Negative Side of the 401k Retirement Plan. Background, Literature Review and Legal Case Study

Table of Contents

I. Abstract

II. Introduction

III. Background Information
a. Basis in Law
b. Growing Popularity

IV. Literature Review
a. Replacing the Pension
b. Insufficient Investing
c. Hidden Fees and High Costs
d. Asset Allocation
e. Market Volatility

V. Legal Case Study

VI. Conclusion

VII. References

I. Abstract

The purpose of this paper is to review the often overlooked negative side of the 401(k) retirement plan. Several major drawbacks of the 401(k) such as insufficient investing, poor asset allocation and the detrimental effect of market volatility ever more apparent by current economic conditions are discussed. The still developing legal liability of 401(k) plans and those implications for Human Resource professionals is also presented through a legal case study.

II. Introduction

More and more Americans rely more heavily on 401(k) retirement plans with the worsening Social Security situation, the decline of pension plans and the commonly held belief that 401(k)s are the superior choice for an adequate retirement. However this belief is rarely questioned, and even less so in prosperous economic times when the inherent high risk associated with many types of investments in 401(k) plans produce good results. Some financial advisors, economists and even lawmakers though have begun to scrutinize the nearly always positive image of 401(k)s for investing in retirement. It goes without much contention though that part of this new scrutiny is of course motivated by current worsening economic conditions.

Experts point to a myriad of misconceptions and inherent shortcomings in the current 401(k) system. These include unguided and often insufficient investing, hidden and sometimes substantially detrimental plan fees, poor asset allocations on investments, inherent and damaging stock market volatility and more. While most financial planners continue to hold that the 401(k) is an excellent way to invest in one’s retirement, some questions are being raised and there is perhaps a growing need for more explanation with that recommendation now.

First background information about the 401(k) retirement plan is presented including its basis in laws related to Human Resources and a brief demonstration of its rise in popularity. Next, the negative side of the 401(k) is presented through a literature review organized by several major bullet points. Lastly, a legal case study is presented to reinforce human resource related employer legal liability followed by the paper’s conclusion.

III. Background Information

a. Basis in Law

In 1974, Congress passed the Employee Retirement Income Security Act or ERISA. The legislation was aimed at ensuring that the pension and retirement plans of employers were both secure and fair. The act has multiple provisions covering contributions, disclosure responsibilities, vesting, transferability, termination procedures and much more. Vesting, or the act of an employee taking a secure and undeniable right, whether it be in entirety or by a growing percentage over time to an asset (such as funds in a retirement account) was further defined and increased in employee favor in the tax reform act of 1986. Employees are now vested by law in retirement accounts at a minimum of 20% after three years of service and that increases up to 100% after five years (“AllBusiness”, 2005).

In 1978, Congress amended the Internal Revenue Service Code and added section 401(k). The amendment allowed for an employer sponsored, voluntary contribution retirement plan for employees that came with a tax shelter where investments selected by employees could be made using their before tax income. Employers offering such a retirement plan were charged with implementing and overseeing the system, mandated to keep a separate account for the funds and unable to access the funds in the 401(k) plan. This also stems from the fact that 401(k) retirement plans are protected under ERISA in that in the event of bankruptcy, unlike with a pension plan there is no danger that the plan could be negatively impacted. The code also defines several other restrictions and requirements that affect employees who invest. To avoid high capital gains and income taxes, employees must forgo withdrawing from the fund until the age of 59.5. However withdraws may be permitted without high taxation for some predefined reasons such as the purchase of a primary residence, medical expenses and more. There are also provisions that do allow for loans to be drawn by employees on their 401(k) account. Lastly employees must start taking distributions from their account no later than age 70.5 (“CHRM Global”, 2008).

b. Growing Popularity

At the end of 2006, The Employee Benefit Research Institute (EBRI) approximated that its database covered 40% of the 401(k) industry in the United States and estimated that there were 20 million participants in 53,931 employer sponsored 401(k) retirement plans in the country. This means that we can estimate the total to be around 50 million participants and 135,000 plans. Also according to EBRI, plan participation and account balances in 401(k) plans are is increasing in popularity, evident by average account balances increasing by nearly 79% between the end of 1999 and the end of 2006 as illustrated in Figure 1:

FIGURE 1

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SOURCE: Employee Benefit Research Institute, Issue Brief No. 308: 401 (k) Plan Asset Allocation, Account Balances, and Loan Activity in 2006, b y Jack VanDerhei, Sarah Holden, Craig Copeland, and Luis Alonso, August 2007.

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