How Fidelity Could Reform the 401(k) Plan System, but Won't

According to Fidelity Investments, withdrawals from 401(k) plans are on the rise. This is a troublesome sign. The average 401(k) plan balance at the end of the second quarter of this year was a paltry $61,800 -- hardly enough to "retire with dignity."

Plan participants reduced their balances by taking loans or obtaining hardship withdrawals. A staggering 22% of participants have loans outstanding, and 62,000 participants took hardship withdrawals. This doesn't bode well.

Need to Access Cash

You can easily understand the need to access the cash in these accounts. More than 250,000 homes were foreclosed in the second quarter of 2010. Expenses for tuition and the purchase of a primary residence were also cited as reasons for these withdrawals.

Hardship withdrawal rules vary with the terms of individual plans. Typically, payment of medical expenses and primary residence purchases qualify. These withdrawals don't have to be repaid, which is good short-term news, but often shifts the problem from the present to the future, when participants may find it difficult to ever retire.

Loans from 401(k) plans can be very problematic. Obviously, you are diminishing the amount in your account. Less money means less return. If you leave your job, you will have to pay back the full amount of the loan. If you cannot repay the loan as required by IRS guidelines, the loan will be treated as taxable income and a 10% penalty will be assessed. Additional restrictions may be applicable depending on the terms of your plan.

What Fidelity Could Do

As the "nation's No. 1 provider of workplace retirement savings plans," there's a lot Fidelity could do to improve this system. If it wanted to be not only the "No. 1 provider," but also the best provider, it could assume full 3(38) ERISA status and agree to act as a fiduciary to plan participants. This would turn the industry on its head.

Instead of populating its plans primarily with expensive, actively managed funds (where the fund manager attempts to beat a designated benchmark), it could limit investment options to its low-cost, stock and bond index funds. It could offer a limited number of pre-allocated portfolios consisting solely of index funds at varying risk levels. Instead of having actively managed funds in its target date funds, it could learn from its competitor Vanguard. Vanguard's target date funds consist solely of its low-cost index funds.

It could refuse to take "revenue sharing" payments from other fund families as the price of admission to the array of investments offered to plan participants. It could disclose all fees and costs in an open and transparent way.

Fees Impossible to Calculate, Difficult to Justify

It's one thing for Fidelity to lament the sorry state of low balances in 401(k) plans and tacitly blame beleaguered employees. Where's the examination of its own conduct? Fidelity participates (as do other fund families) in a system that practically insures the returns will be significantly less than market returns. It reaps huge fees, which are almost impossible to calculate and are difficult to justify.

Raising the consciousness of plan participants that withdrawing funds from their plan accounts may jeopardize their future retirement is useful. Taking a leadership role in reforming a system that primarily benefits mutual fund families and plan advisers would be far more newsworthy.

Don't count on it.