The Trouble With 401(k)s and Other Retirement Accounts
Here's a trivia question: What does Leno, prescription drugs, the iPhone and the 401(k) have in common? Answer: They've all appeared on recent covers of Time magazine.
October 19, 2009
Although I can sing lots of praise for my iPhone, I can't say I share similar enthusiasm about 401(k)s and other retirement accounts like it.
Surprising to many, the 401(k) was never designed to be the vehicle meant to carry people through their retirements. Contrary to popular belief, the 401(k) was originally only meant to be nothing but a cash supplement to pensions, not a replacement of them.
Back in the seemingly ancient days of pensions, many workers retired with their pensions well intact but a problem existed in that they often had limited cash reserves to supplement their monthly checks. To solve this problem, in the late ’70s Congress created what was supposed to be nothing but a minor provision in the tax code that allowed employees to take a percentage of their income, contribute it into a 401(k) and defer the tax so that when they retired, they'd have this "side fund" of savings from which to draw.
The theory of giving workers a retirement side fund sounded great until corporate America found a self serving opportunity nested within it. After all, designing and managing pensions required additional staff, were costly, risky and carried lots of responsibility. As such, many corporations found a way to cut costs and risk by shifting the responsibility of lifelong retirement income to their workers through the framework of the 401(k) (and other types of IRS-qualified plans such as 403(b)s, tax sheltered annuities (TSAs), etc.).
I don't know about you but if I wasn't in the profession I'm in, I highly doubt I'd have much time to understand how to essentially be my own pension manager. To place this responsibility into the hands of the public who understandably has limited time and resources to be their own pension managers is simply unfair. Furthermore, even if someone did successfully manage their own 401(k) to perfection, the chances of success are minimal at best given these plans were being asked to do a job they were never intended on doing in the first place.
Five Concerning Problems
Let's take a closer look.
1. Inadequate Income
Let's take a hypothetical 40-year-old named “Dave” who earns $80,000 per year and who is doing a heroic job of contributing the maximum amount allowed into his 401(k). Contributing $16,500 per year (inclusive of a match) and achieving a steady seven-percent return each year less fees, at age 65 Dave should end up with around $780,000 in his 401(k).
Once retired, an important question arises: How much income can he expect to receive from his account without outliving it?
The answer can be found in something called the "Withdrawal Rate," a general rule-of-thumb agreed upon by both market historians and financial planning professionals. The answer as to how much income one can safely generate from their account without outliving it, is approximately four percent of its value. Any more than that percentage, then the chances for success are significantly decreased. True, an account may very well earn higher returns, but one needs to maintain a cash cushion for the bad years as well as the good, hence the lower-than-market-average Withdrawal Rate.
With the Withdrawal Rate in mind, the income Dave can expect to receive comes out to be approximately $33,000 per year, which comes in at far less than a typical pension would have likely produced at around $58,000 per year (70% of his current income of $80,000; less if the pension is also established to cover a spouse).
If you are interested in some quick rules-of-thumb that can help your clients determine the end result of their efforts, just follow this simple guideline:
Assuming a seven percent growth rate less low fees of 1.5 percent, simply take the amount being contributed into the retirement plan, then follow the math:
- If retirement is 15 years into the future, the gross amount of income they can expect to receive is one times the amount being contributed. As an example, if $10,000 is being contributed, based on the four percent Withdrawal Rate and other assumptions just mentioned, this person can expect to receive an income of $10,000 in their first year of retirement.
- If retirement is 20 years into the future: income will be 1.5-times the contribution amount.
- Twenty-five years in the future: two times the contribution amount.
- Thirty years: three times the contribution amount.
- If there is a company match, simply increase the results by the match percentage.
Although not perfect and exact, the results will at least give your clients a general idea as to the results their efforts can usually be expected to produce. Of course, all this should be considered hypothetical.
Doesn't sound too good? ... It doesn't end there. There's something else that obviously needs to be taken into account:
The above income is all before-tax. Given money withdrawn from these plans are usually fully taxed at ordinary income, let's assume when Dave retires he is in a modest 30 percent bracket. With this factored in, the net-income for Dave would be somewhere around a mere $20,000, which basically equates to purchasing power of around $10,000 when adjusted for three percent inflation.
What chances does he have to survive on this level of income? The answer is most likely, "not much," and hence, the conclusive reason why even in his near perfect situation of maxing out their contributions and achieving steady-market returns without loss, using a supplemental plan such as a 401(k) to replace a pension can’t be expected to yield much success.
3. Market Risk
In a recent segment addressing the problems with 401(k)s, the CBS-TV news-magazine 60 Minutes summarized the risk issue quite well when asking, "What kind of retirement account allows people to lose 50 percent of their money the moment they are due to retire?"
4. Costs and Fees
Different sources report varying costs but if I had to filter through all my research, I feel comfort in estimating total costs in the typical 401(k) coming in at around 1.5 percent to two percent per year of gross dollars invested. In many cases I've seen much higher. To some, two percent might not sound like much, but if you earn an average gross return of seven percent each year, two percent of those earnings equates to giving up nearly 30 percent of your gains.
Most retirement accounts such as 401(k)s are comprised of a menu of professionally-managed mutual funds. While I am not here to say negative things about funds, the fact of the matter is that approximately 90 percent of them fail to outperform the static, low cost and unmanaged indexes to which they are benchmarking their returns.
Some say pointing out the problems is easy, but what about the solutions?
I have a couple of ideas to share with you, some of which are basic and others of which I know are creative and things you may not have heard before.
Stay tuned. I’ll detail them in an upcoming issue.