Have 401(k) plans failed?
The stock market’s dramatic dive over the past year has some people questioning the usefulness of 401(k) plans. A recent article on msn.com reports:
“This is the biggest test that the 401(k) plan has seen to date, and it has failed,” says Robyn Credico, the head of defined-contribution consulting at Watson Wyatt Worldwide, noting that many baby boomers are ready to retire. “We’ve put people close to retirement in a very challenging position.”
The most obvious pitfall is that 401(k) plans shift all retirement-planning risks ‘” not saving enough, making poor investment choices, outliving savings ‘” to untrained individuals, who often don’t have the time, inclination or know-how to manage them.
I want to focus on the usefulness of 401(k) plans, but first I must digress for a moment and comment on this last statement. Claiming that you don’t have the ‘œtime’ or ‘œinclination’ to manage your retirement savings is a ridiculous cop out. If you don’t have the time or inclination to acquire food and shelter, you rightly starve or die of exposure. Similarly, if you don’t have the time or inclination to plan for your retirement, you should rightly be denied that retirement. To claim otherwise is to claim that the responsibility for oneself should fall on someone else. The article doesn’t quote anyone who actually claims this; it seems to be an assertion on the part of the writer. In any case, it is a careless and stupid statement.
But let’s get back on topic. We already have a retirement system that supposedly shifts all retirement-planning risks away from untrained individuals. It’s called Social Security. So we can all relax and not worry about our retirement, right?
That these individuals are ‘œuntrained’ is a valid point. Of course, considering the performance of every major financial institution over the past couple of years, I’m not convinced the professionals would do much better. As for the government, the blatant mismanagement of Social Security by every Congress and presidential administration since its creation demonstrates the government’s ability to manage retirement finances.
The article continues:
“That seems like such a fundamental flaw,” says Alicia Munnell, the director of Boston College’s Center for Retirement Research. “It’s so crazy to have a system where people can lose half their assets right before they retire.”
This makes me wonder if Alicia Munnell has ever heard of Social Security. Alicia, do you realize we have a massive compulsory ponzi scheme which is so underfunded that its future existence is very much up in the air? Workers are contributing 12.4% of their pay (6.2% is visible on their pay stubs, while the other 6.2% is matched by the employer and thus hidden from the worker) into a retirement plan that will provide little if anything in retirement. Think about that ‘“ 12.4%! If we want to sustain the program, the tax will have to be increased even further. Social Security also shifts the responsibility of supporting retirees from one generation to the next, which is a monstrous breach of morality by any rational ethical standard. If the 401(k) system is crazy, what is the Social Security system?
The article mentions some alternative proposals that would provide workers with a safer, more fool-proof retirement vehicle:
One such plan called for establishing accounts that would receive annual contributions from the federal government and would offer a guaranteed, but relatively low, rate of return.
Let’s get a few things straight.
No one can be guaranteed a comfortable retirement. One can briefly imagine that the government could guarantee a nice retirement income for everyone, but it should only take a moment for that thought to lead to the next question ‘“ where does that money come from? ‘œContributions from the federal government’ sounds appealing because it makes it seem like the money just appears from nowhere, but that money has to either come from current taxes, government debt (future taxes), or printing money (inflation).
There is an amusing comment on wsj.com that demonstrates the failure to understand this:
What needs to be done, contrary to existing thinking, is to significantly increase Social Security benefits, make Social Security coverage universal and have it funded by all stakeholders including employers, employees and the federal government.
This commenter suggests three separate sources of funding: employers, employees, and the federal government. However, the federal government can not fund anything since it does not produce anything. It can only tax the producers (employers and employees). Making employers pay the bill sounds good, since that provides employees with ‘˜free’ retirement savings. But again, it should only take a moment of thought to lead to the question ‘“ where does that money come from? Shareholders will pay via reduced profits, employees will pay via reduced wages, or customers will pay via higher prices, depending on how the companies deal with the tax burden (see tax incidence for an introduction to this topic). Since the company must stay profitable to stay in business over the long term, the cost of taxation becomes an expense that has to be paid for somehow. Ultimately, corporate tax is just a hidden tax on investors, employees, and consumers.
As the Social Security shortfall demonstrates, funding retirement through taxation makes those benefits dependent on the ability of others to pay that much in taxes. Funding it through government debt just makes it harder for the next generation to pay a double dose of those same taxes. This is clearly no guarantee.
As the current pension plan shortages demonstrate, relying on pension plans makes your retirement dependent on the ability of professional money managers to get a good return. They struggle with the market just like individuals do, so once again, this is no guarantee.
Fortunately, not everyone is as short-sighted as Alicia Munnel or the commenter I quoted above. Another article on wsj.com quotes:
“There is no risk-free system,” says Brigitte Madrian, a professor at Harvard University’s Kennedy School of Government. “You can argue for expanding Social Security, but we will end up paying higher taxes. You can try to revive defined-benefit pension plans. But due to bankruptcies, we’ve seen employee pension benefits cut substantially.”
401(k) plans do have their drawbacks. Over a year ago, I listed some of the problems with 401(k) plans in The Legislative Bias Against Saving. Why should you have to get one through your employer? Why should your employer choose the investment options? Why should your contributions be so limited, especially in an economic environment like today? The default stance of the U.S. government is to punish saving as a general rule and to encourage it only in narrow, complicated vehicles like 401(k) plans. It’s hardly a wonder that few people have much savings in any vehicle.
