As 401(k) accounts spring back, calls for reform recede

As the worst bear market since the Great Depression sent her 401(k) account into a downward spiral, Cathy Coleman would shudder when her quarterly statement arrived.

“When I saw it in the mail I used to say, ‘Uh-oh,’ ” said the 58-year-old nurse in Tiburon, Calif.

As her nest egg shriveled, along with those of many other Americans, a multitude condemned the 401(k) system as a failure and called for an overhaul to better protect people from the risk of huge losses.

But with the stock market’s stunning rebound since March, Coleman no longer delays opening her statement, and the urgency felt for reforming the 401(k) system has dissipated. Federal legislation designed to improve disclosure of fees and to guard against conflicts of interest is on hold while Washington deals with healthcare. And enthusiasm for a fundamental revamping of the entire system has waned considerably.

“The market gains have definitely contributed to the slowing of the momentum and enthusiasm on Capitol Hill for reform, and certainly for wholesale, huge reform,” said Michael Townsend, vice president of legislative and regulatory affairs at Charles Schwab & Co.

Nonetheless, 401(k) critics, contending that the system still risks leaving vast numbers of Americans financially unprepared for retirement, say the need for reform remains high.

“It has already become clear that 401(k)s have failed millions of Americans, even with the stock market beginning to rally,” said Karen Friedman, policy director at the Pension Rights Center in Washington.

The critics generally want to replace the system with one in which retirement accounts are shielded from devastating market collapses and are guaranteed to yield enough money for retirees to maintain a basic standard of living. The new system would be designed to complement Social Security. There’s no consensus on a particular overhaul proposal.

The fatal flaw of 401(k) plans is that “the employee bears the investment risk,” said Alicia Munnell, director of the Center for Retirement Research at Boston College. “We kind of forget about that in good times, but it comes back in spades in bad investment times.”

But with a broad overhaul appearing unlikely, reform backers are pursuing more-focused changes that would address long-held criticisms.

Rep. George Miller (D-Martinez) has proposed a measure that would require 401(k) investment advisors to clearly explain fees paid directly or indirectly by participants. The bill also is designed to ensure that advisors to 401(k) participants don’t have hidden incentives to recommend investments that may not be best for investors. Critics say such hidden costs and questionable business practices reduce investment returns.

The bill has been stuck in a House committee since last summer while legislators have focused on healthcare.

“It continues to be a very high priority with me,” Miller said.

The federal Labor Department also is expected to unveil rules this year tightening fee disclosure and investment advisory rules.

Friedman and others described the proposed rule changes as worthwhile but not enough to fix an inherently flawed system.

“No matter how much reform we do to the 401(k) system, it’s not enough,” she said.

In 2006, when the stock market was booming, the concern about 401(k)s was that workers weren’t putting enough money into them and weren’t investing the accounts aggressively enough. That year, the Labor Department enacted a rule making it easier for employers to automatically direct 401(k) contributions into target-date funds, which start with significant stock allocations but shift into less risky, fixed-income investments as their investors get closer to retirement.

But during the bear market, even target-date funds designed for people near retirement got pummeled, largely because of many fund managers’ long-held belief that retired workers still need to keep a substantial chunk of their assets in stocks to offset inflation as they age.

It was that demographic -- people in or near retirement -- who felt the most pain from the bear market. They faced the prospect of permanently reduced living standards because they had the bad fortune to retire in a down market. Unlike their younger colleagues, they didn’t have years to recoup their losses.

Last June, just three months into the market’s recovery, 44% of workers at least 50 years old planned to delay retirement, according to a survey by benefits consultant Towers Watson. The main reason cited: depleted 401(k) assets.

Some of those workers may have changed their minds about delaying retirement as their portfolios have kept growing.

The 401(k) industry says the market recovery proves Congress shouldn’t overreact to a once-in-a-lifetime financial crisis.

“When the market crashed, people were saying the system’s broken, and now they’re realizing it’s not broken,” said Cindy Milstead, senior counsel at 401(k) administrator Hewitt Associates. “There’s more focus on what’s wrong and how are we going to fix it rather than saying the whole system is broken.”

Still, the 401(k) picture is not rosy for those who were forced by layoffs or other financial woes to withdraw funds after the market plunged.

Though so-called hardship withdrawals from 401(k) accounts remain relatively low, they were up 13% in the first 10 months of 2009 compared with a year earlier, according to Hewitt.

“It shows that we have a lot of people participating in 401(k) plans and trying to do the right thing, but in some cases they are literally living paycheck-to-paycheck,” said Byron Beebe, Hewitt’s co-head of 401(k) consulting.

In the same vein, employees at companies that eliminated 401(k) matches were more likely to reduce their own contributions, perhaps to build up emergency funds because working at troubled companies made them feel financially vulnerable.

On average, those employees were twice as likely as employees of other companies to cut their own contributions, according to mutual fund giant Fidelity Investments.

And investors who pulled out of stocks in the bear market have paid the price by largely missing out on the resurgence in share prices.

From January 2008 through last March, employees transferred about 6% of their stock assets into more conservative holdings, mainly so-called stable-value funds, according to Hewitt.

“That doesn’t sound like a lot, but it’s actually quite a lot,” Beebe said.

And they’ve been slow to return -- only one-sixth has flowed back into equities.

The good news is that an increasing number of companies that stopped matching 401(k) contributions plan to begin again as the economy stabilizes.

About 7% of companies nationwide reduced or eliminated their matching contributions during the recession, studies show.

In October, about 35% planned to restore the contributions, according to Towers Watson. That was up from 24% in August and only 5% in June.