Lasting Situations of Wealth

Misunderstandings, Unrealistic Expectations, Unintended Consequences
The headline and accompanying photo in the February 19-20, 2011, weekend edition of the Wall Street Journal was attention-getting. As a North Carolina couple stared vacantly across a field at sunset, the above-the-fold headline declared:

Retiring Boomers Find 401(k) Plans Fall Short.

WSJ reporter Jason Henry led off his article with these sobering words:

 The 401(k) generation is beginning to retire, and it isn’t a pretty sight.The retirement savings plans that many baby boomers thought would see them through old age are falling short in many cases.

Actually, this pronouncement is sort of old news. Ever since the stock market tanked in late 2008 and 2009,
devastating the account balances of many 401(k) retirement accounts, an anguished cry has arisen lamenting the “failure” of the 401(k) to deliver on its retirement promises. Some similar headlines, from earlier:

• Real Change: Outlaw 401(k)s, by Dan Solin,  Huffington Post , January 6, 2009

• The Failure of Our 401(k)s, by Tim Rutten, Los Angeles Times , January 10, 2009

• 401(k)s Still Fall Short As A Retirement Strategy, by John Ydstie, NPR, March 4, 2010

If you dig down into each of these articles and others like them, you will find the real problem: Most Americans don’t have enough money saved up to retire, and, other than Social Security, they don’t have a pension either. So why blame the 401(k)? The answer is a combination of misunderstandings, unrealistic expectations, and unintended consequences.

First, a little history. 401(k) plans grew out of the clarification of the tax treatment for the long-standing practice of allowing employees to defer some or all of their non-salaried compensation (typically year-end bonuses). According to Jeanne Sahadi, a CNNMoney.com writer (in January 2001), “At the time it was common for employees to be given the choice to defer half or all of their non-salaried compensation, often bonuses, into a company's cash-deferred profit-sharing plan.” In 1978, these clarifications were formally stated in Internal Revenue Code Section 401(k).

Some creative pension experts examined the rules, and concluded that instead of employers declaring bonuses and giving employees the choice to defer, it would also be possible to allow the employees to defer part of their regular salary on a pre-tax basis, and offer an employer match as extra incentive, particularly for low-paid employees. The first officially recognized 401(k) which gave tax incentives to employer-sponsored salary reduction retirement savings plans was established in 1981.

Twenty-five years later, a November 2006 Investment Company Institute Report would declare “401(k)s are now the most prevalent retirement savings vehicles in the United States.” A March 24, 2010, msn/BusinessWeek article by Chris Farrell affirmed this preeminence saying, “The 401(k) has since evolved into the largest private-sector employer-sponsored retirement plan in the U.S.”

A Big Misunderstanding. It is interesting to note that the same BusinessWeek article also described the 401(k) as the “main U.S. corporate pension plan.” But a 401(k) is not a pension, and this misunderstanding has become one of the reasons for disenchantment with 401(k)s.

The fundamental features of a pension are its certainties and well-defined terms. Provided they meet the vesting requirements, retirees with a pension understand they will receive a specific amount every month. The amount to be paid is determined by a formula which typically includes average annual salary and years of service. While a lump-sum distribution may be allowed in some circumstances, there are no partial withdrawals or irregular distributions; the main objective of the pension is to provide a stream of income as long as the retiree (and/or a beneficiary) is alive. The responsibility for making sure those pension promises are kept falls to the employer. The employer is responsible for the funding, investment, and administration of the plan.

In contrast, a 401(k) is much more open-ended and flexible. Loan provisions, lump-sum distributions, partial surrenders and irregular payments are permitted. While most deposits are payroll-deducted, employees can stop making deposits and use catch-up provisions to add extra dollars. All of these actions are determined by the plan participant. The employee provides the funding, makes the investment decisions and determines how the money will be distributed.

Unlike pensions, which are pools of money to make payments to many people, each 401(k) is a separate financial entity. The success or failure of a 401(k) is based entirely on the actions of the individual (the employee) managing the account.

When first established, the 401(k) was intended to serve as a retirement income supplement. As Tim Rutten put it, “Congress…envisioned the provision mainly as a way for workers to supplement their companies' traditional defined-benefit pension plans and Social Security.”

But for a variety of reasons, the number of employers offering pension plans has declined significantly in the past 30 years (more on that later), leaving the 401(k) as the primary retirement plan for a large percentage of Americans. Today’s reality is that a supplemental retirement account, under the funding and direction of an employee, is now being asked to perform like a large retirement fund under the oversight of investment managers and actuaries.

