So much has changed in the 26 years since the 401(k) was created by Congress, and like other “young adults,” the retirement plan has certainly gone through some growing pains—and still is.

The 401(k) designation refers to the portion of the Internal Revenue Service code that authorized these plans. It came at a time when many more American workers had pension plans, particularly defined-benefit plans and labor union–based plans. These provided a fixed benefit for the life of the retiree, and, if designated, his or her spouse.

According to the U.S. Department of Labor’s Bureau of Labor Statistics, union membership has dropped from 20 percent of the work force 25 years ago to only 12 percent in 2006. In 1980, the year before the creation of the 401(k), 4 out of 10 workers participated in a defined-benefit plan, and 19 percent had a defined-contribution plan, where the contribution is determined by the employee. (A 401(k) is a defined-contribution plan.) By 2004, the percentage of workers participating in a defined-benefit plan had been cut in half, and participation in defined-contribution plans—with 401(k)s playing a prominent role—had jumped to 42 percent.

“The 401(k) was intended as a supplementary retirement plan. It was never intended as a primary retirement plan,” notes Diane Berthel, a pension plan consultant in St. Paul. “Plus, 401(k)s have grown into a huge industry from a different model—one more oriented toward retail investors who were charged higher retail fees for their administration. In spite of that growth, many plan participants are still paying those higher rates.”

Now, with Americans living considerably longer after retirement, many retirees face the distinct prospect of exhausting their 401(k) savings, particularly if they didn’t invest their money wisely.

Because most people appropriately focus their skills development on their day job, many lack the basic investment knowledge to manage their 401(k). In a 2002 study by the John Hancock Life Insurance Company, only 20 percent of the respondents regarded themselves as knowledgeable investors; 38 percent saw themselves as somewhat knowledgeable; and 42 percent said they had little or no knowledge. According to the John Hancock study, some of the mistakes investors make include:


Lack of diversification—Too many 401(k) plan participants plunk an inordinate percentage—sometimes 100 percent—of their contribution into the stock of their own company. That’s bad portfolio management, and doubly bad in that it combines investment risk and employment risk. One word: Enron. Its employees got burned twice—losing their jobs and their retirement funds.

Too much diversification—An example is the employee who contributes to all 25 of the 401(k) fund options available to him, regardless of the underlying asset composition. Without evaluating composition and the risk associated with a certain fund, employees won’t get the mix of funds that best suits their needs.

Failure to rebalance—This is called “status quo bias.” Neglecting to rebalance assets to reflect the original allocation leaves an employee open to increased risk.

Being too conservative or too aggressive—This happens when risk level is not matched to the participant’s time horizon.


Congress has taken notice. The 2006 Pension Protection Act encourages employers to take a more active—some might say paternal—role in the administration of their 401(k) plans, encouraging employers to help their plan participants by offering independent investment advice and protecting employers from liability in doing so.

Going even further, the act enables employers to run their 401(k)s with an “opt-out” approach versus “opt in.” In other words, employers can automatically enroll employees to contribute a percentage of their salary. Employees may stop their contributions, but only by formally requesting to opt out.