Why 401(k) Can Spell “Lousy Retirement Plan”

March 4, 2009 by  
Filed under Retirement Planning

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….

Have you ever wondered why these things are called 401(k) plans?  Why didn’t Congress give it some important sounding name, such as the “Employee Retirement Savings Plan” or the “Social Security Won’t Be Enough Plan”?  After all, the federal government is more than willing to attach optimistic monikers to all of its recently passed bailout and stimulus laws (and they don’t seem to work very well either).

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?

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16 Responses to “Why 401(k) Can Spell “Lousy Retirement Plan””
  1. You’re right about the 401(k) fees being really high. “Investment companies” like Lincoln financial and northwestern mutual will charge huge loads on crappy mutual funds.

    It is better than nothing, but only barely sometimes.

    The 401(k) should be renamed. I like TDRA – Tax Deferred Retirement Account.

  2. Snowy Heron says:

    You are so right about the excessive fees for most of them. Especially if you work for a bank and it invests your contributions in bank owned and managed mutual funds (don’t get me started on the investments in the bank’s stock!!). I would say that no matter how much the bank matches your contribution, it claws it back in expenses associated with those funds. It is a total rip off! Finally I have started to hear rumblings on Capital Hill about fixing this issue, but I don’t think anything has happened yet. The real issue is that no one knows what the fees are on their accounts because there has been no requirement to disclose them. The best way to handle your 401K is to invest in index funds as much as possible, and don’t transfer balances between funds unless its absolutely necessary. You can rebalance by changing your future contributions, but transferring only incurs fees and you end up behind again.

  3. I’m surprised. You really think the government should force people into these plans for their own good – and on top of that, make it difficult to opt out? Should the government force businesses to profit share with employees? I think the market should decide how much employees are worth – competition should set the price for employees.

    If one person prudently saves for retirement and has the advantage of being able to retire, then good for him.

    Plus, why force their investment choices? Modern portfolio theory sings the praises of index funds – and the data supports this, but the government making this choice could lead to worse choices down the road. What if, driven by the insurance lobby, they picked high fee annuities instead? They offer a stable return, yada yada yada. I think people should have the discretion to pick their own investments based on their own risk profile. The gov’t might make the wrong choice.

    Do you mean that this program would replace social security? Or supplement it?

    I agree that the 401(k) system is flawed, but I don’t agree that people should have fewer freedoms in making investment choices. If some employers choose not to offer retirement accounts, I think that should be their choice as well. Employees have the option of moving to another job. I say we let the market work as much as possible. Gov’t intervention is a last resort.

  4. My Journey says:

    Call me confused, but couldn’t some of your “issues” be solved with just increasing IRA contributions from $5k to $16k like a 401(k) or 46K like a SEP?

    You would get:
    1) More choice
    2) Lower fees
    3) Lower risk of cashing out since you don’t have to do anything when switching jobs?
    4) Tax – Part of the tax problem would be fixed because then people could choose to start a Roth IRA (since we are talking lower to moderate income anyway they are probably under that 100k cap). As far as the cap gains/OI tax problem, I don’t agree with you that it should be changed. The gov’t is giving you a chance to defer taxes 30 years or so (in my case) why shouldn’t they get a few more % points?

    Similarly, who the heck knows what tax brackets will look like in 30 years. Go back 30 years (I can not being 27 LOL) but before the 81 ERGTA the highest marginal rate was 70%ish! Maybe we will finally smarten up and use a consumption based tax system lol

    5) Participation would still be low, probably even lower, but that is not the gov’ts job (in my very humble opinion).

  5. kitty says:

    Why not just add choices to plans that don’t have them.

    I’d imagine most of people who have decent 401K plans with good choices and good employer contribution – myself included – would fight any attempts to rob us of our 401K plans tooth and nail. Not only will we lose our employee contribution with any change, do we really want the government to tell us what to do with our money? There already is a mandatory for retirement – it is called Social Security. Why should we think any new government-mandated plan would work better?

