The Big Flaws in Your 401(k), and How to Fix Them

Every week seems to bring a new study with more scary data about the Americans' looming retirement crisis—and it's all too easy to tune out. Don't. As a sobering new book, Falling Short, explains, the crisis is real and getting worse. And if you want to preserve your chances of a comfortable retirement, it's time to take action.

One of the most critical problems is the flawed 401(k) plan, which is failing workers just as they need more help than ever. “The dream of the 401(k) has not matched the reality,” says co-author Charles Ellis. “It’s turned out to be a bad idea to ask people to become investing experts—most aren’t, and they don’t want to be.”

When it comes to money management, Ellis has plenty of perspective on what works and what doesn’t. Now 77, he wrote the investing classic Winning the Loser’s Game and founded the well-known financial consulting firm Greenwich Associates. His co-authors are Alicia Munnell, a prominent retirement expert who heads the Center for Retirement Research at Boston College, and Andrew Eschtruth, the center's associate director.

What’s wrong with the 401(k)? For basic behavioral reasons, workers consistently fail to take full advantage of their plans. Most enroll, or are auto-enrolled, at a low initial savings rate, often just 3% of pay— and they stay at that level, since few plans automatically increase workers’ contributions. Many employees borrow money from their plans, or simply cash out when they change jobs, which further erodes their retirement security. Even if investors are up to the task of money management, their 401(k)s may hamper their efforts. Many plans have limited investing menus, few index funds, and all too often saddle workers with high costs.

When you add it up, investor mismanagement, along with 401(k) design and implementation flaws, have cost Americans a big chunk of their retirement savings, according to a recent Center for Retirement Research study. Among working households headed by a 55- to 64-year-old, the median retirement savings—both 401(k)s and IRAs—is just $100,000. By contrast, if 401(k)s worked well, the median amount would have been $373,000, or $273,000 more. As things stand now, half of Americans are at risk of not being able to maintain their standard of living in retirement, according to the center’s research.

Can the 401(k) be fixed? Yes, the authors say, if employers adopt reforms such as auto enrollment, a higher automatic contribution rate, and the use of low-cost index funds. But even those changes won’t end the retirement crisis—after all, only half of private sector workers have an employer-sponsored retirement plan. Moreover, Americans face other economic challenges, including funding Social Security, increased longevity, and rising health care costs.

To address these problems, authors discuss possible policy changes, such as automatic IRAs for small businesses and proposals for a new national retirement plan. Still, major reforms are unlikely to happen soon. Meanwhile, there’s a lot you can do now to improve your odds of a comfortable retirement. The authors highlight these three moves to get you started:

Aim to save 14%: The best way to ensure that you actually save is to make the process automatic. That’s why few people consistently put away money without help from a company retirement plan. If you save 14% of your income each year, starting at age 35, you can expect to retire comfortably at age 67, the authors’ research shows. Start saving at age 25, and put away 12%, and you may be able to retire at 65. If you get a 401(k) matching contribution, that can help your reach your goal.

Choose low-cost index funds. One of the smartest ways to pump up your savings is to lower your investment fees—after all, each dollar you pay in costs reduces your return. Opt for index funds and ETFs, which typically charge just 0.2% or less. By contrast, actively managed stock funds often cost 1.4% or more, and odds are, they will lag their benchmarks.

Adjust your goals to match reality. You 401(k) account isn’t something you can set and forget. Make sure you’re saving enough, and that your investments still match your risk tolerance and goals—a lot can change in your life over two or more decades. The good news is that you can find plenty of free online calculators, both inside and outside your plan, to help you stay on course.

If you’re behind in your savings, consider working a few years longer if you can. By delaying retirement, you give yourself the opportunity to save more, and your portfolio has more time to grow. Just as important, each year that you defer your Social Security claim between the ages of 62 and 70 will boost the size of your benefit by 8% a year. “You get 76% more at age 70 than you will at age 62,” says Ellis. If working till 70 isn't your idea of an dream retirement, then you have plenty of incentive to save even more now.

More on 401(k)s:
Why Millennials are flocking to 401(k)s in record numbers
Why your 401(k) may only return 4%
This Nobel economist nails what's really wrong with your 401(k)