Has the 401(k) failed?

Unmatched 401(k)s These 10 companies are among the estimated several hundred that have recently cut their 401(k) matches: General Motors Cushman & Wakefield Eastman Kodak Vail Resorts Saks Sears Holding Motorola UPS Hewlett-Packard National Public Radio

Quick Vote

When will the government come up with a plan to reform health care?

• By the end of the year
• By the end of Obama's term
• It won't happen

or View results

More from Fortune

Will Mmmhops be a hit? NBA confirms L.A. Clippers sale to ex-Microsoft CEO Steve Ballmer FBI and SEC probe into Carl Icahn and golfer Phil Mickelson

FORTUNE 500 Current Issue Subscribe to Fortune

(Fortune Magazine) -- Max. It. Out. Of all the personal finance rules -- diversify your portfolio, pay down high-interest debt first -- perhaps no single piece of advice has been so widely touted as this: The key to financial security is putting as much money as you can into your 401(k). After all, what other retirement savings vehicle is portable, benefits from an employer match, provides a tax deduction, and allows the average clock puncher over the course of a career to rack up a seven-figure nest egg?

Well, given the past two years, scratch that last part -- your 401(k) is probably looking more like a 201(k). And in an environment where companies are strapped for cash, that trusty employer match is no longer a given. But all is not lost. Your 401(k) is still portable: You're more than welcome to take yours with you when your job is eliminated. We jest -- but only in part. According to Fidelity, the average 401(k) fund fell 31% from the end of 2007 through the end of March 2009. Retirees are going back to work, those close to retirement fear they can't quit anytime soon, and younger workers are wondering whether it's worthwhile to invest in stocks at all. Underscoring those anxieties is a growing sense that the 401(k) system as currently constituted puts too much of a burden on the people it was supposed to help, requiring ordinary workers to be investment strategists in their spare time. Now some want to tweak the existing system to better protect participants. But a vocal minority has come to a conclusion that seems radical to anyone who came of age in the era of 401(k) adulation: It's time for the 401(k) to be scrapped.

We are certainly a long way from early 2005, when the freshly reelected George W. Bush proposed transforming the Social Security program into a market-based, portable savings plan. Today, instead of privatizing Social Security, the buzzword is "governmentizing" private retirement plans. This summer the Government Accountability Office is expected to release a study on the adequacy of the retirement system in the U.S., and Congress is likely to take up the debate once it has the report. Leading the charge for reform is Rep. George Miller (D-Calif.), who chairs the House Education and Labor Committee and has called 401(k) plans "little more than a high-stakes crapshoot." Expect the debate to be lively. Of course, if the stock market surprises everyone and marches back toward Dow 14,000, the debate will probably melt away, which is why reformers are moving now.

Even in the best of times, the 401(k) wasn't perfect. It was created by the insertion of IRS Section 401(k) in the Revenue Act of 1978; later that year Hughes Aircraft was the first company to prepare a retirement plan under the section. Initial backers envisioned the accounts as a supplement to pensions. But companies soon saw that a 401(k) program could replace those defined-benefit pension programs entirely, saving the company money as well as the administrative challenge of managing a pension program.

At the same time, workers began switching jobs more frequently, and the portability and sense of ownership provided by 401(k)s made them increasingly popular with employees and management alike. Also adding to their appeal: The stock market had set off on a terrific two-decade run. Even so, critics have always pointed to several flaws -- too many people choose not to enroll at all, fees are often obscured, and most of all, among those who do invest, choices can be shockingly bad. A 2008 study by Financial Engines, for instance, showed that 38% of respondents had "worrisome" levels of company stock in their portfolios.

And that's in the best of times. Unfortunately a one-two punch thrown by well-meaning consumer advocates and desperate corporations has worsened an already bad situation. First, as a way to save too-cautious investors from themselves, in 2007 and 2008 some plans changed the default investment from a money market fund to an age-appropriate mix of stocks and bonds. Which then proceeded to tank. Second, a growing number of companies (see the list above and to the right) are eliminating or curtailing the employer match entirely. Doing so when stock prices are low is particularly harmful because it makes it that much harder for investors to recoup losses.

The Obama administration is sufficiently concerned about the 401(k) that in its May budget proposal it considered including a clause that would make workers have to opt out rather than opt in to a plan, but it ultimately chose not to do so (the Investment Company Institute [ICI], which represents the fund industry, as well as the Heritage Foundation and the Brookings Institution, supported the move, but most corporations opposed it on the grounds it would reduce their flexibility). Instead, the budget sets aside tax credits aimed at motivating lower-income workers to enroll in 401(k) and other private retirement programs.

Even the fund industry recognizes that some changes may be necessary. Testifying before Congress in February, ICI president Paul Stevens said that Americans reject the notion that 401(k)s need an "extreme makeover" but conceded that disclosure should be improved, distribution rules relaxed, and education stepped up, among other fixes.

Some think those changes won't go nearly far enough. "What we have now is a voluntary system that is very inadequate and is well liked by a small, relatively well-off portion of the workforce," says Teresa Ghilarducci, the Irene and Bernard L. Schwartz professor for economic policy analysis at the New School for Social Research in New York. She's advocating a government-run retirement system that mandates forced savings and provides retiring workers with a low-cost annuity. The plan would piggyback on the existing retirement program for federal workers, chiefly the government's Thrift Savings Plan (TSP). To ease the mandate for savings, she would provide a tax credit of $600 to every worker in America. Ghilarducci testified before Congress about her plan last fall and drew stinging rebukes from backers of the current system. The Wall Street Journal editorial page compared her proposal (among others on offer) to the Argentine government's questionable takeover of its own private pension system last year.

Professor Ghilarducci's plan has some merit, but it seems a bridge too far, even in the current climate. A recent Financial Times/Harris Poll found that while more than 80% said they'd eschew the prospect of potentially higher investment gains for a more secure retirement income, only 8% believed the government should take the primary role in providing pensions for retirees.

The psychological and real costs of a transition to a government-administered plan would not be small, and the plan would hardly be immune to risk. Ghilarducci's plan calls for an annualized return of 3% a year above inflation. The market, however, has been basically flat over the past 10 years. If her plan can't meet those return forecasts, it's not hard to envision who would have to guarantee the returns. Given the long-term frailty of Social Security, adding a new burden to government doesn't make a lot of sense.

But Ghilarducci is onto something. Why not give workers easier access to the TSP? Though it functions like a 401(k), with a simplified menu of investment options, fees run about 1%, vs. an estimated 3.0% to 3.5% for private plans, according to a GAO study. As in her plan, participants in the TSP could have the option of converting those savings into a low-cost annuity.

Lowering fees is a good first step, but Congress should also strongly consider making enrollment automatic for all employees. Some employers have long fought the idea, saying that it adds one more potential burden to their operations. But having for the most part transitioned to 401(k)s from pension plans, companies have a lighter retirement load than in the recent past. Requiring participation would ensure that young workers start saving -- and compounding -- early.

Finally, give corporations incentives to match employee contributions and penalize them when matches are withdrawn. Corporate matching encourages employees to save, as well as affirming some company responsibility for worker retirement. Of course the notion of having to manage our own money is part of the current frustration. While most workers like knowing that it's "their money," the futility of finding a good investment strategy has raised questions about whether we are collectively equipped to manage for our own retirement. In the debate, the one thing that's certain not to change is the reality of risk. As long as the markets are part of the solution, which they have to be, volatility will be part of the equation.