The Five Biggest Myths About 401(k) Plans
The biggest crisis that’s not talked about is that the inadequate employer contribution to 401(k) accounts, typically equal to 3% of pay, makes it impossible for most Americans to retire. But there are other myths as well: that 401(k) participants need investment advice, that fee disclosure would enable them to “shop” for lower-fee investments, that 401(k) plans benefit the wealthy and that Americans would be better off with regular pensions.
Myth 1: That their biggest flaw is that they shift risk to investors. Truth: it’s that they shift the cost. Many other countries offer successful defined contribution plans that work--the difference is that the employer contribution rates are higher. A report issued in 2008 showed that Australians between the ages of 30 and 34 are projected to have assets of more than $540,000 in today’s dollars in their version of our 401(k) accounts by the time they are ready to retire; those between 20 and 24 will have nearly $700,000. In contrast, only three percent of Vanguard’s participants have accumulated more than $250,000 and the median account balance for those over 65 is a paltry $52,000. What’s more, older workers haven’t accumulated much in their rollover accounts from other employers; the median balance for those age 60 to 65 is $68,249, according to the Employee Benefit Research Institute. So a typical aging Boomer has only accumulated around $120,000 in total savings, about twice the median salary for that age group when would-be retirees need 10 times their salary. Why are Australians better off? Their employers are required to contribute the equivalent of 9% of pay to employee accounts compared to the voluntary 3% contribution in the U.S.
Myth 2: That 401(k) participants need advice about how to invest. Truth: they need to know how much to save. As long as 401(k) participants are offered a target-date index fund with a prudent asset allocation strategy, investment decisions have wisely been made for them (although it’s too bad there isn’t a Global 500 index fund, reflecting that the “investment world is flat.”) The most important advice that participants need and aren’t getting is how much to save in their 401(k) accounts, not where to save it. With the input of pension actuary James E. Turpin of the Turpin Consulting Group, I developed formulas for contribution rates required based on the current typical employer match of 3%. I presented these findings to the Department of Labor’s (DOL) 2007 ERISA Advisory Council’s Working Group on Financial Literacy and the Role of the Employer. As a result, the Working Group recommended to the DOL that employees be told how much they need to contribute.
What I reported is that assuming a typical employer contribution rate of 3% of pay, even participants who are savvy enough to start contributing at age 25 must save 10% of their salary. Waiting until age 35 to start saving increases the contribution rate to more than 17%, waiting until age 40 increases it to more than 23% of pay and waiting until age 50 requires nearly a five-fold increase from the rate at age 25, to 48% of pay. Needless to say, this over-50 requirement flies in the face of the meager current $5,500 limit on “catch-up contributions” currently allowed by the IRS.
Myth 3: That fee disclosure will enable participants to choose funds that are more cost-effective. Truth: It’s likely the employer’s size, not the investment manager, that is driving the fees. Small businesses often have to “outsource” the cost of compliance with ERISA, such as filing Form 5500s, instead of having them less expensively done in-house, as might be the case with a Fortune 500 company. Why don’t small employers address this issue by banding together to “bulk purchase” these services in order to lower fees for their employees? Because they’d all be liable if any of the members of the group violated ERISA.
Myth 4: That affluent 401(k) participants are doing just fine when it comes to retirement adequacy. Truth: Contribution limits prevent them from contributing enough. The Bipartisan Policy Center has proposed tackling the federal deficit by halving the amount that employers and employees can contribute to 401(k) accounts (since contributions are tax deductible). The total combined contribution would be limited to 20% of an employee’s annual earnings or $20,000, whichever is smaller. In doing so, “qualified plans no longer will be a vehicle for wealthy individuals to convert a substantial share of their assets into tax-free retirement assets.”
Except that they aren’t. My household is in the top bracket, thanks to my husband’s salary, which is in the low seven figures. While he has been participating in his employer’s plan for nearly 25 years, always contributes the maximum and his employer contributes the equivalent of 9% of pay, his current account balance is less than one third of his current salary. Why? Because of the contribution ceilings, catch-up contribution ceilings for those over 50, annual compensation limits of $245,000, as well as “non-discrimination” testing. While other companies may have created “non-qualified plans” to help their highly compensated employees retire, his has not and it’s not clear whether the majority of employers do. What’s more, even the wealthiest companies in the U.S. are cutting back on pension coverage. While at the end of 1998, 90 of the Fortune 100 companies offered some sort of pension benefit, according to Towers Watson, today only 17 of them offer them to new hires.
Myth 5: That people would be better off if we had mandatory defined benefit plans. Truth: If that were the case, the vast majority of employees would likely not be “vested,” that is, have ownership of the employer contributions, because of job changes. A 2010 Bureau of Labor Statistics study showed that Baby Boomers born between 1957 and 1964 held an average of 11 jobs from age 18 to age 44 alone. While defined benefit plans, or pensions, are more generous than 401(k) plans, they tend to have stricter rules about when employees “own” employer contributions. In a defined benefit plan, using the “cliff vesting” approach, a company can require that employees work five years before they are vested or with “graduated” vesting could require that an employee stay for seven years. On the other hand, with a 401(k) plan, a company must allow 100% vesting after 3 years with the cliff approach or 100% after six years if there is graduated vesting.
"Crack open this book and enter a bromide-free zone. Jane White knows why American families feel as if they are on a treadmill running out of control, and she explains the reasons with clarity, insight, and rare honesty. She also offers several practical suggestions for how we as individuals, families, and a nation can get out of the mess. Policymakers would be wise to listen."