Why It's Time to Retire the 401(k)

[one...two...tree 2,762]

(It's a bit long, but I've edited it down a bit....a worthy read, IMO)

By Stephen Gandel, Time

Retiree Robert Shively spends his days on the golf course. For many, that would be a dream come true, but not quite in the way Shively does it. The 68-year-old is the cart mechanic at the Niagara Falls Country Club.

Two and a half decades ago, his then employer, Occidental Petroleum Corp., cut its traditional defined pension plan in favor of a 401(k)-type system. So instead of getting a guaranteed pension check of $1,308 a month for his 36 years as a full-time, salaried employee, the former chemical-factory worker receives $225 a month from his 13 years as an hourly employee, plus $180.16 a month from a profit-sharing plan Oxy had for salaried employees until 1994. He also has $70,000 left of the money he saved from his tax-deferred 401(k). On the days he works, Shively rises at 5 a.m. to get to the golf course. He mostly enjoys the job. But on tournament mornings, he has to be at the course at 4 a.m. A few years ago the country club switched from gas to electric carts, some of which have four 84-lb. batteries each. Every year, Shively and another worker have to lift out all the batteries and store them for winter. "Your body aches all over," he says.

This isn't how retirement was supposed to be.

If you have even peeked at your account statements in the past year, it's painfully obvious that something is wrong with the way we save. The tax-deferred 401(k) plan, and others like it, such as the 403(b.) and the IRA, have become our nation's go-to retirement piggy bank. Invented nearly 30 years ago as an executive perk — one more way to dodge Uncle Sam — the 401(k) was never meant to replace the employer-guaranteed pension fund, supplemented by Social Security, as the cornerstone of our nation's retirement system. But propelled by a combination of companies looking to cut costs and consumers who wanted control of their retirement destiny, that's exactly what happened.

The ugly truth, though, is that the 401(k) is a lousy idea, a financial flop, a rotten repository for our retirement reserves. In the past two years, that has become all too clear. From the end of 2007 to the end of March 2009, the average 401(k) balance fell 31%, according to Fidelity. The accounts have rebounded, along with the rest of the market, but that's little help for those who retired — or were forced to — during the recession. In a system in which one year's gains build on the next, the disaster of 2008 will dent retirement savings long after the recession ends.

In what must seem like a cruel joke to many, the accounts proved the most dangerous for those closest to retirement. During the market downturn, the 401(k)s of 55-to-65-year-olds lost a quarter more than those of their 35-to-45-year-old colleagues. That's because in your early years, your 401(k)'s growth is driven mostly by contributions. You control your own destiny. But the longer you hold a 401(k), the more market-exposed it becomes. It's a twist that breaks the most basic rule of financial planning.

The Society of Professional Asset-Managers and Record Keepers says nearly 73 million Americans, or just under 50% of our working population, now have a 401(k). And collectively we pour more than $200 billion into these accounts each year. But retire rich? Don't bet on it. The average 401(k) has a balance of $45,519. That's not retirement. That's two years of college. Even worse, 46% of all 401(k) accounts have less than $10,000. Today, just 21% of all U.S. workers are covered by traditional pensions, and the number shrinks every year. "The time may have come to consider returning 401(k) plans to their original position as a third tier of retirement planning, behind pensions and Social Security," says Alicia Munnell, who heads the Center for Retirement Research at Boston College. "They should not be the thing we rely on for retirement security." And the government seems to agree. This summer, the Government Accountability Office concluded, "If no action is taken, a considerable number of Americans face the prospect of a reduced standard of living in retirement." That's what is known as an understatement.

....

Where 401(k)s Go Wrong

In theory, 401(k)s should provide much more of a retirement cushion than they do. A 2007 study from the National Bureau of Economic Research (NBER) estimated that, on the basis of historical returns, by 2040 the average 401(k) of a near retiree would grow to an inflation-adjusted $451,944. That money, spread over 30 years, could replace at least 50% of the average retiree's income. Add Social Security and even highly paid workers will probably earn more than 80% of their preretirement income. "The only reason these accounts haven't lived up to their potential is that they haven't gotten enough time," says James Poterba, president of the NBER, who co-authored the study.