    I wouldn’t mind some of the changes you propose – like making it difficult to take the money without good enough reason early. However, there are legitimate reasons – like 5-digit or even 6-digit in life saving medical treatments – when people shall be able to take their money. If you have a terminal cancer and your 20% co-insurance for chemo is 1K every 3 weeks (as my mother’s) and you have 2 years left to live or 5 if you are lucky, you have to be able to withdraw. Similarly if your life expectancy is lowered because of an illness, you have to be able to get the money rather than wait until the age you aren’t likely to ever see.

    Similarly, there are times in life when people just cannot afford to save for retirement. A loss of a job in a family member, for example, may make it difficult to pay for mortgage and contribute to retirement at the same time.

    Additionally, the removal of 401K will be unfair to those of us who are in our late 40s or 50s have made plans and investment choices based on future contributions. Some of the employer match is part of these plans.

    For example, one thing my company does is contribute additional money to our 401K (in addition to match) to those of us whose pension plans were frozen to compensate for the loss of pensions. By making a change now, you are going to essentially rob those of us who are older of this money exactly at the time when we need it most. I think what you are proposing is akin to theft – you are going to “steal” the 10% I am getting from my employer.

    Also, what do you propose to do with the contributions we already have? Convert it to some other plan with different rules? Should it be our right to decide what we want to do with the money we saved?

    Why not just modify currently existing 401K programs to provide more choices to those who don’t have enough?

  6. Andrea says:

    I’m quite happy that my company offers a Roth option and agree that it should be offered everywhere.

    If I was to agree on making it extremely difficult to take money out of a 401k (or any other retirement instrument, actually), it would be this – too many people pillage their retirement accounts when what they should be doing is filing bankruptcy. I know there is a big gray area in that statement that covers all kinds of issues like responsible spending and debt management, but the last thing someone who is struggling needs to be doing is to empty an account that should be their support when they are retired, especially when it means starting over and losing perhaps years or decades worth of accumulation. Those assets are protected in bankruptcy, and for good reason.

  7. My Journey says:


    I am sorry but I can’t figure out what the hell you are talking about?

    First, there are things already built into most if not all qualified/retirements plans known as Hardship Withdrawal as well as 72t distributions (google the terms there will be an adequate definition as to both).

    Second, TML is not positing the destruction of your retirement plan, but rather pointing out the shortfalls of the current 401(k) system.

    Third, I am not sure you are aware, if your company felt like it, they can stop contributing anything to your 401(k)…tomorrow. Similarly, who is to say that TML’s nirvana of a private retirement system wouldn’t include a matching portion? Assuming, arguendo, that TML is talking about the destruction of a matching system, why can’t your company just give a different form of compensation (i.e. more money, different fringe benefits, etc.)

    Just attempting to pull from you a little clarity on your opinion here, as you usually offer a differing opinion.

  8. SP says:

    I agree that much of this could be solved by raising IRA limits. Perhaps even an either or: You can contribute $5000 to an IRA and 16,500 to a 401k (or whatever the current $$ are), but what if you could contribute 21500 total, split up however you want?

    I do think it is somewhat of the gov’ts job to force participation, because those who fail to adequately prepare for retirement will ultimately have to be taken care of by the gov’t. We won’t let our elderly go hungry. Why not force people to save a bit of their own money when possible?

  9. kitty says:

    @My Journey – I admit, I’d been a bit in a rush and haven’t thought things clearly when I posted. I am also afraid of losing a very good plan that I have at work – both a regular 401K and Roth 401K, which makes me a bit emotional when I hear about plans to take 401K away.

    A couple of things that I’d like to clarify.
    1. Yes, there are hardship provisions. I do believe, however, that there are some situations where one may need to take the money but your situation may not fit into strict government definition of hardship. Yes, my example with medical bills may fit into hardship, but I don’t think legal bills would? Yet, I think you’d agree that legal bills may be pretty important to someone. Similarly, reduced life expectancy may not be exactly a hardship, but most people in these situations would want to enjoy the money while they can.
    I do agree that many people now withdraw for no reason or for bad reasons. But I don’t believe it is my right to tell them what to do. It is their money. They pay penalty if they do so, they also pay taxes on withdrawals. A friend of mine took the loan out to help her daughter pay her tuition (this daughter is now a cardiologist). Having come to the US only a few years prior to that she hadn’t had time to save enough in both 401K and in college fund. You and I may not agree with this decision, but she felt and still does that it was the right decision for her.

