By Anne Tergesen

Bloomberg Bogle, king of the index fund, says the 401(k) system needs more index funds.

How can we improve the 401(k)? Jack Bogle has a few ideas.

In recent testimony before the Senate Finance Committee. the index fund pioneer– called Saint Jack by fans and foes of index investing alike – laid out his blueprint for fixing the nation’s retirement system, including Social Security, pension plans and 401(k) retirement plans.

Bogle didn’t mince words. “Our nation’s retirement system is imperiled, headed for a serious train wreck,” he said. Still, he added, the problems are fixable – with a few “achievable reforms.”

Bogle devoted most of his testimony to defined contribution plans, such as the 401(k). While the 401(k) system has many flaws – including rules that allow for voluntary contributions and withdrawals that can be “made almost at will, with only a modest tax penalty”—Bogle said the biggest problem lies in the fact that investors pay exorbitant investment fees.

Of course, coming from the guy who founded Vanguard Group, such a conclusion could be seen as self-serving. However, Bogle’s math is persuasive. Bogle described a hypothetical 30-year-old investor who earns $30,000 a year and receives 3% annual raises. If that worker saved 10% of his salary every year in actively managed stock funds, and earned a nominal 7% annual return, he’d have $561,000 at age 70, But if he were to plow the same 10% per year into index funds, he would amass $927,000 – or 65% more.

In other words, Bogle said: “A person saving for retirement who chooses low-cost investments could have a standard of living throughout retirement more than 65% higher than that of a comparable investor in high-cost investments.”

On average, actively managed funds cost an extra 2.2% a year, Bogle estimates. This includes the sales “loads,” or commissions, that many funds charge in order to compensate the brokers who sell their shares. (To be sure, the funds in many 401(k) plans don’t charge sales loads, which arguably puts Bogles estimate at the high end of what most savers actually pay.)

But the bigger issue is that compared with index funds, actively managed funds also charge higher investment management fees, known as expense ratios. Bogle assumed that those expenses accounted for about one percentage point of the cost difference between actively managed funds and index funds.

There are less obvious costs to active management, too, including the drag on returns when managers hold cash in a rising stock market and the trading costs managers incur when buying and selling stocks to juice returns.

In Bogle’s ideal world, he said, all 401(k) plans would be fully indexed. Standing in the way of that vision are “lobbyists for mutual fund managers and industry associations,” said Bogle, who also recommends that Congress require the mutual fund industry to assume a “fiduciary duty,” on behalf of 401(k) participants. Such a requirement would effectively compel fund managers to keep their fees as low as possible.

Bogle had some recommendations for the senators on Social Security and pensions too:

• On Social Security: “To protect the long-term solvency of the system, we need to implement a gradual increase in the maximum income level subject to the payroll tax,” he said. He also recommended “A gradual increase in the retirement age to, say, 69; and a modest means test that limits payouts to our wealthiest citizens.”
• On defined benefit pensions, Bogle noted that “virtually all plans – private and public alike – are assuming overly optimistic future investment returns of 8% per year on their pension assets.” He noted that today, Treasury bonds have yields of around 3% and future stock returns seem likely to be in the 7% range. Bogle’s conclusion: “A 60/40 stock/bond portfolio might be expected to return about 5.5% during the coming decade—much less than 5.5% after the costs of investing are deducted.”

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Anne Tergesen covers retirement for The Wall Street Journal. Follow her on Twitter  @AnneTergesen .