Less than a week ago, US News posted an article in the Smarter Investor section titled 7 Threats To Your Retirement. While the article thoroughly discusses some of the threats to retirement, such as switching jobs, early retirement and lump sum distributions, which are indeed valid threats to the average American’s ability to retire comfortably, the author seems to focus more on the issues facing employees with defined benefit plans.
The reality is that a large percentage of Americans these days are not going to enjoy the security of pensions when they retire as less and less employers offer defined benefit plans (i.e. traditional pensions) and more and more employers offer defined contributions plans(i.e. 401Ks) with a tiny match, if any… Therefore to me, the real issue to discuss is
What are the 7 threats to your retirement when all you have is a 401K?
A little bit of history can help us understand the current reality…
In 1974 when The Employment Retirement Income Security Act gave formal approval to employee-funded savings plans via a pronouncement that became the Internal Revenue Service Sec. 401(k). By 1981, regulations had been issued and the 401(k) plan formalized.
Johnson Companies quickly introduced the first 401(k) plan. It was designed to give employees another way to save. Theoretically, it would provide a way for workers to supplement their pensions with additional, tax-deferred personal savings. These plans differed from their predecessors, where employees received a defined benefit, and came to be known as defined contribution plans, because the amount put into the plan is defined but the amount that comes out is variable.
As time has passed, companies have replaced their defined benefit plans with defined contribution plans. It saves money for the companies, as they are no longer responsible for providing income to retired employees. Today, most employees think of their defined contribution plans as “pension plans,” but real pension plans come with a guarantee. So what is the result of the DC plan experiment?
Defined contribution plans are often for most Americans the closest thing to a pension plan. One with a few pitfalls which pose a threat to retirement and make planning for it that much more important and also challenging.
- 401K plan contribution is too voluntary – Every employee gets to choose how much, if at all, they are going to contribute to their 401K plan. Very often young employees find a myriad of what seems at the time legitimate excuses to postpone contributing to a 401K plan. It is not unusual for college graduates to be heavily burdened by student loan debts which they are repaying well into their 30s and therefore not contributing or contributing very little to their defined contribution plans. The investors who fall in this category don’t start thinking about retirement planning into their 40s at which point they have lost the benefit of time and now have to contribute much more than if they had started contributing in their 30s.
- Often employees use the loan option as an ATM – The loan options on most 401K plans allow for access to quick cash but unfortunately can put the accumulation of wealth in the nest egg at risk. As a matter of fact, close to 30% of people who have the option of a 401K loan have already taken advantage of it. Without a doubt, having the ability to take a loan against the vested portion of the 401K can come in very handy in a situation of an emergency when savings only cannot cover the need. However, it is possible to ignore the disadvantages of borrowing from the retirement nest egg such as fees, possibility of hurting the credit score in the event of default and most importantly the opportunity cost of 401K loan. Or in other words, how much of a tax-deferred growth are you giving up by taking the money out of the fund.
- When compared to traditional pension accounts, it is really a pay cut for workers – The logic here is quite simple, yet this is one of the most significant disadvantages of defined contribution pension plans. Compared to the few lucky ones who are still offered defined benefit plans by their employers, the majority of Americans who only rely on a 401K take in essence a pay cut in order to contribute to the plan. According to the Social Security Administration, the National Average Wage index for 2010 is $41,673. If one were to contribute the maximum 401K deferral amount per IRS regulations of $16,500, that represents a whopping 40% of income.
- There are no guarantees – This is really a continuation of the previous point. Unfortunately, even saving a significant percentage of annual income, and thus forgoing the ability to spend it now, there is no guarantee that the securities or funds in the plan will not fall in value and therefore make it imperative for the employee to continue working. The worst is that this market risk does not end at retirement.
- Fee Structures no matter what- Another issue to consider is that al though the investor is exposed to market risk discussed above, the mutual fund provider, the custodian, the clearing firm, the transfer agency and a myriad of other functionaries get paid their fees even if the stock market falls.
- Possibility of making bad decisions – Defined Contribution plan participants are responsible for choosing their own investments. While some might argue that this option empowers employees, the truth is that most investors are not that great at picking investments. This is not necessarily due to lack of knowledge. Same is true for professional fund managers. For example, The Vanguard S&P 500 which is the most famous index fun in the United States marketplace, failed to match the performance of the benchmark index as of December 31, 2011.
- Timing is everything – Bottom line, the success of any 401K plan depends on timing more than anything. Financial markets do rise and fall and if one has the luck to be in the markets when they are rising, fortunate enough to make enough money to cover the numerous expenses associated with retirement and astute enough to pull all the money of the market before the next recession, then the 401K plan might indeed help to cover the cost of retirement.
So what is the conclusion?
While 401K plans are not all doom and gloom, it is imperative that they are a part of a well though out financial plan. Just like with any other investment decision, your individual overall investment goals need to be evaluated in order to determine the most effective investment strategy. Although certain general rules apply, there is never a “one size fits all” answer when it comes to investing. Your adviser will help you determine the most favorable strategy in your particular case.
Best of luck!!