    2. Yes, I realize that my employer can stop contributing for any reason. After all they changed our pension plan twice before freezing it entirely. They can also fire me at any time. But this doesn’t mean I want the government to take it away.

    3. Why would the government be any better in finding a good company to manage this plan than the company hired by my employer? It’s not like government has a very good track record in finding good contractors. Would you really want the government anywhere near your money?

    4. I don’t want any mandatory plan where I have to give more of my money to the government regardless of where they are going to put it. What if someone simply prefers to keep all of their savings – retirement or not – in personal accounts? I believe we already have a social security tax and we don’t need any more mandatory programs.

    Having said that, I do agree with some of TML points, but I think they can be resolved by a) requiring companies to provide better choices and to provide a Roth option b) allowing to use a brokerage account or a “mutual fund window” (as my employer does) within 401K c) doing what SP suggests and having a common limit for IRA and 401K so that people whose employer doesn’t offer a good 401K can put as much money in their IRA. I would also like to be able to buy individual bonds in my 401K and not just bond funds so that I can have an option of holding to maturity.

    I also agree with TML point that having to pay income taxes vs capital gain taxes on capital gains or not being able to write off capital losses is a drawback. But this could be addressed by simply viewing your 401K and your other investments as one pool of money and keep a higher percentage of your stock investments and tax efficient mutual funds in a taxable portion of your investments, while keep more bonds and less tax efficient mutual funds in tax deferred investments.

  10. MasterPo says:

    The fact that only 65% of people participate isn’t the plan’s fault. People have the choice and if they choose not to, dumb as it is it’s still up to them. Same with cashing out instead of rolling over.

    Let people fail. It will be a good lesson.

  11. Andrea says:

    @MP – What a ridiculously cold attitude.

    Part of the same legislation that allowed corporations to switch to an “opt-out” default also required personal finance education for employees. That, however, is still lacking.

  12. MasterPo says:

    Andrea – You can lead a horse to water but…

    If people don’t educate THEMSELVES then all the legislation in the universe won’t help.

    And the fact still remains that a great many people (I see it every day) would rather spend money on Xbox and Starbucks then put into a 401k even 1%.

    You can’t protect people for being stupid.

    But tell you what, if you think it’s so heartless then YOU put 5% of YOUR pay into someone else’s 401k for them because they are too lazy to sign the form!

  13. Andrea says:

    You see it every day, huh? You’re an inquisitive bloke, hanging out at the checkout counter at Best Buy and asking people who buy an XBox if they’re contributing to their 401k. ;

    They don’t have to sign the form, MP. 401ks are opt out now. Truly lazy people would be saving for retirement.

  14. Under normal circumstances I am opposed to government intervention in our financial lives. On the other hand, if people are allowed to ignore their obligations to save for their own retirement, the taxpayers will end up paying the tab to provide extra services and support for seniors. I would prefer to force people to make those preparations with their own money.

  15. Roger says:

    Not a bad plan, overall. I like My Journey’s suggestions; it seems a lot of the problems with 401(k)s (which I think has a bit of a ring to it, even if it’s just a random section of the tax code) could be solved by simply a) increasing the limits on IRAs, b) making it easier for corporations and small business to set up arrangements with fund families to host their retirement plans, and c) make it harder for people to avoid contributing to the plan. I’d also think that setting up some tax advantages for companies to put 10% of the employee’s compensation directly into the IRAs would make it more likely for the companies to participate.

    I’d like to hear more about your thoughts regarding how to change our current retirement system. Frankly, the cobbled together mix of pensions, Social Security, IRAs and 401(k)s that we call a national retirement system needs to be replaced by something, and I’m sure you’ve got a better view than I do of what that something should be.

  16. Anonymous says:

    So many employees cash out on layoff for a stupidly simple reason. America has a poor unemployment benefits system – and those checks are taxed. So, the 401(k) ends up being a glorified severance package! What we need is a Swedish style unemployment and retirement system and throw the 401(k) under the high speed train.

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