The big stock market slide of the past month has been bad news for the over 50 million Americans with 401(k) plans. Many of these investors have yet to recover from the 2008 crash and have been counting on a market upswing to make up for lost ground.
Yet even if stocks do rebound, the truth is that most 401(k) holders will never accumulate enough money in these accounts for a secure retirement. Few workers and their employers contribute at the level needed to build up a serious nest egg, and the median balance in a 401(k) for people approaching 65 is under $100,000, according to a recent study by my colleague at Demos, Robert Hiltonsmith. On top of that, 401(k)s have been battered by two major stock market crashes in the past 12 years and, further, many Americans have withdrawn money from their 401(k)s to cover emergency expenses. Experts on retirement forecast that millions of middle class baby boomers will fall into poverty, or near poverty, in old age -- thanks to the failure of the 401(k) experiment.
Why has the 401(k) been such a flop? Five reasons stand out.
First, the 401(k) system of individualized accounts is inherently inefficient. While traditional pension funds invest worker contributions in large pools, keeping administrative costs low, each 401(k) holder pays fees to the firms that manage their individual accounts. Those fees can add up big time and chisel away at savings. According a recent Demos report, 401(k) nest eggs end up nearly 30 percent lower over a lifetime of saving thanks to fees.
Second, the 401(k) system has never covered all workers. Some 40 percent of employees do not have access to a 401(k) plan, and many workers with this option choose not to participate or contribute negligible amounts. Given such huge gaps in who is covered by 401(k)s, it's wrong to see this system as the primary private supplement to Social Security.
Third, 401(k)s expose individuals to too much risk. While investment firms always tout long-term "historical returns" of the stock market, real-life individuals can be in big trouble if they need to retire during a prolonged slump in stocks. Pooled pension funds, in contrast, can better manage such downturns and buffer individuals. Such funds are also managed professionally, while the 401(k) lets ordinary Americans decide how their money is invested. Yet many workers are clueless about how to allocate their savings among the menu of investment options that most 401(k) plans offer and often don't revisit their choices even as market conditions change.
Fourth, the 401(k) system depends on the financial industry acting in the best interests of investors -- which, too often, it doesn't do. Research has found that the fees charged by 401(k) plans and mutual funds are often excessive, far beyond the actual costs of managing investments. Financial firms have a bottom-line interest in pushing these fees as high as the market will bear -- an interest in conflict with the needs of investors. Investment advisors and firms have historically not had a legal fiduciary responsibility to act in the best interests of 401(k) holders. And while the Dodd-Frank Wall Street reform empowered the SEC to write rules that could impose such a responsibility, it has not yet done so.
Fifth, consumer choice does not offset the failures of the 401(k) system. In a truly competitive marketplace, educated consumers would shop for 401(k) plans with the lowest fees and switch to those plans. But surveys have found that most Americans don't have a clue about the fees associated with their 401(k)s. And switching plans can be difficult for individuals, since employers choose the plans. In turn, employers can find it time consuming to move to a new plan. Wall Street charges such high fees for 401(k)s because they can in the face of consumer ignorance and high barriers to switching plans.
It is easy to forget that 401(k) plans have only been around for three decades. We have learned a lot in that period, and the jury is now in: The 401(k) experiment has failed. This system does a better job of enriching the financial sector than in providing retirement security to Americans.
It's time for a new approach. One idea, offered by economist and Demos Senior Fellow Teresa, is the Guaranteed Retirement Account (GRA), which would supplement Social Security and be a universal system of individual accounts where investments are managed in pooled savings with low fees and buffers for individuals who retire during turn downs in the stock market.
The 401(k) system emerged after elected leaders changed the tax code in 1978. There is no reason we have to live with this mistake forever.
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HowStuffWorks "How 401(k) Plans Work"
What Is a 401(k)? - Personal Finance - WSJ.com
401(k)'s and Similar Plans - Your Money Guides - NYTimes.com
A defined benefit plan has two components - savings / investing (periodic, usually annual cash contributions to a trust account) and payout management. Usually a board of professionals (frequently people in the plan provider) oversee asset managers, actuaries and accountants.
When the savings / investment component fails to produce the intended results, the ability of the plan to meet it's obligations will require contributions by the plan provider - i.e,. if the market enters a prolonged downturn, the plan provider must add cash (or sometimes securities) to make up the difference.
The difficulty here is that the plan provider (usually the employer) may have other more pressing needs for the money, and thus lets the plan go unfunded (think the IL state plan whose funding ratio is substantially below normal).
The author brings up valid points - mutual fund choices with high expense ratios can lead to sub-optimal outcomes; plan participants will not always manage their 401K plans in a manner best suited to their needs; leakage; declining wages; unemployment, or simply having children - all of these situations can cause plan participants to accumulate far less money than would be ideal.
But the answer is not to eliminate the 401K plan - what would take it's place? There's too little information available on the GRA to make an informed choice.
Of course thats provided market crashes stay as the exception and don't become the rule.
The average account balance at $100,000 at age 65 converts to around $500 a month for life.
Good Luck! Many Public Employee Retirement plans pay $100,000 a year. Maybe the public sector knows something about retirement plans the private sector does not.
1. Putting money into a retirment account which provides a tax deduction from the worker's income.
2. Many employers provide a matching of funds
3. Many 401k's have a variety of choices which enable people to invest based on risk tolerance (i.e., different types of bonds and different types of stocks). One could invest solely in government bonds if they wanted to (virtually no risk)
4. Many employers use Vanguard, whose fees are usually around one quarter of one percent (awfully low)
5. Workers could read a few magazines/internet articles and get a general idea about how their money should be invested
6. The fact that people don't save enough isn't the fault of the 401k - it's the fault of stagnant incomes, rising health and education costs, etc.