Get Rid of the 401k?

A recent cover story in Time Magazine suggested just that. It’s lengthy but a worthwhile read, if nothing else to better understand fully what follows here.

The article was filled with stories about people who are nearing or in retirement and don’t have enough money. It states that they lost significant sums of money in their 401k over the difficult 10 years we have just experienced in the stock market. It then throws out some stats about how much better these people would have done with an old fashioned pension plan. The conclusion? Get rid of the 401k for everyone and go to a defined benefit pension plan.

Before I point out all the erroneous premises and conclusions with the article, let me start by pointing out where I, at least at a high level, agree with the article. First, there is a serious flaw in the 401k concept: giving people the tool and the ability, hell the mandate, to save for their own retirement without giving any education, advice, or guidance. The only “guidance” people are getting is from CNBC and they only encourage greed and fear. A good first step that I have seen is the introduction of Life Cycle, or Target Date, funds. Even better is when the company automatically sets up an employee in the 401k program and defaults him/her to the appropriate fund based on age. No, this really isn’t education but it at least gets you participating in a relatively appropriate choice. I do have issues with the Target Date funds in that they all have different ideas about what a Target Date should mean; there is no standard definition or guidelines for them. The result is some funds are taking on more risk than I would call appropriate. But, with no other option, they are a decent choice.

Now my problems with this article. Every one of the examples the author used and several hypothetical cases he uses have you losing 25%, 30% or more of your 401k the last 1 to 5 years before retirement. In other words, between 60 and 65 years of age, you lose 1/3 of your 401k value. Pretty scary sounding isn’t it? Picture me in a Jim Cramer moment here, jumping up on a table, pulling my hair and screaming WHY!? WHY!? WHY!? Why did they lose that much? They were most likely heavily invested in equities. At that age no one should be that much in equities and therefore no one should be losing that much. Is that because the 401k is bad? No, it’s because people were operating on ignorance, greed or fear. This does tie back into my criticism of the 401k. Without investment education, people will be ignorant of the important choices they need to make. At a minimum everyone should read Personal Finance for Dummies or something similar. Do a Google search for asset allocation like this one on Money.com. In the last 10 years before you retire your primary goal is protecting your retirement money, not having visions of life on a tropical beach because you are riding that Emerging Market wave with 100% of your account and making a killing. Don’t let greed take over.

He gives examples of how these people would be so much better off if they had a traditional pension plan and that’s why we should scrap the 401k and go to some kind of guaranteed income system for everyone. We already have something like that today. If you invest, appropriately, in a 401k, when you retire you can simply purchase an immediate annuity that gives you a fixed amount of income you need each month. Any difference left in your 401k you can then invest, and continue to grow that balance. Another option would be to offer an annuity in the 401k program that you can purchase as an alternative and have that guaranteed payout. I do have issues with offering tax-deferred variable annuities in a 401k, but, if it an option and those options are explained to people, it removes some of my oppositions.

This is my favorite. The author cites a 63 old retiree with $500,000 in a 401k, who spends $75,000 a year. He then states the retiree would be better off with a traditional pension. I have several issues with this one. First, spending $75,000 a year with a $500,000 401k balance? At that rate, he’ll run out of money in three years, no matter how you do the math. The author’s solution: under the old pension plan the retiree would be receiving a $2200 monthly check. Apparently the author did not do very well in 6th grade math because $2200 a month x 12 months a year = $26,400 a year. That is a far, far cry from the retiree’s $75,000 “need.” What if they purchased an immediate annuity with that $500,000? He has $3200 a month. Still a far cry from $75,000 but he is 45% wealthier than under the traditional pension plan. Looks like the author didn’t do that well in 3rd grade math either. So what is the retiree doing? He is watching CNBC so he can gamble on the market hoping to hit it big. Bad 401k or bad decision making by the retiree?

The solution proposed in the article is a government run pension plan (anyone think of Social Security) where you put in (they take from you) 5% of your pay and you get back 26% of your final salary. We all know how well Social Security is run so it makes perfect sense to expand it right? Think about this. If you invest 6% of your income starting in year 1 of your employment, have a 50% match by your company and invest in a money market fund in your 401k, then retire at age 65 with $100,000 salary you would have a $450,000 balance. You then purchase an immediate annuity and get $2900 a month, or $34,800 a year. That is with investing in nothing but a money market fund. Under the author’s plan you would get $25,000 a year. I know I don’t write for Time so maybe I am missing something but to me $34,800 a year is better than $25,000 a year.

I’m tired of hearing all these people, like the author, complain that no one is taking care of him and they want a nanny state to provide all these things. If they want to live that way, that’s fine with me as long as it doesn’t force me to. I like the 401k; I like having to ability to control my own destiny and I have averaged 9% a year over the past 5 years in my 401k. The S&P has averaged -8.5% a year over that same time. Has this been a “lousy idea, a financial flop, a rotten repository for our retirement reserves” for me as the author claims? I emphatically say no. Maybe he’s bitter because he lost a lot then went searching for others who did the same.

I do hope that companies figure out that their employees need help with their retirement investing. I also hope that investors give a lot of thought to retirement and when it is appropriate based on how much they have in savings. When you are 10 years away from retirement, start talking to a fee -only financial planner. They aren’t giving stock investment advice but will help ensure you are on the right track toward your retirement goal. They also won’t let you stay fully invested in stocks the year before you retire. At least I hope not.