Improving 401(k) Investment Performance

William G. Gale (), J.Mark Iwry (), Alicia Munnell and Richard H. Thaler
Additional contact information
William G. Gale: The Brookings Institution
J.Mark Iwry: The Brookings Institution

Issues in Brief from Center for Retirement Research

Abstract: Public policies toward private pensions reflect a fundamental tension between free choice and paternalism. When people act in their own best interest without harming others, government intervention is unwarranted. But a key motivation for public policies to subsidize retirement saving in the first place is the belief that, without such subsidies, people would fail to act in their own best interest in making saving and investment choices. A striking example of this tension relates to employees’ freedom to choose how their 401(k) accounts are invested. Self-direction of investments is a common feature of 401(k) plans, but it is not working as well as it could. Employees frequently fail to diversify their investments or rebalance portfolios over time. One of the most dramatic failures is that workers often overinvest in their employer’s stock. These errors can prove costly, as demonstrated by the plight of Enron employees. Overinvested in employer stock, they lost not only their jobs but much of their retirement savings. But even when the plan sponsor does not collapse, poor investment choices impose unnecessary risk on workers, threaten the level and security of retirement income, and reduce the public policy benefits from 401(k) tax subsidies. Given the prevalence of 401(k) plans, workers’ widespread inability to make appropriate investment choices is a first-order concern. This brief summarizes the key conclusions discussed at the June forum on the nature and sources of the underlying problem and potential solutions. Emerging evidence shows that default choices can strongly influence — and, from the perspective of economic decision making, improve — participation and contribution behavior in 401(k)s. A similar approach for asset allocation and investment options, while still preserving employees’ option to self-direct their accounts if they so choose, could be one solution to poor asset allocation choices. Even without establishing such a default, conference participants generally agreed that encouraging employers to promote diversification (for example, by reducing concentrations in employer stock, allowing 401(k) participants access to diversified mutual funds and/or making available independent investment expertise and management) could substantially improve 401(k) asset allocation. Plan sponsors that offer certain qualifying investment arrangements could receive a measure of safe harbor fiduciary protection. These types of solutions deal simultaneously with the frequently poor investment choices made in 401(k)s and the specific problem of overconcentration in employer stock.

Keywords: private pensions; 401(k); investment (search for similar items in EconPapers)
JEL-codes: D91 J26 J33 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fmk
Date: 2004-12

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Working Paper: Improving 401(k) Investment Performance (2004)
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