401(k) Plans’ Inefficiency Struggles Will Grow


Piggy Bank2

We have all seen proud parents and frustrated parents.  Relatable, right?  Imagine the feeling of having a 35-year old that has not yet matured or started working.  Imagine being the father of the 401(k).  In fairness, Ted Benna (widely seen as the father of the 401(k)) notes that 401(k) plans are failing, and that the do-it-yourself plans were never meant to replace pensions. He has said that it was simply a financial product that “took off.”

The 401(k) is no closer to working today than it was all those years ago, despite 35 years of tweaking (for example, should we match in company stock?).  The system remains inefficient, and financial advisors still can’t tell people how much they can safely withdraw per year in retirement.  The 4 percent rule of thumb (meaning a half-million dollars in retirement savings would produce only $20,000 in annual retirement income before tax) could take out too much money from the retirement nest egg in a poor stock market, according to recent studies.

The inefficiency of 401(k)s has been proven repeatedly in study (1988-2004 data) after study (1995-2011 data) after study (1990-2012 data), by researchers and even corporate consulting firms.  Each study shows that traditional pension funds outperform 401(k)-type plans, meaning you get more benefit per dollar invested. 

During the years these studies covered, 401(k) plans had a structural advantage over pensions with a less mature demographic profile.

However, in the next 35 years, those who are retired, or nearing retirement, will have to invest more conservatively.  These near-retirement individuals tend to have the accounts with the largest balances, too.

For individuals in or approaching retirement today, the fundamentals they face are brutal:  historically low bond yields and a loss of principal (in “safe” bond investments) if interest rates rise.  Meanwhile, retail investment advisors continue to fight a requirement that they work in their client’s interests – what most of us see as a basic professional responsibility!

Another key issue highlighted by the Center for Retirement Research at Boston College in their most recent study, is the trend of IRAs performing even worse than 401(k) plans on investment returns.  In fact, during 2000-2012, the average returns on IRAs were only 2.2 percent.  Granted these were very difficult years for investing, but defined benefit plans managed returns of 4.7 percent over the same period.  Knowing that the level of investment returns is a major driver of costs for retirement planning, relying upon IRAs that are falling short by 2.5 percent of assets each and every year means the cost of a secure retirement will skyrocket.

This finding is consistent with CRR’s 2006 study, where IRAs earned only 3.8 percent over 1998-2003, far worse than either defined benefit or defined contribution plans.

Moving forward, we should expect more 401(k) assets to move into the retiree column (lowering yields further), and a lot of assets to be moved into IRAs.  The inherent financial advantage enjoyed by retirement plans with pooled investments should not be understated. 

Sure, 401(k)s make some sense as a supplemental savings vehicle (other than the regressive nature of the federal subsidy if you want low income workers to save more).  But, 401(k) plans simply do not function well as a primary retirement plan. 

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