Less than a week ago, US News published an article in the Smarter Investor section titled 7 Threats to your retirement. While the article thoroughly discusses some of the threats to retirement, such as job switching, early retirement and lump sum distributions, that are, in fact, valid threats to the ability of average Americans to retire comfortably, the author seems to focus more on the issues facing employees with defined benefit plans.
The truth is that a large percentage of Americans these days will not have the security of a pension when they retire because fewer and fewer employers offer defined benefit plans (i.e. traditional pensions) and more and more employers offer defined contribution plans (i.e. 401k) with a small match, If any… So for me, the real issue to discuss is
What are the seven threats to your retirement when all you have is your 401K?
A little history can help us understand the current reality…
In 1974 when the Work Retirement Income Security Act gave formal approval to employee-funded savings plans through a proclamation that became the Internal Revenue Service Sec. 401(k). By 1981, regulations were passed and the 401(k) plan became official.
Johnson Companies quickly introduced its first 401(k) plan. Designed to give employees another way to save. In theory, it would provide a way for workers to supplement their pensions with additional tax-deferred personal savings. These plans differed from their predecessors, in that employees received a set benefit, and became known as defined contribution plans, because the amount put into the plan is set but the amount that comes out is variable.
Over time, companies have replaced defined benefit plans with defined contribution plans. It saves money for companies, as they are no longer responsible for providing income for retired employees. Today, most employees think of their defined contribution plans as “pension plans,” but real retirement plans come with a guarantee. So what’s the outcome of DC’s plan experiment?
For most Americans, defined contribution plans are often the closest to a pension plan. One with some pitfalls that pose a threat to retirement and also make planning for it more important and a challenge.
- Contribution to a 401k plan is completely voluntary Each employee must choose how much, if at all, to contribute to their 401K plan. Young employees often find countless what seem at the time legitimate excuses to delay contributing to a 401K plan. It’s not unusual for college graduates to be burdened with student loan debt that they’re paying off well into their 30s, and so don’t contribute or contribute minimally to their defined contribution plans. Investors who fall into this category don’t start thinking about retirement planning in their 40s, at which point they’ve lost the time advantage and now have to contribute much more than if they had started contributing in their 30s.
- Employees often use the loan option as an ATM – The loan options in most 401K plans allow access to quick cash but unfortunately can put the accumulation of wealth in your nest egg at risk. As a matter of fact, nearly 30% of people who have the option to take out a 401k loan have already taken advantage of it. There is no doubt that having the ability to get a loan against the earned portion of your 401K can come in very handy in an emergency when savings just can’t cover the need. However, it is possible to ignore the disadvantages of borrowing from a retirement egg such as fees, the potential for damage to credit score in the event of a default, and most importantly the opportunity cost of a 401k loan. Or, in other words, how much tax-deferred growth you give up by withdrawing money from the fund.
- When compared to traditional pension accounts, it’s really a pay cut to workers – The logic here is very simple, but this is one of the major drawbacks of defined contribution pension plans. Compared to the lucky few who are still offered defined benefit plans by their employers, the majority of Americans who rely solely on a 401k essentially take a pay cut in order to contribute to the plan. According to the Social Security Administration, the national median wage index for 2010 is $41,673. If one were to contribute the maximum deferral amount to a 401k per IRS regulations of $16,500, that would be 40% of the income.
- No guarantees – This is really a continuation of the previous point. Unfortunately, even saving a large percentage of the annual income, thus giving up the ability to spend it now, there is no guarantee that the securities or money in the plan won’t depreciate and thus force the employee to continue working. The worst is that this market risk does not end in retirement.
- fee structures whatever they are- Another issue to consider is that despite the investor’s exposure to the market risks discussed above, the mutual fund provider, custodian, clearing house, transfer agency and countless other employees get their fees even if the stock market goes down.
- The possibility of making bad decisions Participants in a defined contribution plan are responsible for choosing their own investments. While some might argue that this option empowers employees, the truth is that most investors are not adept at choosing investments. This is not necessarily due to a lack of knowledge. The same goes for professional fund managers. For example, the Vanguard S&P 500 Index, the most popular cheerful index in the US market, failed to match the performance of the benchmark index as of December 31, 2011.
- timing is everything – Bottom line, the success of any 401K plan depends more on timing than anything else. Financial markets rise and fall, and if one is fortunate enough to be in the markets when they rise, he or she is lucky enough to have enough money to cover the many expenses associated with retirement and smart enough to withdraw all of the market’s money before the next day. In an economic downturn, the 401K plan may actually help cover the cost of retirement.
So what is the result?
While 401K plans aren’t all doom and gloom, it is essential that they are part of a good financial plan. Just as with any other investment decision, your individual overall investment goals must be evaluated in order to determine the most effective investment strategy. Although certain general rules apply, there is no “one size fits all” answer when it comes to investing. Your advisor will help you decide which strategy is most appropriate in your particular case.
good luck !!