By Pat Regnier and Joan Caplin

(MONEY Magazine) – (O)n or about December 2001, the 401(k) dream died. After Enron employees saw their company-stock-laden retirement funds fall to pieces, even those of us with less go-go 401(k) investments woke up to what the bear market had done to our balances. In the following months, Time magazine would declare that "most of us will have to work well into our seventies." Variations on the grim joke, "our 401(k)s have become 201(k)s," appeared in at least 40 different magazine and newspaper articles. You could even hear some widely quoted experts calling the 401(k) "a rip-off" and "a hoax." Meanwhile, both Congress and the White House loudly promised swift action to make our 401(k)s stronger and safer. And to nothing.

All of the major 401(k) reform bills fizzled out last year, and the media have moved on to the next crisis, and the next. As for the Bush administration, it has grandly changed the subject by proposing to eliminate taxes on stock dividends and to vastly expand personal tax-free savings accounts. Instead of dwelling on our 401(k) losses, the President is saying we ought to be saving and investing even more money outside employer-based plans. Even if these proposals fail (and the word in Washington is that the big tax-free accounts are a long shot), the message behind them is clear: Saving for retirement is going to be largely a do-it-yourself job in America. For now, all the government wants to do is get out of your way.

The trouble is, that sweaty rhetoric about a 401(k) crisis has accomplished this much: A lot of us are scared stiff. And that could have devastating consequences if it gives people yet another reason not to save. Already, according to the financial services consultancy Spectrem Group, some 28% of workers eligible for a 401(k) are making zero contributions, compared with 20% in 1999. And giving up isn't the only way to mess up. If you've been hearing that 401(k)s are doomed to fail or are some sort of scam, you may be more willing to cash out your account when you switch jobs. Or perhaps you'll be tempted to borrow from your current plan to buy something you need here and now. There is a real 401(k) crisis, all right. It is a crisis of confidence.

It's time to take a fresh look at what's become the keystone of our retirement system, now accounting for 40% of America's private pension savings. Has the rise of the 401(k) been as great a disaster as some of its critics say? No. But the 401(k) flaws that experts have long recognized--high fees, poor investment choices, under-participation and overreliance on company stock--are harder to ignore now that double-digit stock gains aren't masking them. Even Ted Benna, the Pennsylvania benefits consultant who in 1980 drew up the very first 401(k) plan, says, "If I were starting from scratch today building the 401(k), investment-wise, I'd frankly blow up the existing structures." Well, even if we can't start from scratch, there's plenty that lawmakers, the financial services industry and employers can do to fix the 401(k). And there are steps that every investor should take to make the most of these plans. In this article and in "The 401(k) Solution," which follows, we offer action plans for improving the effectiveness of these critical accounts.

"There just ain't enough money, buddy"

For most 401(k) participants, what's wrong seems painfully obvious--stocks have been killing us. The average 401(k) balance was $45,000 in 1999, according to Cerulli Associates; by 2001 it had fallen to $36,000, even though investors kept pouring money in, and that sum has surely dropped further since. According to two of the most passionate critics of 401(k)s, William Wolman and Anne Colamosca, investors shouldn't look for the market to bail them out soon. In their 2002 book, The Great 401(k) Hoax, the husband-and-wife team argue that the market is even now wildly overestimating corporate profits, and that 401(k) investors will be lucky if they see a 2% annualized real return on stocks in the coming decade--about what investors got in the long bear market of the late '60s and '70s.

Now, that 2% forecast is controversial, to say the least. Most market pros are projecting a long-term rate of return closer to 7%, and the fact is that nobody knows what's next. But Wolman and Colamosca--like a lot of 401(k) detractors--would probably still object to the system if the market bounced back tomorrow. In fact, they think the bull market of the 1990s was part of the problem. As long as 401(k) balances were rising, nobody noticed that corporations were throwing off traditional pensions and that the Social Security promise was eroding. We were increasingly being forced to fend for ourselves in a harsher world.

This much is certainly true: The traditional defined-benefit pension, which guarantees you a monthly check in retirement based on your salary, not the pension fund's investment performance, has been on a steady decline since at least the 1980s. In 1985, 29 million private-sector workers had an old-fashioned pension, according to a 2002 Vanguard study, compared with 23 million today. In the same period, 401(k) plans have boomed, from just 10 million participants to almost 50 million; for 28% of these employees, a 401(k) or similar defined-contribution plan is their only pension.

