Why 401(k) Retirement Plans Really Don’t Work, and How to Fix Them

Posted on | October 25, 2009 |

I originally wrote this article back in January for the Saving Advice Blog, but I’ve seen a lot of chatter recently about it again - including this issue of Time magazine - and I feel very strongly about protecting individual retirement savings from the government, so I thought I’d go on the record here and post my thoughts about it on Simple Debt-Free Finance.

And now, without further ado, the article.

With the death of defined pension plans, 401(k) retirement plans have become a staple for many employees, but the recent financial turmoil has put these once infallible savings vehicles under the microscope. There have been numerous news articles detailing the stunning losses of the stock market since October of last year. Such stories usually offer a profile of some victim around 55 years old who was preparing to retire in the next few years, only to have 25% or more of his 401(k)’s value wiped out over night.

This has led to calls for the government to step in and fix the problem. Economist Teresa Ghilarducci has put forth a plan to do just that, and congressmen George Miller and Jim McDermott support it. Under Ghilarducci’s plan, contributions to a worker’s 401(k) plan would no longer be tax deferred. This would effectively tax the contributions twice - once when you earn the income that you then contribute to the plan, and again when you withdrawal the money in retirement. Under such conditions, why would anyone continue contributing to a 401(k)?

Ghilarducci’s plan also proposes implementing a government provided “guaranteed retirement account” to be administered by the Social Security Administration. Under this plan, worker’s would be required to invest 5% of their pay, and would receive a guaranteed return of 3%, adjusted for inflation.

This is the wrong way to fix the problem.

First of all, why would we want to reinvent social security when it’s been documented to be unsustainable? The government has already tapped the money many times over that was supposed to be set aside for the program. Isn’t this just recreating that problem? Secondly, the stock market has returned, on average, roughly 10% per year since WWII. How would worker’s be better off earning 3% per year? Thirdly, it doesn’t address the real reason 401(k) plans have left people short on their retirement funds.

The 401(k) plan did not fail. The stock market did not fail. This person simply had too much invested in the stock market for his age and retirement goal. The problem lies with the individual, and the lack of information and education provided to the individual, not with the 401(k) plan itself.

401(k) participants are investors, whether they know it or not. The problem is that most do not. The real reason 401(k) plans fail to the extent that people perceive them to is because the participant often lacks the education to make appropriate decisions. Many 401(k) participants don’t want to be investors, they just want to do their job and live their life. Another problem with 401(k) plans is that the individual is often entirely in charge of their investments, and have no safety valve in times of extreme panic or greed. Just look at the recent economic turmoil and see how many have pulled everything out of their 401(k) because they don’t trust the market. Once the loss has happened, pulling out is the worst thing they can do, but these people are simply reacting emotionally. They don’t have the background to approach it rationally.

The real way to fix this problem is education. Employers could provide professional assistance by way of making an impartial financial planner available to employees in the plan. Most plans provide life cycle or target date funds where employees choose the fund with their target retirement date, and the plan manager gradually adjusts the allocations between stocks and bonds over time. This is essentially a set it and forget it approach that has been proven to work over time. But so many employees are ignorant to their existence and their use. If that 55 year soon-to-be retiree had a proper asset allocation in his 401(k), he would still be on course to retire, though he might still choose to work a little longer for a better post-retirement lifestyle but the choice wouldn’t be so drastic as losing a quarter of your retirement.

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One Response to “Why 401(k) Retirement Plans Really Don’t Work, and How to Fix Them”

2009, year in review.
December 30th, 2009 @ 10:24 pm

[...] 2009 saw a lot of talk about the future of the 401(k). It seems only natural, given that it is one of the major means of saving for retirement for many American workers who had just seen those savings drop like a stone in the 2008 stock market crash. A lot of the talk was centered around ways to “fix” the 401(k) when it isn’t broken. This bothered me enough to blog about it in that post as well as Fixing What Isn’t Broken and Why 401K Retirement Plans Really Don’t Work And How To Fix Them [...]

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Why 401(k) Retirement Plans Really Don’t Work, and How to Fix Them

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