But 401(k) plans still have one big thing going for them: when you put money in them, you know you’ll have something to show for it 30 years later, because the account is yours. With pension plans imploding and Social Security hopelessly underfunded, this one aspect of 401(k) plans makes them a comparative success.
—–
Bill keeps a personal blog, touching on a range of disparate topics, from relationships to video games to economics and politics.
Photo credit: stock.xchng.
Years ago during my degree earning days (Accounting) I sat down and figured out that if at age 25 you took a minimum wage job that ended up paying you gross $250 a week ($12,500 a year) for 40 hours and your Social Security deduction along with the Employer match which totaled around $30 a week was put into just a simple Savings Account earning 6% (like passbook accounts did then…required Federal minimum it was stupid to do away with) and was Tax Free like an IRA.
Assuming you NEVER earned more than the Minimum Wage (or $250 a week back then) after 40 years when you turned 65 the account would have $250,000 in it…which at 6% the Annual Interest is $15,000.
You would then retire getting MORE ($300 a week)than you earned in the workforce as a $250 a week Minimum Wage worker AND when you died their would be that $250,000 to pass on to your heirs.
It was rather simplistic as I assumed 1/ you were a Minimum Wager all your life. 2/ Minimum Wage never increased. 3/ Zero Inflation. And 4/ Contributions during a defined time period of 40 years from age 25 to 65.
But assume it had been allowed…banks would have a huge pool of money in perpetuity to loan on housing at say 8%. You would have something to leave your heirs..(this is why the Democrats fought Bushs Private Accounts so hard). And imagine how much larger the accounts would be where you earned more than minimum wage and icreased the time period to a persons whole life before 65.
Bill, great write up, I could not agree more. As a youngin that just started a real job, I hate seeing that social security deductions on my paycheck for, as you rightfully called it, a pyramid scheme run by the government. As far as all those people screaming about wiped out 401ks, that’s complete bs. 401k does not lose or make you money. What you decided to invest in your 401k will determine that. If they did not want to lose so much money, should not have been investing into stocks/mutual funds. Simple as that. Risk = reward long term. You can take my social security contributions now but I am almost certain to come out ahead investing for the long term. Up yours, baby boomers 😉
Bill: I agree the system is broken, but liberals never seemed to like the idea of Personal Retirement Accounts (PRA) because they were part of Bush’s reform plan.
Do you think PRAs will ever replace social security? And what do you think will happen with reform in this administration?
FrugalZen, although I don’t agree that the government should be manipulating interest rates, I do agree that even a simple tax-free savings account would be a better retirement plan than any sort of government-run program. The important thing is that people should own their own retirement account. Otherwise it is all too easy for the politicians to swipe the money. Of course, in Argentina the government actually did take the money from even individual retirement accounts when the government got into trouble – but I don’t think that would fly here. At least I hope it wouldn’t.
Dima, kudos for being this financially aware when starting your first real job. I’m betting you’ll be in pretty good shape when retirement age comes around.
Nina, unfortunately, I think the current administration will either do nothing or the exact opposite of what needs to be done. What needs to be done is more or less what Bush proposed. It was one of the few good things he did propose (HSAs were another). Democrats are far more likely to do everything possible to prop up or expand government ownership of retirement and to reduce individual ownership. This will be framed as removing the burden from individuals, but it actually means taking individuals’ control over their own future away.
I sincerely hope Obama proves me wrong on this last point.
Bill, I love that you’re so skeptical about the government’s ability to “manage” anything.
As for the viability of 401k plans, my mom just closed out her personal 401k because it was hemorrhaging money and had lost 50% of it’s value over the past 2 years. She is way to close to retirement to be loosing money like that. She has faithfully been putting her money into a 401k for over 30 years. I remember times when our family had to make hard decisions about how to spend the family’s limited money. My mom would never budge on putting money toward life insurance or her 401k. And so seeing her efforts disappear like that in such a short amount of time has been very disheartening. She’s done the responsible thing, and this is how she is rewarded?
I think you’re right to distrust the government, but it’s hard to trust the banks anymore, either.
Indeed, Serena. When it comes to your money, you shouldn’t be trusting banks or government or anyone else to do the right thing on your behalf. I’m guessing that if your mom lost 50% she was not conservatively invested, probably because she didn’t have any good conservative options in her 401(k) plan. My own plan suffers from the same thing. I hate that my employer gets to choose what options to make available to me. I know what I want better than they do. Again – why not set people free to save how they want? 401(k) plans are only a ‘good’ option right now because the other options are so bad. I would like to see people free to save limitless amounts of tax-free money in whatever investments they want. Your mom should have been able to move her 401(k) into money markets or some other ultra-safe investment, regardless of whether her employer made one available. Our current laws simply don’t allow that.
I love this post. While I’ve definitely seen coworkers make very bad decisions about 401Ks out of sheer ignorance, I think the plans (even in their current incarnation) are still superior to relying on the gov’t to make our investments for us. As someone who is at the wrong (young) end of the Social Security Ponzi scheme, and who has seen my previous employer’s pension plan go belly-up, I’ve got a whole lot more trust in my 401K getting me through retirement. I’m fortunate to have a good range of investment options available.
Something that would go a long way towards eliminating the ignorance problem would be employers who made info available about 401Ks that was written at a 4th grade reading level and/or in languages other than English. I’ve had a fair number of coworkers who couldn’t really comprehend the only written materials we were given, and my best efforts to translate/simplify for them were probably a pretty poor substitute for materials deliberately written to those demographics.