Unrealistic Expectations. Farrell nicely capsules the fact that the 401(k) was also a product of its time. “The rise of the 401(k) largely coincided with one of the great secular bull markets in history from 1982 to 2000.” In this environment, investing in capital markets “took on the characteristics of a powerful mass social movement, especially in the 1980s and '90s.” Getting rich in the stock market became part of the American Dream.

Although determining the full economic value of a pension is a complicated calculation, people looked at the oversized returns that were coming from high-flying equities markets and thought “Who needs a pension when I can make more with a 401(k)?” The math seemed magical. Generous employer matches and the prospect of double-digit annual returns made 401(k)s the trendy strategy to accumulate a lot of money, and retire early.

Unfortunately, 401(k) participants have encountered two bear markets since 2000. To make matters worse, many employers reduced or eliminated matching contributions as the economy tightened. Now the math is no longer magical, but depressing.

If a pension plan appears to be suffering from poor investment performance or inadequate funding, law requires the company to make up the difference. But most individuals have not had the financial wherewithal to simply add more money to cover their losses and keep their retirement objectives on track (and even if they did, they might have been constrained by contribution limits). 

Unintended Consequences. Around the same time as 401(k)s were being introduced, Congress also established tighter guidelines for pension plans. Shorter vesting schedules were imposed, which meant companies had to increase their pension funding, since more employees would be eligible for payment, even if they didn't stay with the company for more than five to seven years. These increasing financial and regulatory obligations prompted many companies to suspend or terminate their pension plans, and offer 401(k)s as replacements. For employers, this decision simultaneously lowered administrative and funding costs, while transferring the responsibility for investment decision-making to the employee.

“Nobody bothered to ask employees whether they wanted to swap their pensions for choice or ownership,” says Rutten, “nor did anybody stop to notice that very few people are suited by background, ability or temperament to actively manage investments.” But as more and more employers realized the economic liabilities inherent in pensions, switching to 401(k)s was an easy corporate exit strategy, a no-brainer.

Does the 401(k) need to be fixed?
The answer depends on what you want to accomplish. As a supplemental retirement program, the 401(k) has pros and cons. The automatic payroll deduction feature appears to be a great help in getting individuals to save regularly and consistently. A substantial employer match can help participants achieve greater accumulations at a faster pace – if your underlying investments are profitable.

On the other hand, 401(k) investment choices are restricted by the preferences of the employer; a self-directed IRA offers a much wider spectrum of investment choices. And 30 years ago, the operative paradigm was one of deferring tax today, then distributing the deposits and earnings at a lower income tax rate in retirement. Today, fewer people are sure they will be in a lower income tax bracket when they retire. Hence, the increasing attractiveness of Roth IRA accounts, which feature after-tax deposits with tax-free withdrawals in the future.   

As a primary retirement program, one of the biggest challenges with a 401(k) is how to translate an account balance into a stream of income in retirement. The WSJ article mentioned at the top of the article notes that the Center for Retirement Research finds the average 401(k) holds just under $150,000. That might seem like a big number, but when the Center calculated the monthly income for a retiring couple from an annuity guaranteeing lifetime income, the result was $9,073 annually, or $756/mo. Suddenly, $150,000 doesn’t seem like a lot of money. This exercise highlights an often-overlooked point: the key number in a retirement plan is not the account balance but how much monthly income can be derived from the accumulation.

The biggest issue with 401(k)s is how much responsibility should be placed on average Americans to oversee their financial future. A week after the WSJ article came out, the paper’s “Letters to the Editor” page was flooded with comments, and most of them were none too complimentary about the financial savvy of their peers. As one writer put it,

“I have co-workers who have no idea how to get into their accounts and if they do, they have no idea what to do. Certainly there are seminars, financial planners, articles and other avenues available for people to learn from others’ knowledge and expertise. Instead of taking control of their own money and growing it, people put their heads in the sand, hope for the best and attempt to blame others for their financial morass when their retirement funds run short.”

 Recognizing the apparent financial illiteracy of many Americans, some experts are calling for new retirement plans and/or 401(k) modifications that mandate “approved” investment options, require minimum funding levels, and offer guarantees. But as long as 401(k) plans continue to place the burden on the individual for funding, investment selection and retirement income translation, personal education and oversight are musts. Like a home, a 401(k) requires regular maintenance, and as the owner, this is your responsibility.

HOW OFTEN DO YOU REVIEW YOUR 401(k) ACCOUNT?

WOULD YOU LIKE AN IDEA OF WHAT THE INCOME TRANSLATION IS FOR YOUR CURRENT 401(k) BALANCE?