Why 401(k) Can Spell “Lousy Retirement Plan”
Mr. ToughMoneyLove doesn’t have have a pension plan or a golden parachute. When I leave my job for good, my employer will say thanks (by then, probably more like “thanks for finally leaving”) and cut me a small check for the book value of my stock in the business.
Our retirement income will depend on other assets plus Social Security. A large (but shrinking) part of those assets is my 401(k) plan. Discounting 2008 and 2009, I’ve been happy with it. But for many people, 401(k) plans can make lousy retirement plans. That’s why I will continue to do a lot of investing outside my 401(k) plan. I actually have reasons, starting with….
The reason why we are stuck with “401(k)” as a name is that these “plans” were never intended to function as a complete retirement savings vehicle for the masses. The name identifies a section of the Internal Revenue Code that was inserted to allow Americans in the upper tax brackets to shelter some of their income from taxation. Congress never imagined that folks would latch on to this “help the wealthy” scheme and promote it as a retirement income cure-all. So they didn’t even bother to give it a real name.
But the investment industry saw a great opportunity and pounced. It has promoted 401(k) plans to workers at all income levels who have eagerly contributed, thinking that this is a great thing for them. The mutual fund companies, plan advisers, and benefit consultants have firmly attached themselves to that section of the tax code and marketed it for all its worth, and then some.
So what factors can make your 401(k) plan lousy for retirement?
1. Low Participation. According to the Employee Benefit Research Institute, only 66% of eligible employees participate at any level in their employer’s plan and of those, only 10% make the maximum allowed contribution. These are discouraging numbers when you consider that since 2006 employers have been permitted to automatically enroll new employees, forcing them to opt out if they did not want to participate. There apparently has been lots of opting out in favor of more important expenditures, like car payments and vacations.
2. No Staying Power. Again according to the EBRI, 60% of employees who change jobs cash out at least some of their accounts. That is a sad statistic. But the employers are bad at this as well. More recently, employers have been cutting back or eliminating the company match, which is by far the most important benefit of a 401(k) plan.
3. Poor Investment Choices. A high percentage of the plans that I see offer very limited investment options. Although some plans have some decent index funds, often there is not enough variety to implement a well-rounded asset allocation. For example, REIT and energy index funds are a rare find. Even for those plans that offer quality, low cost investment choices, the employees often make poor choices because the guidance they receive is minimal or non-existent.
I have been fortunate because my 401(k) plan allows participants to opt out of the standard menu of investment choices and operate from a self-managed brokerage account. From this account, I can buy any stock or fund traded on any conventional market, all from within my 401(k) account. This option would be wasted on or even dangerous for an inexperienced investor. Thus, plan providers should consider this option in combination with offering at least a once per year consultation with an unbiased investment advisor for plan participants.
4. Excessive Costs. Part of the problem with the investment options offered by many plans is that they have high fees. Every 401(k) plan should include at least some very low cost index funds from Vanguard, Fidelity, or T. Rowe Price. Many plan are top heavy on managed funds. Sometimes the plan provider engages an investment advisor who also takes a piece of the pie. The overall costs need to come down.
5. Taxes. There are two negative tax issues associated with 401(k) plans. First, higher income earners by virtue of their high tax brackets receive a better tax benefit from participation compared to folks in the lower tax brackets. Second, when funds are withdrawn in retirement, all investment gains are taxed at ordinary income rates instead of the lower capital gains rate. I think this problem is going to get worse as tax rates inch up at all income levels to pay for all of the government spending and borrowing. This why I think all 401(k) providers should be required to offer a Roth 401(k) option and that employees in the low to moderate tax brackets should be encouraged to use that option.
So why am I identifying all of these 401(k) deficiencies? I think the time has come to transition to a new, semi-mandatory employee retirement plan. There is discussion about this already in Congress. I haven’t thought all the way through the design of such a plan, but we need to make it very difficult for employees to opt out. The plan needs to provide investment options that are well-suited for moderate income employees, meaning a few low-cost index funds with “made for retirement” asset allocations. We need to get employers out of the business of managing these plans and instead centralize them in a handful of providers who would submit competitive bids to the government. (We do not want the federal government actually managing the funds because it would end up “borrowing” them like they do the Social Security Trust Fund.)
Employers should be given fiscal incentives to make profit sharing contributions to the employees’ accounts. I like profit sharing contributions so that employees can develop a sense of investment in the future of the company, like quasi-shareholders.
Finally, this new plan needs to eliminate the employee’s option to cash out at every job change. Maybe it is a good thing to establish barriers that interfere with an employee’s propensity to make bad decisions about retirement security. Someone needs the power to tell an employee “no, you will not use retirement funds to pay for your son’s wedding.”
As I said, I’m still trying to design the 401(k) replacement in my own mind. What are your ideas?