Insights & Advice

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Have 401(k) s failed the test?

When the U.S. government created tax-deferred 401(k) retirement accounts back in 1972 they never dreamed that together with Individual Retirement Accounts, they would become the primary savings vehicle for over 50 million Americans. Nor did anyone care as long as these tax-deferred retirement assets continued to grow but now that over $2.5 trillion of their value have been wiped out in less than a year, well, things are different.

These 401 (K) plans were originally intended to be a supplement to the main engine of retirement savings, the company pension plan. Back then most companies offered a defined benefit plan which guaranteed employees a certain income once they retired. The company assumed the risk of the investments so assets were invested conservatively. The system worked well and together with Social Security payments, most Americans believed they would be on Easy Street once they hit 65. To most investors, the 401(k) legislation was simply icing on the cake. It added a bit more to the worker’s nest egg but for the most part it was used by highly-paid company executives to shelter some of their income through tax –deference.

However, companies soon realized that 401(k) s were cheaper to manage (and even better) transferred the investment risk from the company to the employees. A wholesale exodus occurred as pension plans were transferred to these voluntary savings accounts. Companies provided a sweetener by volunteering to “match” a portion of each employee’s contributions when they could. Since all of this occurred during the onset of a multi-year bull market the increased investments returns appeared to be a win-win for everyone. Who needed stodgy old pension funds when the real action was in technology, energy or emerging markets?

Another problem was in the voluntary nature of the plans. The onus was on the individual to save, unlike pension plans where companies contributed a certain amount of money yearly toward the worker’s retirement. Although the government provides an incentive in the form of tax savings for the plans, over time fewer and fewer Americans have contributed less and less to their retirement plans.

Another problem is the array of investment choices that employees have to consider. I have many clients who are successful professionals in their fields but that does not qualify them to select from a menu of twenty or more mutual funds in different asset classes. Many times they simply selected the most aggressive choices available reasoning that the markets would continue to go higher. Obviously, that proved to be the wrong strategy in 2008.

Of course, many companies attempt to provide literature or even investment classes for their employees. But crash courses only go so far and how much time does the average employee have to follow the markets and make adjustments to their plans in a timely fashion? Last year even the most experienced market pros couldn’t make the right investments.

Remember too that my generation will use any excuse to avoid saving and now they have plenty. The decline in the stock markets has devastated their retirement savings. At the same time many companies in a cost-cutting effort have announced they will no longer provide matching contributions to their 401 (K) plans. Finally, many workers have stopped contributing feeling they should keep some cash on hand just in case they too join the ranks of the unemployed.

The bottom line: Americans are contributing even less to their 401 (K) and IRA plans while their existing savings are inadequate for retirement. Since Social Security payments alone are insufficient to support most American retirees, who or what will be called on to make up the difference? I suspect that today’s baby boomers will look to the government as a back stop and they have the voting power to force the issue.

So expect some changes in the way Americans are encouraged to save. Congress is already conducting hearings on the subject. There may also be adjustments, possibly restrictions on how our retirement savings can be invested similar to the guidelines followed by many of our corporate pension funds today. I believe the last thing the government needs right now is to pick up the tab for my retirement and hopefully the new administration agrees.

Posted in A Few Dollars More, Financial Planning