401(k)risis

See this year's 401(k) Special Report.

Soon after Section 401(k) of the Internal Revenue Code took effect in 1980, it morphed from an obscure investment option into the goose that laid the golden nest egg.

Has that goose been cooked?

The value of the equities held in defined-contribution plans has declined by $2.8 trillion since the market peaked in 2007. The Hewitt 401(k) Index finds employees moving substantial sums into fixed-income investments. And multiple surveys have found that a majority of employees, from the C-suite to the front lines, are now delaying or reconsidering their retirement plans as a result of the sharp decrease in their personal wealth.

This has already had some short-term effects, notably employees fleeing to safer investments or abandoning 401(k) plans altogether. What it will take to restore their comfort level in equities, and what impact their understandable skittishness will have on their overall retirement strategies, remains to be seen.

But far more profound may be the impacts still to come: lawsuits, new regulations, and the specter of an aging workforce that, like a bad party guest, shows no inclination to leave.

It wasn't supposed to be this way. Almost from the start, 401(k) plans enjoyed a huge marketing push from companies and investment firms, and an enthusiastic embrace by workers. Positioned initially as the proverbial "third leg" of the retirement-income stool (along with pensions and Social Security), 401(k)s quickly became the dominant leg (see "A Wobbly Stool" at the end of this article), and companies worked hard to encourage participants to invest for growth rather than safety.

They may rue the day. Many experts in the field say it's nearly certain that the massive investment losses will fuel ERISA-related class-action lawsuits against employers. "If an allegation of a breach of fiduciary duty can be made, it will be made," warns class-action defense attorney Gerald L. Maatman Jr., a partner in Seyfarth, Shaw, a national management-side law firm. Across the board, anxious sponsors are reviewing and retooling their 401(k) programs to minimize their exposure to litigation, even as they try to encourage employees to keep saving.

Fear and Anger
Companies find themselves in a very difficult position. At Call4Health, a medical answering-service company with 60 employees, CFO Nicholas Koutrakos says the company fought a valiant but losing effort to save its plan. "We maintained our match, and we did everything we could to encourage people to stay in the plan," he says. "But our employees are scared. The last thing they want is to put more money into a market that's already down so much." As the economy unraveled, participation dropped from 70 percent to just 30 percent, contribution levels fell drastically, and the plan became too cost-heavy to support. Call4Health terminated the 401(k) plan and now accommodates employees who want to save for retirement by providing direct deposit into individual retirement accounts (IRAs).

"People are afraid," says Karen Martin, who administers Southern Communications Corp.'s SIMPLE Plan. "They aren't looking for a return on their money now; they just don't want to lose any more. Selling seems to make no sense, but neither does riding it out."

Of course, even as companies struggle to address employees' fears and anger, and to maintain a baseline interest in what remains a critical component of a retirement strategy, many are also further dimming the appeal of the plans by reducing or eliminating the company-match component. Kodak, Sears, FedEx, UPS, and many other large companies (12 percent, according to a February survey by Watson Wyatt) have taken that step, and another 12 percent expect to do so in the next year.

Properly managing a 401(k) plan these days entails far more than threading the needle between cost-reduction and participant encouragement, however. First and foremost, companies should take steps to reduce legal exposure. They should also keep a close eye on proposed changes to how the plans operate. And they will, at some point, need to think about the potential impact that all those cracked nest eggs may have on the demographic composition of their workforce.

The 10 biggest settlements for ERISA-related class actions in the United States topped $17.7 billion last year, a 10-fold increase over the $1.8 billion paid out in 2007. Four of the biggest settlements involved allegations of breach of fiduciary duty, says attorney Maatman. He advises CFOs to brace for more such lawsuits this year. Robert Walter, a principal at Buck Consultants, concurs. "As the economy deteriorates, the likelihood of claims by participants goes up," Walter warns. "This is not the time to forget the niceties of 401(k)-plan governance."

Dismal investment returns alone don't expose a sponsor to liability. ERISA doesn't set a market-performance standard, and indeed, none of those large settlements last year were directly linked to the plunging Dow. But lawyers may well see new opportunities, and as fiduciaries plan sponsors must offer a range of suitable, reasonably priced investments and disclose their relative risks and costs — or suffer the legal consequences. And that fiduciary liability rests squarely with plan sponsors, no matter who administers the program, warns Robyn Credico, a defined-contribution practice leader for Watson Wyatt.

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