This shift has been a boon for corporations. Running a 401(k) can cost a company less than half as much as a standard-issue pension. Employees with only 401(k) plans are in a sense getting paid a lot less than those with traditional pensions, and most probably don't realize it. They have to save more on their own, and they have to take on the risk that their company used to bear. And they have come to count on high returns. "You cannot transfer income from the private sector, via the financial markets, in an adequate sum to support the retirement population," says Wolman, who was BusinessWeek's chief economist. "You can't do it. There just ain't enough money, buddy."

The $1.8 trillion loophole

One crucial thing to understand about the 401(k) is that it was never designed to be the country's primary pension vehicle. Truth be told, it was never really designed at all. Section 401, paragraph (k), of the U.S. tax code doesn't say anything about automatic payroll deductions or investing in mutual funds. And Congress certainly didn't mean to overhaul private pensions when it added the provision in 1978. It was a technical tweak, designed to allow a relative handful of companies (at the time, mostly banks) to keep putting part of their employees' year-end bonuses into tax-deferred accounts. It was thought that the tax break would cost the federal government a few hundred million dollars. "My reaction at the time was, it's nice that this happened, but it's not a big deal," says Benna.

Benna's tale is a reminder not to get too nostalgic about the days of the big fat traditional pension. Back in the early '80s, Benna's bread and butter was setting up defined-benefit plans for professional practices--such as doctors' offices--that were chiefly looking for a tax shelter for the top management. Benna recalls that their main goal was, "How can I get the biggest tax break and give as little as possible to my employees?" At the age of 39, Benna worried that he was wasting his life "helping these characters." He considered quitting his job to go into the ministry and prayed for guidance. He believes the idea for the 401(k) was God's answer to those prayers.

Benna's proposal to let employees invest part of their paychecks with pre-tax dollars was based on an aggressive reading of the code, and it was initially met with a wall of skepticism. The small bank Benna designed the first plan for turned it down. Many tax attorneys said that it was clearly against the law. Even after Washington signed off on the 401(k), few grasped just how big the plan could get. By 1985 there was $145 billion in tax-deferred 401(k) plans, putting a big enough hole in federal revenue that the Reagan administration proposed banning them. By 1995, 401(k) accounts totaled $865 billion. Today they hold more than $1.8 trillion.

The competitive pension

How could this clever loophole come to redefine the pension? Critics of the 401(k) at times make it sound as if companies tricked their employees into giving up their safer defined-benefit plans merely by dangling the gaudy promise of double-digit 401(k) returns. It's certainly true that corporate America badly wanted out of costly pension liabilities by the 1980s. "Companies couldn't compete," says David Wray, president of the Profit Sharing/401(k) Council of America. "The Japanese were eating our lunch." But few large employers actually dropped their pension plans; it's just that many younger, growing firms never offered one. And they hardly needed to dangle the carrot of a 401(k) to get away with that.

Because traditional pensions are so opaque, they happen to be a lousy way to attract and keep talent. "The employees would undervalue them until they were about 60," says Notre Dame economist Teresa Ghilarducci. Though unions still pound the table for pensions, labor groups represent just 9% of private-sector jobs. And some employees prefer the 401(k), which seems ideally suited for an economy that increasingly demands and rewards flexibility; traditional pensions can hurt frequent job hoppers or tie you down to a job you'd rather leave. Even if the value of the 401(k)'s portability is overstated--Ghilarducci says that even now most workers land their best jobs about 20 years before they retire and stay put--traditional pensions seem just plain irrelevant for many Americans.

Are you better off now than you were 10 years ago?

More by accident than by corporate conspiracy, the 401(k) turned out to be a kind of vast, uncontrolled social experiment. With a 401(k) laying the potentially devastating consequences of market risk on each employee's shoulders rather than the company's, Americans have had to get smart about investing. Three years into a bear market, there's no better time to ask where that experiment has left us.

According to New York University economist Edward Wolff, even when the market was still fairly strong, the 401(k) didn't seem to have left the typical American much better off. In a study for the Economic Policy Institute that is frequently cited by 401(k) skeptics, Wolff shows that the total value of the average 47-to 64-year-old's private pension accounts (traditional pensions plus 401(k)s or similar plans) spiked up 29% from 1983 to 1998--thanks almost entirely to the stunning growth in 401(k)s.

