The 401(k) Doesn't Measure Up

When asked about their top financial worry, Americans cite retirement at the top of the list, according to a recent Gallup poll.

And they are right to be worried, at least based on the numbers and projections.

Fewer and fewer companies are offering defined benefit pensions. They are turning to defined contribution plans, such as 401(k) plans.

We can’t really blame companies for doing this. Taxes and regulations mean more expenses for companies trying to compete. Instead of cutting employee wages, it is easier to cut certain benefits, especially the ones that employees don’t benefit from immediately.

In addition, with life expectancies increasing and health care costs rising, companies don’t want to offer defined benefit plans. It is difficult to predict the statistics of the future, and offering lifetime benefits can put a company at risk in the future if costs are higher than expected.

Meanwhile, governments (federal, state, and local) are in major trouble, and the biggest reason is because they have made big promises for the future that are not possible to keep.

You can see this with the federal unfunded liabilities — with some estimates exceeding $200 trillion — that will never be fulfilled. The federal government will have to raise the retirement age and/or cut benefits in the future. It is statistically inevitable.

For state and local governments, the problem is realized faster because they can’t print money out of thin air. They are forced to come up with something close to a balanced budget. For this reason, more local governments are at least considering implementing defined contribution plans, as opposed to defined benefit plans, for government workers.

But outside of government, most companies have already made the change and are offering defined contributions in the form of 401(k) plans and other retirement vehicles. You know the standard now, where the employee contributes a certain amount and gets matching funds from the employer up to a certain amount.

Where are the Savings?

According to a recently released report, the median 401(k) plan has just $18,433 in it. While this would also include young employees who just recently started, this is an astonishingly low amount, especially considering that most employees now are not getting a separate pension benefit.

The median number is a better measure than the average, as a small number of plans with a million dollars in them will distort the latter. With the median number, we know that half of Americans participating in a 401(k) plan have less than $18,433.

Of course, many of these workers are not close to retirement, so what about older workers? According to Vanguard, its customers who are 55 to 64 years old have a median amount of $76,381.

If you are nearing retirement age, don’t have a pension, and only have $76,000 in a retirement account, you better plan to keep working a lot longer. Social Security isn’t going to buy you a very nice lifestyle, and a middle class couple could blow through $76,000 in a year after paying taxes and taking a couple of nice vacations. And someone today who has already reached the age of 65 is statistically likely to live well into their 80s.

So Americans have good reason to worry, but why aren’t they then saving more? The answer is likely a simple one: Wages have basically stayed stagnant over the last several decades. Our living standards have increased with technology, but our financial position is no better.

It is tough for many families to simply scrape by. Life is expensive, especially when you are essentially forced to fork over a large amount of money for health insurance. And when the federal government takes about a quarter of your income through taxes and inflation, and then state and local take another big chunk, you end up paying almost half of your money to the government at some level — and that doesn’t even factor in the wasted resources on the tens of thousands of pages of government rules and regulations.

So while Americans find a way to contribute a small amount to their 401(k) plans, there isn’t too much else to show for.

The biggest assets for Americans are their retirement plans and the equity in their houses. These are mostly illiquid assets. And with the housing bust of the last decade and the small 401(k) balances, you can see that the median net worth is not too great.

Advantages and Disadvantages

401(k) plans have their good points and bad points. They are good in the sense that you can defer taxes. Some companies also offer a ROTH 401(k) plan, where you can contribute after-tax dollars but then pay no taxes upon withdrawal in retirement.

401(k) plans are also good for those who are undisciplined. As long as they have enough discipline to sign up (or not opt out), then they will automatically save some portion of their income each pay period. And it is always nice to collect that company match with it.

There are also disadvantages to 401(k) plans. As stated before, they are illiquid. If you are still working for your employer that sponsors the plan, then you can’t withdraw money until the government-approved retirement age, unless you can take a loan or get a hardship withdrawal. And even if you quit your job, a withdrawal will cost you taxes plus an additional penalty.

Another disadvantage is that your investment options are limited. You probably have a small number of mutual funds that you can invest in. You may be able to get a special brokerage account through your 401(k) that will enable you to buy any mutual fund. But even with that, don’t expect to be able to buy any individual stocks or ETFs.

Of course, with any mutual fund, you will pay the fund management fees. 401(k) plans have been something of a gift to Wall Street collecting all of the commissions. But as you can see from the numbers, the American people have benefitted far less.

Finally, one last major concern with 401(k) plans is that the government can change the rules at any time. We hear stories of retirement fund confiscations in other countries. I don’t think an outright confiscation is likely in the U.S., only because so many Americans have 401(k) plans now, but we can be sure that some politicians will try it.

The more likely scenario is that the government will just attempt to change the rules down the road. They could increase tax rates, increase early withdrawal penalties, change the retirement age, etc. The politicians will also find schemes to get Americans to “invest” in U.S. government debt, just to keep their game going for a bit longer.

Is a 401(k) Plan Right for You?

If you work for a company that offers a 401(k) plan, then you have to decide what is right for you.

My typical suggestion is to contribute only up to the amount that you receive an employer match and no more. But even here, there are exceptions.

If you have absolutely no liquid savings, then you may want to hold off on 401(k) contributions. Of course, it is important to take the money that would have been contributed and use it to build up an emergency fund.

It is also hard to argue with someone who wants to opt out and use it to get a higher income through a business venture, real estate, or obtaining some kind of certification to advance a career. We can be sure that most of the great entrepreneurs of our day were not worried about contributing to a 401(k) plan.

But if you are not planning to be the next Mark Zuckerberg — or even if you are — there is nothing wrong with contributing to a 401(k) plan. You just shouldn’t count on it alone to make you rich.

Let’s hope the average American with $18,000 in a 401(k) plan also realizes this, because it isn’t going to get them very far.

Until next time,

Geoffrey Pike for Wealth Daily