We've Already Tried Private Accounts!

President Bush wants to “privatize” a portion of the Social Security program. As part of that debate, we should remember that our experience with 401(k) plans provides some evidence about how well such a program might work. The results to date are not encouraging and should serve as a blinking yellow light.

401(k) plans, which are tax-favored savings accounts, emerged in the 1980s as supplements to traditional employer-defined benefit pensions, where benefits are based on years of service and final salary. Individual 401(k) accounts, funded with employer and employee contributions, end employer liability for pension payments. Not surprisingly, 401(k)s have emerged as the dominant pension arrangement. And in the private sector, most of the responsibility for retirement security has moved from employer to employee.

The supposed advantages of 401(k) plans for employees are twofold. First, workers with 401(k)s can take their full accumulations with them as they change jobs. This arrangement is much better for mobile workers than traditional defined-benefit plans, where, even among firms with identical plans and immediate vesting, workers receive significantly lower benefits than they would have with continuous coverage under a single plan. The portability argument, however, is irrelevant to the Social Security debate because Social Security is a universal defined-benefit plan, and, as such, its benefits are fully portable as people move throughout the labor force.

The second argument offered for 401(k) plans is that they allow people to control their investments and match their investments with their tolerance for risk. Presumably this responsibility is something workers welcome. In fact, the evidence suggests that 401(k) account holders generally make terrible investment decisions, and when offered the opportunity to turn over the decision making to someone else, they grab it.

In theory, workers could do very well under a 401(k) plan. Simple simulations suggest that a worker with a history of average earnings could, through steady contributions, accumulate roughly $300,000 in a 401(k) plan by age 62. In fact, the typical older worker covered by a 401(k) has less than $50,000. Enthusiasts could counter that 401(k) plans emerged only in the early 1980s, so that today's older workers haven't had time to accumulate substantial balances. True. But even those in mid-career appear to be falling considerably short of the amounts needed for secure retirement.

Why the low balances? Employees make a lot of bad investment decisions. A quarter of those eligible to participate in a 401(k) choose not to do so, forgoing an employer match. Less than 10 percent of those who do participate contribute the maximum, often because of low take-home pay. More than half fail to diversify their investments, many overinvest in company stock, and few rebalance their portfolios in response to age or market returns. As a result, many employees lose their retirement savings by investing their entire 401(k) portfolio in company stock, or end up with miniscule balances at retirement by concentrating their investments in money-market funds.

The fundamental problem is that making decisions about saving and investing through 401(k) plans is difficult. Most participants lack sufficient financial experience, training, or time to figure out what to do. As a result, they are swayed by the enthusiasms of the times or, more generally, they simply stay put.

Employers have tried education, but have found that it is very hard to get workers to understand even the basics of investing. In repeated surveys of plan participants, John Hancock Financial Services found that less than one-quarter of respondents characterized themselves as knowledgeable investors. Even those who thought they were knowledgeable showed considerable confusion. It's not that people are stupid; it's just that becoming a financial expert is low on their priority list.

Concern that employees need help led the Labor Department to make a rule change in December 2001 that allows investment companies to hire independent advisory firms to manage 401(k) accounts for individual investors. David Wray, president of the Profit Sharing/401(k) Council of America, which lobbies on behalf of plan sponsors and their employees, wrote in a recent Wall Street Journal article, “Employees are saying, ‘I don't want to make these decisions -- please make them for me.'” But even with this improvement, 401(k)s are no substitute for Social Security.

In short, we have taken private accounts for a test drive, and they have not performed very well. The 401(k) experiment should caution us about transferring even more responsibility for crucial protections to already overburdened workers.

Alicia H. Munnell is the Peter F. Drucker Professor of Management Sciences at Boston College, and was formerly a member of the President's Council of Economic Advisers and Assistant Secretary of the Treasury for Economic Policy.