In practice, 401(k)s haven't been nearly so rewarding. When Boston College's Munnell looked at the returns 401(k)s have actually produced compared with the projections, the difference was sobering. The average 55-to-64-year-old should have a 401(k) balance of $320,000. In fact, at the end of 2007, the average 401(k) of a near retiree held just $78,000 — and that was before the market meltdown.

Why don't these accounts amount to much? Munnell found a number of reasons. Some people don't contribute as much as they should — essentially ignoring free money from company matches and tax relief. And, as the original engineers of the 401(k) suspected, the less you earn, the less you are likely or able to contribute. For most employees, the maximum contribution to a 401(k) is $16,000 annually. She found that just 5% of people earning $80,000 to $100,000 maxed out, compared with 30% of those making $100,000 or more.

Additionally, to get the hypothetical higher returns over time and avoid investing disasters, you have to hold a diversified portfolio of stocks and bonds. Many of us don't. Munnell found that 14% of workers held no stocks at all, leading to weaker-than-average returns. On the opposite end, more than a quarter of all 401(k)s were 100% stocks, exposing those accounts to big losses when the market dropped.

Earlier this year, mutual-fund company T. Rowe Price tried to determine the optimum retiree portfolio — the mix of stocks and bonds that would produce the highest returns without the risk of the nest egg running out. To do this, the analysts ran something called a Monte Carlo simulation, which mimics the real-life ups and downs of the market. Most of the time, the market goes up slightly. But some years — ka-pow! — stocks and bonds do spectacularly poorly. What T. Rowe Price found should frustrate anyone who has spent time wondering if 25% of a portfolio should be in international bonds or small-cap stocks. No portfolio is 100% safe from disaster.

....

The solution: a new type of insurance. Retirement savings, it turns out, are exactly the type of asset we need insurance for. We need insurance to protect against risks we can't predict (when the market collapses) and can't afford to recover from on our own. "People tend to meld savings and insurance in their mind, but they are not substitutes," says Nancy Altman, a former Harvard professor and the author of The Battle for Social Security. "It's fine to have a savings plan as a supplement but not as the main retirement protection for everyone." She says the best way to guarantee a replacement for people's wages in retirement is by pooling risk, and the way to do that is through insurance.

Altman is not alone. Teresa Ghilarducci, an economics professor at the New School, has proposed a plan in which the government would divert 5% of everyone's wages. In return, you would be guaranteed in retirement a check for 26% of your final salary every year until you died. Altman would also like to expand Social Security to pay an additional 20% of workers' final pay. It's unlikely Congress would go for that at the moment.

But guaranteed accounts don't have to be run by the government. The ERISA Industry Committee (ERIC), a group that represents the nation's largest employers, has proposed a system of exchanges that would allow individuals the ability to buy a guaranteed retirement account on their own. Some government regulation would be needed, but it would be a private plan.

What the ERIC plan and others like it are essentially proposing is a form of retirement insurance. So instead of putting 6% of your salary into a 401(k) or some other investment account, each pay period you would send 6% of your check to a retirement-insurance provider. The policy would work similarly to a traditional pension in that it would provide a guaranteed monthly check equal to about a quarter of your final pay, from when you quit working until you die. Some employers might even be willing to pay the annual premium as a perk. If not, employees would pay for it much as they currently fund their own 401(k)s. But the policy would be portable. Contribute for 30 years and you would be guaranteed income in retirement, no matter how many employers you worked for. Combine your retirement-insurance check with the money you get from Social Security, which can equal as much as 50% of final pay, and presto: you have something approaching retirement security.

Would it be feasible, politically or otherwise, to get people to dispense with their 401(k)s? Corporations, for one, are not the least bit interested in taking on pensions again — the cost would be enormous, and the expense makes them less competitive globally. "There are people in the Obama Administration who are supportive of some kind of guaranteed system," says Dean Baker of the Center for Economic and Policy Research. "People should not have to shoulder the risk of a bad turn in the market."