Here's the rub: Much of the new wealth in 401(k)s isn't really so new. "A lot of it's just come out of other assets," says Wolff. For example, liquid assets such as checking and savings accounts used to account for 17% of household wealth; today it's 9.6%. Even more important, the average pre-retiree's pension value of $121,000 in 1998 is skewed by the enormous 401(k) gains of a relative few. From '83 to '98 the median 47-to 64-year-old American--the one who's doing better than exactly half of us--saw his private pension wealth rise just 3%, to about $40,000, according to Wolff. He reckons that a huge 42% of these pre-retirees won't even be able to replace half of their salaries in retirement.

There are good reasons to believe that Wolff--as well as Wolman and Colamosca--are being too pessimistic. Some economists complain that Wolff fails to forecast the future value of 401(k) accounts; his gloomy numbers are based strictly on their value in 1998. Wolff calls this criticism "partially true" but argues that the future value of 401(k)s depends on "the vagaries of the stock market and the future contributions of the worker."

But perhaps we can make some educated guesses about what 401(k) investors can accomplish through steady saving and diversification. One recent study by the Employee Benefit Research Institute (EBRI) attempts to predict what a 401(k) investor making fairly typical choices in a typical plan could accumulate. It finds that a worker could replace 72% of his pre-retirement income with a 401(k) and Social Security. That's assuming the stock market returns an annualized 7.7% before inflation--more than Wolman and Colamosca's scary 2% but no more than you would have earned from 1929 to 1978, the worst 50 years for stocks in U.S. history. The key is to be consistently covered by a 401(k) plan, from your late twenties on.

There are hitches: The EBRI study shows that a three-year bear market at the end of a working career could cut replacement rates dramatically. Plus, no 401(k) can force you to make good choices. A recent Vanguard study of participants in its 401(k) plans found that dollar-cost averaging and diversification meant that the typical investor lost only 13% in 2002 vs. a 22% drop for the stock market. However, nearly a quarter of those 401(k) investors lost more than 21% last year. Bottom line: You are free to totally blow it. To make sure you don't, check out our five-step 401(k) survival guide on page 94--because, unfortunately, the way 401(k)s are set up today makes mistakes frighteningly easy.

A few not-so-small repairs

Crumbling stocks and poor investment decisions are only the most immediate problems with the 401(k). The deeper flaw is that while we've been asked to take on more risk in our retirement savings, we still haven't been given the tools we need. Depending on the choices of our bosses, we could be able to invest in 100 great funds or a few lousy unknown ones. Our costs could be low or high. We could get a big match or no match or just company stock.

For many 401(k) critics, these inconsistencies argue for a bigger Social Security system. On the opposite side of the political spectrum, the answer to the shortcomings of the 401(k) is to expand tax breaks. A return to a traditional pension system, funded and managed by employers, isn't even on the table. (In fact, as Lisa Gibbs explains on page 91, the defined-benefit pensions that remain are under pressure as well.)

The 401(k) is what we have now, and it can be better. Our employers, their plan providers and, of course, politicians all have an opportunity to take leadership here. Here are our candidates for their top priorities.

EXPAND COVERAGE. Even Wolman and Colamosca urge investors to participate in a 401(k). Almost everyone agrees that the biggest threat to retirement is that at least 40% of Americans have no pension plan at all. The recent Bush proposal for new tax-free savings accounts at least addresses this concern. It would simplify 401(k)s somewhat, easing some regulatory requirements for employers. But more important--and controversial--is the call for two new Roth IRA-like accounts, which allow you to stash away up to $15,000 a year. The idea is to give even those with no 401(k) plan a huge incentive to save on their own. "Our savings rate has fallen so far," says Pam Olson, assistant secretary of the Treasury for tax policy, "and we have so tilted our tax code against savings that we really needed to take some dramatic steps to turn that around."

No argument here. But the Bush plan, as outlined, might well hurt employees of small companies. Business owners often set up 401(k) plans just so they can join them themselves; Bush's proposed accounts would make doing so unnecessary for some. And even though workers without 401(k)s could use the new accounts as an alternative, the fact is that many won't save without a push from their boss. (Automatic payroll deduction is a powerful tool.)

