Investment Company Institute President Paul Schott Stevens recently testified before the U.S. House of Representatives Education and Labor Committee, avowing that the 401(k) model is working, in spite of the market’s downturn.

Americans have continued to contribute to their 401(k) as a responsible measure to prepare themselves for retirement, Stevens said. Half of the $16 trillion that Americans have saved for retirement is held in 401(k)s, and that $8 billion would probably have not been set aside for retirement were it not for these instruments, Stevens said.

Despite the market’s steep declines, Americans are “not panicking,” he noted. “As of October, only 3% had stopped contributing to their accounts, and [only] 3.7% had taken withdrawals. Clearly, 401(k) savers are staying the course.”

That said, Stevens spelled out a number of ways 401(k) plans can be improved, beginning with better education about saving at all stages of Americans’ lives, starting in the first grades of school all the way through the workplace.

Stevens also said that the current state of the market has made it abundantly clear that required minimum distributions at age 70 1/2 are penalizing those retirees who must withdraw their money now, when the market is so weak.

Further, fees, risks, holdings and performance must be much more clearly spelled out, Stevens said. In addition, 401(k) plan sponsors should be required to make automatic enrollment and automatic savings escalation mandatory. That said, Stevens said Congress should not determine what the default investment choice should be. Rather, that should be left up to plan fiduciaries.

Decumulation options for those workers about to retire should also be left up to the discretion of the plan fiduciary, he added. “The optimal distribution choice for a participant could be a single product or combination of products,” Stevens said. But that “will depend on individual circumstances, including health status, other income sources, such as Social Security and defined benefit plans, and whether a retiree hopes to leave an inheritance to children. That there is no solution that is right for all retirees means that education and advice are of great importance in the distribution phase.”

It should also be easier for employers to diversify participants out of heavy concentrations of company stock as they near retirement, and easier for employers to offer savings plans. For those workers whose employer does not offer a 401(k), they should be able to invest in an “R” series of Treasury savings bonds.

Target-date funds need realistic target dates

For decades, annuities were shunned by money managers for their high cost and lack of liquidity. Recent market losses have brought guaranteed income products back in vogue, but mutual fund companies and insurance agencies are still fighting over who will control those assets.

“Pound for pound, the same benefits are cheaper with variable annuities,” says Tamiko Toland, editor of Annuity Insight at Strategic Insight and moderator of a panel at the Institute for International Research’s fifth annual Managing Retirement Income conference in Boston.

Annuities typically get a huge share of rollover assets when investors retire, but fund companies have been coming up with innovative ways to keep that money in 401(k)s for as long as possible, such as adding a guaranteed income option to target-date funds to protect investors from huge market losses while still giving them exposure to equities.

“There is a lot of interest from plan sponsors in these products,” said Fred Conley, president of the institutional retirement group at Genworth Financial. “They want to know how it will fit into their plan and how it integrates with other components.”

Conley said the first generation of target-date funds focused on building assets to age 65. These funds were stable and relatively safe for a long time, until some managers lost their way and started putting more and more money in equities.

The result has been a target-date universe that is more aggressive than intended. And those poor decisions were reflected in the range and the depth of target-date funds’ returns in 2008; while the overall market fell 39% last year, target-date funds declined an average of 17%. Even 2010 funds, which are supposed to be the most conservative, fell in value anywhere between 3.5% to 41.3%.

Now many in the industry have returned to the drawing board for target-date funds. “What should a target-date fund be? Employment-to-grave or employment-to-retirement?” asked Ron Surz, a principal at Target Date Analytics LLC.

Surz said target-date funds are a great idea with terrible execution. A good target-date fund should have broad diversification, plenty of risk controls and a sound theory, he said.

The purpose of a target-date fund is to automatically rebalance an investor’s stock/bond mixture so it becomes less risky as they approach retirement. Despite this principle, many 2010 funds have aggressive stock allocations and were hammered in the last six months when the stock market tanked.

“There were retirees in that 2010 fund who lost 22%. It’s really hard for them to come back into the workforce,” Surz said.

Surz said 2010 funds with a nearly 100% bond allocation did just fine last year, even without a guaranteed income component. “There should be some truth in advertising,” Surz said. “If you intend your 2010 fund to go on for 30 years, you should rename it a 2010/2040 fund. We firmly believe a target-date fund should end on the target date with 100% in safe investments.” Most investors don’t even keep their money in a target-date fund after they retire, he said. They take their assets with them.

The reasons why older investors have been so heavily invested in equities comes down to a combination of insufficient savings and the daunting amount of money needed for a retirement that could last much, much longer than planned. For many investors, a 100% bond portfolio won’t provide enough growth for an extended retirement.

Most Americans are woefully unprepared for retirement, said Brian Perlman, senior vice president at Mathew Greenwald and Associates, adding that a large percentage of elderly women would be in abject poverty right now without Social Security.

“Most people can’t save their way to retirement without a significant investment in equities,” but taking so much risk can be devastating if things go wrong, Perlman warned. “You need something in the system that’s going to reduce panic,” Perlman said.

If a target-date fund is going to have a guarantee, “the use of these guarantees should go into effect five to 10 years prior to the target date,” he said. “We need to meet consumer demands,” Toland said. “We can design these great products, but if people don’t buy them, it doesn’t help them at all.

Most investors will look at a variety of solutions.” The best thing for many investors is a customized solution, she said, and it will be a lot easier to customize a product if all its components are unbundled first.

The goal of the adviser should be to provide investors with a clear replacement level of income during retirement, said Andrew Scherer, managing director at Van Kampen Investments. “As products are unbundled, the role of the adviser will be critical,” said Ann Connolly, a director at Deloitte Consulting. “New products will focus on income payout and risk mitigation, and service will be the new means for differentiating the brand.”

Investors will have to rely on their advisers to reassemble the unbundled products into a customized plan that’s appropriate for their own individual needs and risk tolerance, Connolly said, and this will put the focus back on the consumer, rather than on engineering new products.

“As we emerge from this crisis, financial services companies will rekindle their interest in innovation,” she said. “There will be a lot of innovation once we pull out of this.”