Nonetheless, a government-run system is not in the cards. "I think there is broad political support for the government administering some sort of retirement plan," says Christian Weller, a senior fellow at the liberal-leaning Center for American Progress. "But even if health-care reform is passed, the debate over the public option has made a similar solution for retirement less likely."

But many policy experts say some type of change to our retirement-savings system is coming. First of all, given the market carnage, there is some backing for the idea — not to mention anger and disappointment among retirees who can't really retire. Recent opinion polls show that people would be willing to give up the flexibility of a 401(k) for a guaranteed return. What's more, the fact that ERIC supports a guaranteed plan is encouraging. "Whether the 401(k) is a perfect plan or even the right plan is something that is being questioned in Congress," says Democratic Representative George Miller of California, chairman of the House Education and Labor Committee. "When you have seen the market's ability to create bubbles, you've got to ask whether the people trying to save for retirement should have to ride that risk."

http://www.time.com/time/business/article/...1929119,00.html

[I AM NOT THAT GUY 5,715]

You are talking about converting to a defined benefits plan, that will create it's own set of problems, the reason the PBGC was created, and one of the reasons GM, for all intents and purposes, went bankrupt.

The two biggest problems are 1) Pension funds tend to be grossly underfunded, and what funds there are left, tend to heavily leveraged; and 2) Pension funds that are not fully funded tended to favor recent retirees, but disenfrancise future retirees, like Social Security is currently doing. In other words, what is being proposed is nothing more than a quick fix ponzi scheme.

[one...two...tree 2,762]

You are talking about converting to a defined benefits plan, that will create it's own set of problems, the reason the PBGC was created, and one of the reasons GM, for all intents and purposes, went bankrupt.

The two biggest problems are 1) Pension funds tend to be grossly underfunded, and what funds there are left, tend to heavily leveraged; and 2) Pension funds that are not fully funded tended to favor recent retirees, but disenfrancise future retirees, like Social Security is currently doing. In other words, what is being proposed is nothing more than a quick fix ponzi scheme.

I take it you didn't read the whole piece?

Go back and read the last few paragraphs about a solution. It's not a Pension Fund per se since the employee would be contributing to the plan. (see below)

But guaranteed accounts don't have to be run by the government. The ERISA Industry Committee (ERIC), a group that represents the nation's largest employers, has proposed a system of exchanges that would allow individuals the ability to buy a guaranteed retirement account on their own. Some government regulation would be needed, but it would be a private plan.

What the ERIC plan and others like it are essentially proposing is a form of retirement insurance. So instead of putting 6% of your salary into a 401(k) or some other investment account, each pay period you would send 6% of your check to a retirement-insurance provider. The policy would work similarly to a traditional pension in that it would provide a guaranteed monthly check equal to about a quarter of your final pay, from when you quit working until you die. Some employers might even be willing to pay the annual premium as a perk. If not, employees would pay for it much as they currently fund their own 401(k)s. But the policy would be portable.

[I AM NOT THAT GUY 5,715]

But guaranteed accounts don't have to be run by the government. The ERISA Industry Committee (ERIC), a group that represents the nation's largest employers, has proposed a system of exchanges that would allow individuals the ability to buy a guaranteed retirement account on their own. Some government regulation would be needed, but it would be a private plan.

What the ERIC plan and others like it are essentially proposing is a form of retirement insurance. So instead of putting 6% of your salary into a 401(k) or some other investment account, each pay period you would send 6% of your check to a retirement-insurance provider. The policy would work similarly to a traditional pension in that it would provide a guaranteed monthly check equal to about a quarter of your final pay, from when you quit working until you die. Some employers might even be willing to pay the annual premium as a perk. If not, employees would pay for it much as they currently fund their own 401(k)s. But the policy would be portable.

I thought liberals hated insurance companies? That is still working like a defined benefits plan: Once you have payed a sufficient amount into a fund, then you become 100% vested, and you are guaranteed a certain regular payment upon retirement, or the funds could be transferred to another type of retirement account upon separation. The only difference is that the employee, not the employor, is making the contribuion.

