Meditations on Money Management

Andrew Silton: The 401(k) was never intended to be the retirement plan

CorrespondentNovember 30, 2013 

Americans are painfully aware that they are financially ill-prepared for retirement. Studies show that younger workers aren’t saving enough money and older folks are postponing retirement.

Investment experts lament the country’s low savings rate and urge Americans to increase the amount of income they set aside. This is great advice if you make a lot of money, but many people are living paycheck to paycheck.

In this column I’ve highlighted a variety of practices, such as active management, market timing, and excessive trading, which have limited investor gains. However, the lack of adequate retirement savings is actually the byproduct of unintended policies set in motion by Congress and not the result of investor mistakes.

In the mid-1970s, Congress enacted two provisions with laudable purposes. First, it allowed people without retirement plans to create tax-deferred individual retirement accounts (the IRA). Second, it allowed taxpayers, mainly high wage earners, to defer a portion of their current income under a new provision of the Internal Revenue Code called section 401(k). So far so good.

In 1981, the 401(k) was expanded into a supplemental retirement plan, and the IRA was enlarged so that people with traditional defined benefit retirement plans could also contribute to IRAs and still get a tax deduction. These changes seemed fairly enlightened. Ironically, this marked the beginning of the end of America’s progress toward retirement security.

Wall Street wins

Wall Street pitched the 401(k) and the IRA as a win-win-win strategy. I don’t think investment bankers’ goal was to destroy the retirement safety net. Instead they saw an opportunity to make a lot of money.

First, the investment bankers convinced corporate executives to discontinue or freeze defined benefits plans, which guaranteed retirees a fixed amount of retirement income. This move freed up cash for companies as well as executive bonus plans.

Second, they pitched 401(k) plans as a way to shift retirement risk from corporations to employees. With the stock and bond market soaring in the final two decades of the twentieth century, the shift masked the risks facing employees.

Third, they sold the new 401(k) plans to employees as portable vehicles that they could take with them if they changed jobs or roll into individual accounts. While the 401(k) was supposed to be a supplemental retirement plan, the bankers were turning it into the primary retirement vehicle for Americans.

Wall Street was a big winner in the rapid expansion of 401(k) and IRA programs. Retirement investing had been an institutional marketing opportunity. With the creation of the 401(k) and IRA, brokers, distributors and money managers had huge new opportunities to charge new and higher fees than those they had been able to generate from traditional retirement plans. Instead of charging wholesale prices to defined benefit plans, money managers could charge retail prices on the new savings vehicles. Truth be told, I participated in this bonanza.

Dire situation

For the next 20 years, one traditional defined plan after another was eliminated until public and union employees were the only ones with widely available guaranteed retirement plans. Now these remaining plans are under attack as the general public has become envious of the superior retirement security afforded civil servants and organized labor. This attack is extremely misguided, because as these workers lose their defined benefit plans, they too will fall into the retirement crisis that will unfold in the next couple of decades.

Here’s the problem in a nutshell for those of you relying solely on a combination of 401(k)s and IRAs. Even if you are reasonably diligent about retirement savings, it is likely that you will have a problem if you retire in your mid-60s and live into your 80s.

Suppose you and your spouse are about age 65 with an average retirement balance of $250,000 (according to Fidelity, this is the average for folks at this age, although the median is probably lower since wealthy folks skew the average), and you earned about $100,000 per year when you retired. You’ll get somewhere around $40,000 per year from Social Security, which means you’ll need an additional $30,000 to $40,000 to live on.

You’ll have to draw from your 401(k) and/or IRA, and in the absence of other savings or equity in your home, you’ll have depleted your 401(k) by the time you enter your ninth decade. This assumes you don’t face some type of extraordinary health or personal crisis.

Millions of aging baby boomers face this situation. If you’ve saved money beyond your retirement accounts, you might get into your 90s, but you or your spouse could face financial ruin in the last few years of your lives.

As a country, our collective situation is more dire than I described above. Thirty-seven million households have no retirement plans of any kind. Admittedly, some of these folks are many decades from retiring, but millions of others are heading toward retirement with only Social Security as their source of income. Someone is going to pay for the hardship, disease, and social unrest that will come when a growing cohort of elderly face poverty and need.

Expand defined benefits

The traditional solutions favored by Republicans and Democrats won’t work. Increasing the amount you can contribute to retirement accounts or creating new types of individual savings plans only helps folks who are already in decent financial shape. Doing so also allows Wall Street to make more money. Quite simply, the average taxpayer probably doesn’t have the wherewithal to make substantially higher retirement contributions.

Although it’s incredibly unpopular in this day and age, we need to go back to the days before the mid-’70s when defined benefits were the rule instead of the exception. We need to consider expanding Social Security instead of narrowing it. Every developed country in the world has a broad-based retirement safety net. These systems work if the overall population isn’t aging, which means that America has the means of providing retirement security. This would most certainly be the case if we eventually adopt immigration reform and expand our tax base.

The financial markets are the method by which we can save for retirement. However, the markets can’t solve the problem if we don’t have the ability or will to put enough money into retirement security. The existing tax-deferred vehicles are grossly inadequate and place too much of the onus on individuals. Retirement security is a problem facing our entire society.

Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog

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