401K Plans: An Example of Rational Irrationality in Action

     You go Brad Delong! Preach it brother! As the title of his blog post about 401Ks says we need a bigger Social Security system with higher not lower benefits. Amen. His reasoning here is because clearly the 401K system is not doing its job.

     "Edward Filene's idea from the 1920s of having companies run employer-sponsored defined-benefit plans has, by and large, come a-crashing down. Companies turn out not to be long-lived enough to run pensions with a high enough probability. And when they are there is always the possibility of a Mitt Romney coming in and making his fortune by figuring out how to expropriate the pension via legal and financial process. Since pension recipients are stakeholders without either legal control rights or economic holdup powers, their stake will always be prey to the princes of Wall Street."

     "That suggests that what we really need is a bigger Social Security system--unless, of course, we can provide incentives and vehicles for people to do their retirement saving on their own. But 401(k)s have turned out to be as big a long-run disaster as employer-sponsored defined-benefit pensions when one assesses their efficiency as pension vehicles."

     "And so let me turn the mike over to James Kwak:

The Problem with 401(k) Plans: Ian Ayres has made a lot of people upset, at least judging by the Wall Street Journal article about him (and co-author Quinn Curtis) and indignant responses like this one from various interested parties. What Ayres and Curtis did was point out the losses that investors in 401(k) plans incur because of high fees charged at the plan level and high fees charged by individual mutual funds in those plans. The people who should be upset are the employees who are forced to invest…. Ayres and Curtis estimate the total losses caused by limited investment menus (small), fees (large), and poor investment choices (large)…. What really annoyed people in the 401(k)) industry (that is, the mutual fund companies that administer the plans and the consultants who advise companies on plans) was Ayres and Curtis’s charge that many plans are violating their fiduciary duties to plan participants by forcing them to pay these fees….

The response of the industry has been one of righteous indignation and blanket assertion. For example, Drinker Biddle huffs, “In our experience, most plans are well-managed.”  401(k) plans provide different “services,” so different plan-level fees are appropriate; and high fund fees are OK because “it is commonly accepted that the use of actively managed funds is prudent.” Just because lots of rent-seekers say so doesn’t make it so…. There’s no good reason not to just provide a lineup of cheap, big index funds with low costs and low tracking error….

So yes, most plan sponsors and administrators are violating their fiduciary duties…. Not that they should stay up nights…. The courts have for the most part endorsed current behavior, probably “reasoning” that if everyone’s doing it, it must be OK. But anything Ayres and Curtis can do to draw attention to the problem of high fund fees and plan fees will help move us closer to the day when workers don’t have to pay for their companies’ poor choices.

     "I disagree: they should stay up nights. Chances that they will be hauled into a this-world court are low, it is true. But they do have to worry about how they are going to bear looking into the mirror in the bathroom when the sun rises."

     http://delong.typepad.com/sdj/2013/08/why-we-need-a-bigger-social-security-system-with-higher-not-lower-benefits.html

    Well right now 'this-world courts' may not be nailing them but all the consternation about Ayvres' and Curtis' work shows that they fear this may not be the case in the future. If public sentiment changes courts may start ruling differently. So this might be why they are staying up nights.

    What we have here is a classic market failure. 

    http://diaryofarepublicanhater.blogspot.com/2013/08/john-cassidy-market-failure-and-thek.html

    http://diaryofarepublicanhater.blogspot.com/2013/08/when-markets-fail-john-cassidy-explains.html

    The market does a good job in providing most goods and services to consumers-whereas as the various countries that have tried Communist experiments-the Soviet Union, China before 1978, etc-have shown empirical evidence that the government is not who you want doing this.

    Certain things, however, the market does not do well-as we've just again learned the hard way, contra Alan Greenspan

    http://diaryofarepublicanhater.blogspot.com/2013/08/the-fed-chairman-nomination-whos-worst.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+DiaryOfARepublicanHater+%28Diary+of+a+Republican+Hater%29

   like self-regulating the financial market or setting safety and environmental standards or providing adequate R&D-due to the free rider problem.

  Another area is healthcare. Indeed here, even Kenneth Arrow-who created the models that prove markets are efficient-said that healthcare is one area markets don't excel.

  http://diaryofarepublicanhater.blogspot.com/2013/08/kenneth-arrows-on-market-efficiency-in.html

  It's really not surprising that 401Ks are not the best way for workers to prepare for their retirement. So yes, we do need a bigger Social Security system-which should be financed by removing the very low cap on payroll taxes.