Saving savings: most 401 plans do a good job. Should anything be done about the rest?

National Review, April 21, 1997 by Patrick Chisholm

When Carter Hawley Hale Stores went bankrupt in 1991, the employees weren't just out of a job. They lost much of their retirement savings, too. The California-based retailer ran a 401(k) retirement plan enrolling ten thousand employees, with Carter Hawley Hale stock as the only investment option. The company emerged from bankruptcy in 1992, but in the meantime, the 401(k) plan had lost about 90 per cent of its value.

More recently, Color Tile Inc., a floor-covering chain, was another company that put most of its 401(k) assets into the company itself. Color Tile invested the money in its own stores, which it then leased back to the company. Color Tile went into Chapter 11 last year, and now the employees cannot touch their 401(k) money.

Though the vast majority of 401(k) plans are run responsibly, there are numerous cases, primarily involving small companies, of 401(k) money being squandered outright. During the past two years, the Department of La-bor initiated over 1,300 civil and criminal cases involving employers who took money from the employees' 401(k) plans.

Irregularities like this have risen in tandem with the surging popularity of 401(k) plans. The plans got their start in 1978 when Congress modified the Employee Retirement Income Security Act (ERISA) with Section 401(k). The Act, signed into law four years earlier, restricted employers from investing more than 10 per cent of pension assets in the company's own securities. The amendment made a distinction between traditional "defined benefit" plans and 401(k)-style "defined contribution" plans. The latter were exempted from the 10 per cent limit in order to preserve a profit-sharing tradition that often encouraged productivity.

No one predicted at the time that these defined-contribution plans, then relatively rare and seen as supplemental to defined-benefit plans, would eventually overtake traditional pension plans in popularity. By 1995 there were an estimated 30 million 401(k)-plan participants, according to the Profit Sharing/401(k) Council of America, up from 10 million a decade earlier. The Chicago-based Council estimates that 401(k) plans held about $850 billion in assets in 1995.

Employees like 401(k)s because their contributions are tax deductible. The employee can also decide how much to contribute and, in most cases, where to invest the money. The earnings accumulate tax-free until they are withdrawn at retirement. And workers can take their plans with them to other companies when they change jobs. As for employers, they receive a tax deduction when they contribute to the plan, and they can use such contributions as incentives to employees for higher productivity.

As younger generations' confidence in the Social Security system diminishes, the plans' importance grows. And if a political miracle is pulled off and Social Security gets partially privatized, personal savings plans such as 401(k)s will take on even more importance. One of the more attractive privatization proposals is a Chilean-style system, where workers would be required to deposit a portion of each paycheck into "personal security accounts." As with 401(k) accounts, the money would be invested in private securities and managed by private firms.

Privatization implies that retirees would have little or no safety net in the event their savings disappeared. It is imperative, therefore, that 401(k) savings be invested wisely, and that they not be abused or misused by employers. The challenge is to attain this goal without introducing excessive regulation that might burden businesses or discourage creation of 401(k) plans.

And yet avoiding excessive regulation opens the door to the kinds of mismanagement cited above. And 401(k) plans are also vulnerable to outright corporate fraud. It's tempting and easy, especially for small companies, to divert 401(k) money for their own purposes.

Such was the case of Job Shop Technical Services, Inc., in Farmingdale, N.Y., an employee-leasing company for engineers and consultants. The former owner pleaded guilty in 1995 to embezzling $2.7 million from the company's 401(k) plan, which covered about 750 workers.

In another example, Broaches, Inc., of Roseville, Mich., a manufacturer of steel cutting tools, went for several years being late in depositing 401(k) contributions withheld from paychecks. After being sued by the Department of Labor, the president of the company restored $330,000 to the plan.

With the rise in the use of 401(k) plans comes a rise in the potential for abuse. The DOL estimates that less than 1 per cent of all 401(k) plans have been delinquent in making payments, but that still represents a lot of plans. The DOL beefed up its policing measures in 1995 by launching a national enforcement program targeting plan abuse.

The DOL went overboard, however, when it proposed measures to speed the deposit of 401(k) contributions into employees' accounts. In the original law, companies could hold employee contributions 90 days before depositing them, and some companies were using this as the opportunity for an interest-free loan. And so, the DOL proposed shortening the time period to the next business day for companies with large 401(k) plans, which would have sharply raised costs for companies. Fortunately the DOL agreed to modify the rule, requiring that the money be deposited within 15 business days following the month in which it was withheld. Industry representatives find this acceptable.