Another option, instead of purchasing stocks, or mutual funds, would be to purchase annuities, as many retirement plans offer as an alternative.

Another problem I see, there is no mention of what happens if the employee dies before reaching retirement age, as 401K's and most self-directed retirement plans have cash value that can be passed on to the survivors.

Edited October 31, 2009 by Lone Ranger

[Gary and Alla 3,694]

You are talking about converting to a defined benefits plan, that will create it's own set of problems, the reason the PBGC was created, and one of the reasons GM, for all intents and purposes, went bankrupt.

The two biggest problems are 1) Pension funds tend to be grossly underfunded, and what funds there are left, tend to heavily leveraged; and 2) Pension funds that are not fully funded tended to favor recent retirees, but disenfrancise future retirees, like Social Security is currently doing. In other words, what is being proposed is nothing more than a quick fix ponzi scheme.

I take it you didn't read the whole piece?

Go back and read the last few paragraphs about a solution. It's not a Pension Fund per se since the employee would be contributing to the plan. (see below)

But guaranteed accounts don't have to be run by the government. The ERISA Industry Committee (ERIC), a group that represents the nation's largest employers, has proposed a system of exchanges that would allow individuals the ability to buy a guaranteed retirement account on their own. Some government regulation would be needed, but it would be a private plan.

What the ERIC plan and others like it are essentially proposing is a form of retirement insurance. So instead of putting 6% of your salary into a 401(k) or some other investment account, each pay period you would send 6% of your check to a retirement-insurance provider. The policy would work similarly to a traditional pension in that it would provide a guaranteed monthly check equal to about a quarter of your final pay, from when you quit working until you die. Some employers might even be willing to pay the annual premium as a perk. If not, employees would pay for it much as they currently fund their own 401(k)s. But the policy would be portable.

The best thing about 401Ks is that anyone that has one can eliminate it any time they want. That is freedom.

[one...two...tree 2,762]

I thought liberals hated insurance companies? That is still working like a defined benefits plan: Once you have payed a sufficient amount into a fund, then you become 100% vested, and you are guaranteed a certain regular payment upon retirement, or the funds could be transferred to another type of retirement account upon separation. The only difference is that the employee, not the employor, is making the contribuion.

Another option, instead of purchasing stocks, or mutual funds, would be to purchase annuities, as many retirement plans offer as an alternative.

Another problem I see, there is no mention of what happens if the employee dies before reaching retirement age, as 401K's and most self-directed retirement plans have cash value that can be passed on to the survivors.

No, there's a lot more that is different than current pension funds. For one, the retirement insurance plan as proposed by the author of the article stated, would need to be well regulated to ensure that the money is protected. Many retirees have seen their pensions vanish because their were no protections from risky investments. When you buy car insurance and God forbid you were in terrible accident requiring hospitalization, your insurance company will pick up the tab. A retirement insurance plan as described in the article can work as a reliable source of retirement money that no 401k plan can offer.

[mawilson 2,133]

You don't have to invest your 401(k) in stocks, you know.

You can invest it in US Treasury bonds or state municipal bonds and you will be as close to 100 per cent safe as is humanly possible.

[mawilson 2,133]

Many retirees have seen their pensions vanish because their were no protections from risky investments.

Sure there were - it's called "do not invest in risky assets".

That's why they are called "risky" investments - because investing in them is risky, duh.

No-one's forcing you to put your 401(k) money at risk.

[SuperDuper! 230]

The 401K has been a scam from day one. The average American cannot pick out good socks, much less good stocks and bonds and funds.

The average American ends up with a bunch of investment bull and a drained acct., and the wrong end of the bull at that, Pffft!

[Kathryn41 3,205]

My husband not so humorously jokes that after the recent economic crisis his 401k is now a 101k. He doesn't have the choice of stocks and bonds in the portfolio - that is decided through his company- and they didn't make some good choices. He was hoping to retire next year. Now, he doesn't know when he will be able to afford to retire. There definitely has to be a better solution.