Any better ideas? For a start, as long as tax cuts are in play, why not use them to spur employers on? Letting companies take larger deductions on the cost of providing a 401(k) would lead more of them to offer plans. Alternatively, Wolman and Colamosca advocate an intriguing idea that's come out of a think tank called the Economic Opportunity Institute. It has proposed setting up a basic 401(k) plan run by the state that could be administered by the existing state-employee pension system and could take contributions out of anyone's paycheck. Employers could even make contributions to the plans.

DRAW US IN. What about those of us who have a plan but don't contribute enough--or at all? In many cases, of course, people feel they can't afford to save. (One remedy for that is to roll out tax credits for low-and moderate-income workers to encourage them to contribute.) But it's also a matter of inertia. "When I talk to the people who aren't participating," says Benna, "the No. 1 reason is that they just didn't get around to it." Here's one easy fix that's already been adopted by a handful of companies: Make employees opt out of 401(k) plans, instead of having to opt in.

A new 401(k) twist could solve the problem of underfunding. Behavioral economists Shlomo Benartzi and Richard Thaler have developed the SMarT program, which asks participants to agree to have a slightly higher percentage of their salary automatically taken out of their pay each year. For example, you might make a 2% contribution the first year, then 4% and then 6%. The idea is to save your raise, without ever having to see your take-home pay decreased. "You can't miss what you never had," says Jim Norris, head of 401(k) services at Vanguard, which has recently adopted the SMarT program.

KEEP IT SIMPLE. There's been a lot of talk in Washington lately about making it easier for plan providers to offer advice to 401(k) participants. Clearly, those investors who've lost 30% or more in the past year could have used some guidance. But letting brokers push their own company's funds to a captive audience smacks of conflict of interest. The truth is, what 99.99% of 401(k) participants need to do is easy enough. They need to diversify.

Giving participants 100 investment options, as many plans now do, doesn't necessarily help. Instead, Benna recommends that all plans should offer a basic menu of just six or seven "life cycle" funds that mix aggressive and conservative stocks, as well as bonds and cash, to suit an investor's time horizon or risk tolerance. Some big plan providers, including T. Rowe Price, Fidelity and Schwab, already offer funds that do something like this. The only trouble is that many participants miss the point of these so-called one-decision funds and mix them with other investments. To really work, either such portfolios should be the only options available or there should be strict limits on--or, at least, stern warnings against--investing beyond the set portfolios for investors who choose one.

SET US FREE. Of course, for some 401(k) participants, the problem isn't too many choices. It's that the limited choices they've been given are lousy. Especially at smaller firms, participants can be stuck with costly or poorly managed investments. Some really useful options, such as inflation-adjusted bond funds, are conspicuously absent from most plans. In some cases, participants can have a hard time even figuring out what their plan's funds invest in. There are also some more sophisticated investors who could benefit from having 100 choices but are stuck in a plan with just three. To get around these limitations, all plans should offer a relatively low-cost "window," or an account that lets them invest outside their plan. Some big plans already offer brokerage windows that even allow stock trading. That's fine, as long as investors are warned of the risks of day trading their retirement savings. Better, asserts Benna, to limit participants to funds.

SET ONE LIMIT. Wolman and Colamosca argue that there's just one thing participants shouldn't be able to do: Load up on company stock. This makes sense. Although it would be a bad idea to keep companies from offering stock as a matching contribution--doing so might keep some companies from matching at all--buying your company's stock with your own money is a risky bet. Companies should be able to offer shares either as a match (giving you the option to sell immediately) or as an investment option, but not both. And where company stock is an option, plans should set strict limits on how much you can buy.

MAKE IT CHEAPER. In some plans, participants can give up more than 2% a year in expenses, compared with 1.4% for the average retail stock fund or 0.2% for a well-run index fund. Apparently small differences in expenses can really add up. According to the Department of Labor, high fees can easily knock almost 30% off your lifetime accumulations in a 401(k).

So what would help? Clearer pricing could go a long way toward holding expenses down, especially if investors could take their money elsewhere--to a state-run plan, say, or out through a fund window. Ideally, plans should have to reveal their annual expenses to each participant on their account statements, and in dollars, not expense ratios. When participants see exactly how much they are paying, they may put more pressure on their bosses to keep costs down.

The 401(k) is a product of changing times, and we think it can continue to evolve. But much of this work may take a while. You need to plan for retirement now. So read on.