Less than a week ago, US News published an article in the Smarter Investor section titled 7 Threats to your retirement. While the article takes an in-depth look at some of the threats to retirement, such as changing jobs, early retirement, and lump-sum distributions, which are in fact valid threats to the ability of the average American to retire comfortably, the author seems to focus more on the issues faced by employees with defined benefit plans.
The reality is that a large percentage of Americans these days will not enjoy pension security when they retire, as fewer and fewer employers offer defined benefit plans (i.e., traditional pensions) and more and more employers offer retirement plans. defined contributions (ie, 401K). with a small coincidence, if any… So, for me, the real issue to discuss is
What are 7 threats to your retirement when all you have is a 401K?
A little history can help us understand the current reality…
In 1974, when the Employment Retirement Income Security Act gave formal approval to employee-funded savings plans through a pronouncement that became Sec. of the Internal Revenue Service. 401(k). By 1981, regulations had been issued and the 401(k) plan had been formalized.
Johnson Companies quickly introduced the first 401(k) plan. It was designed to give employees another way to save. Theoretically, it would provide a way for workers to supplement their pensions with additional tax-deferred personal savings. These plans differed from their predecessors, where employees received a defined benefit, and came to be known as defined contribution plans, because the amount that goes into the plan is defined but the amount that goes out is variable.
Over time, companies have replaced their defined benefit plans with defined contribution plans. It saves money for businesses as they are no longer responsible for providing income to retired employees. Today, most employees think of their defined contribution plans as “pension plans,” but real pension plans come with a guarantee. So what is the outcome of the DC plan experiment?
Defined contribution plans are often the closest thing to a pension plan for most Americans. One with a few pitfalls that pose a threat to retirement and make planning that much more important and challenging.
- Contributing to the 401K plan is too voluntary – Each employee can choose how much, if any, they will contribute to their 401K plan. Too often, young employees find a myriad of what at the time seem like legitimate excuses to postpone contributing to a 401K plan. It’s not uncommon for college graduates to be overwhelmed with student loan debt that they are paying off well into their 30s and therefore contribute little or no contribution to their defined contribution plans. Investors who fall into this category do not start thinking about retirement planning at 40, by which time they have lost the benefit of time and now have to contribute much more than if they had started contributing at 30.
- Employees often use the ATM loan option: The loan options in most 401K plans allow access to quick cash, but unfortunately they can put the accumulation of wealth in savings at risk. In fact, about 30% of people who have the option of a 401K loan have already taken advantage of it. Certainly, having the ability to borrow against the vested portion of the 401K can be very helpful in an emergency situation when savings cannot cover the need. However, it is possible to ignore the disadvantages of borrowing from retirement savings, such as fees, the potential for credit score damage in the event of a default, and most importantly, the opportunity cost of the 401K loan. Or, in other words, how much tax-deferred growth you’re giving up when you withdraw money from the fund.
- Compared to traditional pension accounts, it’s actually a pay cut for workers: The logic here is quite simple, but this is one of the most significant disadvantages of defined contribution pension plans. Compared to the lucky few who are still offered defined benefit plans by their employers, most Americans who rely solely on a 401K are essentially taking 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 401K deferred amount under IRS regulations of $16,500, that’s a whopping 40% of income.
- There are no guarantees – This is really a continuation of the previous point. Unfortunately, even by saving a significant percentage of annual income and thus giving up the ability to spend it now, there is no guarantee that the securities or funds in the plan will not depreciate and therefore it becomes imperative that the employee continues to work. The worst thing is that this market risk does not end with retirement.
- Fee structures no matter what- Another issue to consider is that while the investor is exposed to the market risk discussed above, the mutual fund provider, custodian, clearing firm, transfer agency, and myriad other officials receive their fees even if the stock market values falls.
- Possibility of making bad decisions. – Participants in the 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 aren’t that good at choosing investments. This is not necessarily due to a lack of knowledge. The same is true for professional fund managers. For example, The Vanguard S&P 500, which is the most famous fun index in the US market, failed to match the benchmark index’s performance as of December 31, 2011.
- timing is everything Simply put, the success of any 401K plan depends more than anything on timing. Financial markets go up and down and if you are lucky enough to be in the markets when they are going up, lucky enough to earn enough money to cover the many expenses associated with retirement and smart enough to get all your money out of the market. before the next recession, then the 401K plan could help cover the cost of retirement.
So what is the conclusion?
While 401K plans are not all doom and gloom, it is imperative that they are part of a well-crafted financial plan. As with any other investment decision, your individual overall investment objectives must be evaluated to determine the most effective investment strategy. Although certain general rules apply, there is never a “one size fits all” answer when it comes to investing. Your advisor will help you determine the most favorable strategy in your particular case.
Best of luck!!
