crisis. “There was not a massive flight out of the system,” Wray said, “which back in the 1980s people absolutely predicted would happen.”

It wasn’t just plan participants who stayed cool during the crisis, Wray added. “Plan sponsors were thinking the same way. They could have bailed as well. They could have terminated their plans. To my knowledge, there was not one single plan termination through all of this, except where companies filed for bankruptcy.”

While 14.8 percent of plan sponsors did suspend their matching contributions to their 401(k) plans during the financial crisis, and 3 percent reduced their match, Wray noted that another 4.7 percent increased their match and 76.8 percent left their policy unchanged. Approximately half of those who did suspend their match had either restored it, or planned to do so, by the first quarter of 2010.

Wray called stable value funds, which are available only to participants in defined contribution plans and certain college savings plans, one of the features that make 401(k) plans special. “My view has always been that you need a fixed income investment where the principal does not fluctuate,” he said. “From a participant standpoint, this is a special deal; they get security, plus a bond rate of return. Where else can you get that?”

Nonetheless, Wray said the stable value industry must do a better job of promoting the benefits their product brings to the marketplace, not just for investors saving for retirement but also for those who have already stopped working and are looking for a secure source of retirement income.

That may require some new thinking about who should participate in defined contribution plans, which right now are the only place where stable value funds can be used. Historically, the majority of plan participants have either cashed out their 401(k) accounts upon retirement or rolled their balances into an IRA. Fortunately, Wray said, increasing numbers of large employers are already starting to encourage their employees to stay in their 401(k) plans after they retire. “A stable value fund,” he said, “is a good option for the most conservative portion of a retiree’s investment portfolio.”