Edward A. Zelinsky is the Morris and Annie Trachman Professor of Law at the Benjamin N. Cardozo School of Law of Yeshiva University. He is the author of The Origins of the Ownership Society: How The Defined Contribution Paradigm Changed America. In this article, Zelinsky discusses the federal government’s promotion of common stock investments for 401(k) participants. He suggests that, in light of the Crash of 2008, that promotion constitutes misguided paternalism.
Even as we contemplate the financial carnage of the Crash of 2008, the federal government sends a strong, paternalistic and, ultimately, misguided message to 401(k) participants: Invest your retirement savings in common stocks.
Congress, in the Pension Protection Act of 2006 (PPA), directed the Secretary of Labor to promulgate regulations specifying the “default investments” to which 401(k) funds will be directed if participants fail to make their own investment choices. Under the regulations issued by the Secretary of Labor, a plan fiduciary obtains immunity from liability for a participant’s investment decisions only if the plan’s default investment constitutes a “qualified default 
investment alternative.” Among other requirements, a qualified default investment alternative must satisfy one of three mandatory patterns: a “life-cycle” pattern under which “a mix of equity and fixed income” investments changes for the individual participant as the participant ages, a “balanced” portfolio under which each participant has the same “mix of equity and fixed income” investments “consistent with a target level of risk appropriate for participants of the plan as a whole,” or a “managed account” under which an investment manager allocates a particular participant’s account to “a mix of equity and fixed income” assets.
When one cuts through the bureaucratic verbiage, a strong message emerges: 401(k) funds, particularly the funds of younger participants, should be invested in common stocks.
At one level, the PPA and the DOL regulations which implement it reflect a plausible investment theory, namely, that common stocks, for the long run, do better than do more conservative investments. The PPA and the DOL regulations also respond, in light of this theory, to two accurate perceptions about the 401(k) world: First, unless participants direct otherwise, 401(k) plans have historically placed participants’ resources into conservative, low-yield investments like money market funds. Second, 401(k) participants often fail to diversify their holdings out of these conservative default investments.
Hence, the PPA and the DOL regulations channel 401(k) funds toward common stocks by effectively requiring that at least part of passive participants’ accounts be invested in such stocks.
Surveying the wreckage of the Crash of 2008, this looks like misguided paternalism. Many investors who buy common stocks in the current bearish environment are likely do well in the long run. But, as they say, past performance is no guarantee of future success. And some, particularly smaller investors, may sincerely and (from today’s perspective) rationally prefer to avoid the volatility associated with common stocks.
There is, as we have just seen, a reason that the extra projected profit associated with common stocks is labeled a “risk premium.” The passive 401(k) participant who leaves his funds in conservative, low-yield investments looks more reasonable today than he did when Congress passed the PPA in the bull market of 2006.
A defender of the PPA and the DOL regulations could retort that they do not require participants to invest in common stocks, but merely send 401(k) funds to equity investments unless the participants direct otherwise. True. But the PPA and the DOL regulations nevertheless reflect a father-knows-best attitude, taking it as the federal government’s responsibility to privilege its preferred approach to investing and enshrining that stock-based approach in the law.
Before the Crash of 2008, such paternalism looked plausible. At an as yet unknown date in the future, such paternalism may look plausible again. Today, it looks misguided.
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Defined Benefit Pensions are Dead; Long Live DB Pensions
I appreciate Zelinsky calling like it is — the so-called 2006 Pension Protection Act and the DOL regulations privilege a faddish approach to investing which is overweighted towards stock. (Zelinsky calls it a “enshrining stock-based approach in the law.”)
Government paternalism, though is not the problem as Zelinsky characterizes it. He calls the government’s default option for automatic 401(k) contributions, “paternalism.” The problem actually is the government’s lack of caring. The Paulson – Bernacke plan proposes a bailout of the investment firms with very little new regulation and maintaining the same legal biases toward 401(k).
The government should do a lot more, I call for a democratic “paternalism.” Instead of giving investment banks a way out – the government is providing a market for their junk assets – it should be giving near retirees and retirees the option to clear the junk out of their accounts and transfer them to government guaranteed bonds. I describe these vehicles in my new book; they are called “Guaranteed Retirement Accounts.” Every worker would get $600 annually from the government in exchange for investing 5% of their pay every pay period to invest in a retirement account that the government would pay 3% indexed for inflation.
The government is now pursuing a misguided message – retirement security can be achieved through 401(k) accounts. What all workers need is access to the same investment vehicles that most public sector workers have, including all federal workers, and most unionized workers. All workers need a secure vehicle, like a defined benefit plan. All workers deserve to put their retirement dollars in a vehicle that guarantees a low–fee and safe return. If we swap tax breaks for 401(k) plans (70% got to the top 20% of wage earners) for a $600 contribution to a guaranteed account for all workers it would cost the government nothing and help the people who need help the most– unlike all the other proposals swirling around.
Teresa Ghilarducci, author of “When I’m Sixty-Four: The Plot Against Pensions and the Plan to Save Them.”
[…] piece here from Ed Zelinsky (Cardozo) on the 401(k) aspect of the 2008 economic collapse from the Oxford University Press Blog: Even as we contemplate the financial carnage of the Crash of 2008, the federal government sends a […]
While there is some truth to Mr. Zelinsky’s position he overlooks a related issue. Pre PPA most “default” investments were money market funds. Some of them were falling below a dollar per share last week as well, making them no better than the mutual funds he’s opposing.
As for the participant who “may sincerely and (from today’s perspective) rationally prefer to avoid the volatility associated with common stocks” all he or she has to do is make an active election.
[…] Ed Zelinsky comments in this recent article on provisions in the Pension Protection Act of 2006 (PPA), directing the Secretary of Labor to […]
I wondered at Mr. Zelinsky not recognising explicitly that the DOL was acting exactly in accordance with executive branch policy as expressed by pres. Bush during his first administration. His then agenda of dismantling the social security administration brayed a rather general dependance on the stock market, assuming that it could absorb the future needs of the working class. This to me at the time looked wildly foolish, resembling a test baloon designed to prove the naivete of the American public. In retrospect I admire Mr. zelinsky’s erudition and bringing this perspective to the fore.
Hat’s off to Mr. Zelinsky
This new DOL rule for default investments has been personally painful to me. I left my 401(k) balance in my former employer’s plan. My Dec 07 investments were where I wanted them. I checked my account in Oct 08 for rebalancing and find the administrator had changed and I was placed in a retirement target fund which by the 3rd Qtr lost 25% vs a 3% loss if I was permitted to retain my investment balances. Lesson learned, don’t have accounts where others can tamper with.