Saturday, October 17, 2009

"Myth" Information

Recently, Time magazine ran a story called “Why It's Time to Retire the 401(k).” For the most part, the article was little more than a tired rehash of criticisms that continue to be trucked out with disappointing regularity by those who, IMHO, should, by now, know better.

Here’s my take on five “myths” that keep being told about the 401(k).

You can’t save enough to retire on in a 401k.

I’ll concede that when one looks at the “average” 401(k) balance today, it’s hard to imagine how anyone could live out the year, much less retirement, on that sum (1). Even if you look at the average balance of a near-retiree (rather than an average that includes the accounts of 25-year old savers), it’s hard to see how most could live for another 20 years on that balance.

That said, there’s a difference between saying you can’t save enough and you haven’t saved enough (2). Every situation is unique, but ultimately, a voluntary savings system “suffers” from the reality that it is voluntary. That isn’t the fault of the 401(k), however—a design that basically allows workers to defer taking (probably spending) and being taxed on pay today as they prudently set it aside for retirement. Of course, we all know the 401(k) was never designed to be the sole source of retirement income (even its critics acknowledge that). IMHO, those, like the authors of that recent Time article, who want to “retire” the 401(k) because it isn’t ready to carry a load it wasn’t designed to do are ignoring the critical role it is playing—and will play—in making a more financially secure retirement possible for millions. They might just as well fault the design of a car that fails to reach its destination because the driver refused to fill the tank.

It’s a tax dodge for executives.

One of the most pervasive arguments of 401(k) critics is that the plans are little more than a tax-sheltering scheme for the very highly paid, one into which only they can afford to contribute to the maximum amounts the IRS permits for the plan.

Now, it is true that higher-compensated individuals generally do have more disposable income, and thus they are significantly more likely to hit those caps. It is also true that those who are paying income taxes do benefit more from a system that provides for a deferral of those taxes, and those with higher incomes (who pay higher tax rates) benefit even more.

On the other hand, as tax dodges go, the 401(k) is a pretty inefficient way to go, IMHO. Those higher-paid deferrals are hemmed in by discrimination tests, limits on considered compensation, and a hard cap on the annual amount that can actually be deferred into these programs on a pre-tax basis, in addition to maximum annual additions. So, take a second; add up how much (little) can actually be deferred into these programs by those executives. Then, compare that to the base pay of folks who qualify as “highly compensated” (which, in many areas of the country, is all-too middle-income)—and think about what they’ll be trying to replace (at least in part) with the $16,500 (plus match and maybe another $5,500 if they’re old enough to qualify for catch-up).

And then, hope that they don’t do that same math, and figure that there are better ways to spend company resources than in keeping up with a 401(k).

Employers have pushed 401(k)s on workers in place of pensions.

First off, pensions were never as ubiquitous as described in some media accounts (something less than half of private sector workers were covered, even at the peak of their popularity), and even where pensions did exist, the service/vesting requirements (coupled with the tenure typical in most private industries) meant that many workers in the private sector never got as much from those programs as one might think/hope (see . Retirees With Pension Income and Characteristics of Their Former Job)—or, more accurately, as they might have if they had actually worked 30 years for the same company.

That’s not to say, or course, that some workers didn’t—nor does that mean that some of today’s retirees haven’t enjoyed a much more financially secure retirement because they had a pension (certainly in the public sector). But the data suggest that those situations are rarer than we’ve been led to believe by some of today’s wistful news coverage (the data also suggest that the median private-sector pensioner is getting less than $10,000/year from that pension).

Certainly, there have been financial reasons for employers to prefer the relative financial obligation certainty and control associated with a defined contribution approach compared with a defined benefit plan. Moreover, recent changes in accounting rules and regulatory requirements have largely served to discourage the perpetuation of DB plans in the private sector, and have done nothing to spawn the introduction of new programs.

That said, this is not just a corporate decision. I have spent more than a quarter century in this business watching private-sector workers (including myself) “walk away” from pensions. Why? Well, because people make employment decisions for many other compelling reasons. And frankly, even if you have a pension and get a statement that tells you how much that pension is worth, until you have accumulated a couple of decades worth of service (and most don’t), the present value of that benefit is—well, let’s just say it’s not an attention-grabber.

Could we do things to change that? Sure. In fact, I wish we would (unfortunately, we’ll need some help from Congress). But make no mistake: Employers have found it increasingly difficult to offer traditional pension benefits—and IMHO, many, perhaps most, of their workers seem to prefer the 401(k).

401(k)s have been used to shift retirement costs to workers.

In a world where we all once had employer-paid-for pensions that have now been replaced by 401(k)s, this might at least be one way to think about it (see above, however).

On the other hand, if you look at the longstanding pre-401(k) estimates on plan expenses, you’ll find that the general rule was 70% of the expenses were investment related, 20% were attributed to recordkeeping, and the remaining 10% went to things like trustee/custodian, legal, and other administrative matters. And at that point in time, employers frequently wrote a check for everything but the investment fees—which were then, as they are now, largely netted against earnings. These days, it’s not uncommon for the “investment” fees to be the only explicit expense of the 401(k), leading commentators and critics alike to bemoan the “shift” of 100% of the plan fees to participants.

But most defined contribution/401(k) plan participants have always paid 100% of the fund expenses, which, even 30 years ago, typically included administrative expenses, 12(b)-1 fees, and sub-TA expenses (and yes, trading expenses of the fund)—even when the employer was also paying separately for recordkeeping and those other expenses. What has changed is not how much participants are paying (or how they are paying it), but rather how much employers pay. Now, you can certainly argue that the system has worked to reduce employer expenses, but to my eye, participants are still paying what they always paid. It’s just that, these days, the fund company doesn’t keep it all.

401(k)s are dangerous.

The Time article did break some new “can you believe they said that” ground when the author said, “Saving more, another common prescription for fixing the 401(k), has its downside too. That's because of another unpleasant quirk of the 401(k), which was mentioned earlier: the older you are, the riskier a 401(k) gets.”

Huh? What possible correlation could age have with risk? The author “explains” it this way: “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.”

No, that’s because, in your early years, your 401(k) mostly IS your contributions. Now, if you look at a recent study by the Employee Benefit Research Institute (EBRI) (see “The Impact of the Recent Financial Crisis on 401(k) Account Balances”), you will find some “support” for the author’s position. What you won’t find in the Time article, but will find in the same EBRI analysis, is the following comment: “At a 5 percent equity rate-of-return assumption, those with longest tenure with their current employer would need nearly two years at the median to recover, but approximately five years at the 90th percentile.” Now, that’s not tremendously good news if your retirement savings got caught in the downdraft of the worst market downturn in recent memory just as you were heading into retirement. But it also suggests that recovery is not only possible, it’s likely—specifically if you fill some of that gap by continued, and perhaps increased, savings. Consider also that much of the account “heights” from which we’re now recovering were a result of that same market exposure. What remains critical is that we approach retirement with an eye toward preservation of those gains. Not doing so is like setting your car’s cruise control—and then taking your hands off the steering wheel on a winding road.

Speed without direction is—always—dangerous.

Sort of like believing that myths are reality.

—Nevin E. Adams, JD

(1) those “average” 401(k) balances also don’t include the accumulated balances from other 401(k) plans that workers roll into IRAs.

(2) there remains a heated debate about just how much people need to save in order to retire – see “Scare Tactics

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