[mawilson 2,133]

He doesn't have the choice of stocks and bonds in the portfolio - that is decided through his company- and they didn't make some good choices.

Employees can usually opt out of the employer-directed moves - are you sure it wasn't an option?

[Mr. Big Dog 10,747]

The average American ends up with ... the wrong end of the bull

Edited November 1, 2009 by Mr. Big Dog

[peejay 327]

Teresa Ghilarducci, an economics professor at the New School, has proposed a plan in which the government would divert 5% of everyone's wages.

From the same people that are currently (mis)managing the bankrupting of the Social Security system.

Talk about risky investments!!! At least you can opt out of a voluntary 401K plan. Try that with a mandatory government mandated payroll tax.

Who the #### is kidding who? Womb to the tomb risk free security? Only in the clueless mind of a Big Government liberal.

[SuperDuper! 230]

Teresa Ghilarducci, an economics professor at the New School, has proposed a plan in which the government would divert 5% of everyone's wages.

From the same people that are currently (mis)managing the bankrupting of the Social Security system.

Talk about risky investments!!! At least you can opt out of a voluntary 401K plan. Try that with a mandatory government mandated payroll tax.

Who the #### is kidding who? Womb to the tomb risk free security? Only in the clueless mind of a Big Government liberal.

You are being generous and too kind. Bankruptcy is for legitimate financial businesses. Soc. Sec. is a Ponzi scheme that might as well be run by a real pro like Madoff himself.

[one...two...tree 2,762]

You are being generous and too kind. Bankruptcy is for legitimate financial businesses. Soc. Sec. is a Ponzi scheme that might as well be run by a real pro like Madoff himself.

Soc. Security is NOT a ponzi scheme. There are fundamental differences that Right Wingers overlook.

Is Social Security a Giant Ponzi Scheme?

Jim Cramer has called Social Security the largest Ponzi scheme in history. To an extent, he's making a valid comparison. Like a Ponzi scheme, Social Security pays its benefits out of new contributions, rather than out of investment returns.

Also like a Ponzi scheme, Social Security is in the process of collapsing under its own weight. According to its most recent annual report, the Social Security trust fund is expected to exhaust itself by 2037. With similarities like that, it's no wonder Cramer felt he could make the comparison.

Surely that's not right?

But Social Security isn't exactly a Ponzi scheme, no matter how similar it may seem on the surface. For one thing, Social Security is a mandatory program. With few exceptions, if you're a working American, you're paying into the system. That helps shore up its foundation far more firmly than a typical Ponzi scheme.

For another, Congress has the authority to increase the taxes you pay into Social Security -- and it has, on numerous occasions. When the program started, taxes for retirement benefits were set at 2% of the first $3,000 of your earnings. That figure now sits at 10.6% of your first $106,800 of income (half paid by you, half by your employer on your behalf). That's quite an adjustment, and it's a big part of the reason Social Security hasn't collapsed yet.

And of course, while Ponzi schemes attract clients by promising impossibly high returns, Social Security promises no such nonsense. On the contrary, on average, Social Security's promised payout is about the same as a minimum-wage job. Not promising the moon and the stars also helps keep Social Security from quickly falling apart, like a Ponzi scheme would.

It's still not enough

Perhaps the biggest difference between the two is that Social Security admits its shortcomings in a way no Ponzi scheme ever would. Regarding what you can expect from the program, here's what the Social Security Administration itself says:

"For an average worker, Social Security replaces about 40% of annual pre-retirement earnings. Since Social Security will only replace part of your lost earnings, your savings and investments play an important role in ensuring adequate income for you and your family."

And even that 40% level won't be reached after the trust fund is exhausted in 2037. Once again, Social Security has this to say on the matter: "Even if modifications to the program are not made, there would still be enough funds in 2037 from taxes paid by workers to pay about $760 for every $1,000 in benefits scheduled."

In other words, you shouldn't depend on getting more than about 30% of your preretirement earnings from Social Security, starting around 2037.

http://www.fool.com/retirement/general/200...nzi-scheme.aspx