When lawmakers added a subsection to the tax code called the 401(k) more than three decades ago, they could not have imagined that this string of three numbers and a letter would become a fixture in the financial lexicon.
Nor could they imagine the stress it would unleash.
A poll by Gallup last year showed that for two-thirds of Americans, not having enough money for retirement topped seven other financial worries, including medical bills, mortgage payments and their children’s college tuitions.
Worrying about having enough money for retirement is not a new phenomenon. But the rise of the 401(k), dating to the early 1980s, has steadily shifted more financial responsibility onto the shoulders of many Americans who are — let’s face it — clueless.
The number of people who are unprepared is growing. In 1983, researchers now at the Center for Retirement Research at Boston College calculated that 31 percent of working-age households were “at risk” of not being able to maintain their standard of living after they retired. By 2009, it was 51 percent.
“I don’t know how you feel, but managing your own money is just horrible,” said Alicia Munnell, director of the center. “We just don’t know how to do it.”
Consider the hurdles between every American with a 401(k) and a decent retirement: First, wade through your HR department’s paperwork to enroll in a plan at your company. Second, save enough. (Imagine what you think is enough. Then save more.) Next, manage your investments intelligently through stock market highs and lows, tending to your portfolio every year to make sure you have the right balance of stocks and bonds, and avoid withdrawing any money early. And not least, when you retire, ration your money at just the right rate: not so little that you live uncomfortably but not so much that you run out.
The result has been a system that works well for people who know how to use it. For many others, it’s better than nothing, but it still may not be enough.
“Does the system work or not? It’s really a ‘compared to what’ question,” said Eric Toder of the Urban Institute. “One side emphasizes the glass is half-full and the other emphasizes the glass is half-empty. The real question is, how do we make the system work better for the people for whom it’s not working while not destroying the benefits?”
As company pension plans peter out, Munnell estimates that it will be another decade before people rely almost entirely on their 401(k)s.
That means 10 more years before a system — once imagined to be only supplementary to Social Security and pension plans — is fully tested. That’s 10 years in which bigger waves of workers sign up for a savings vehicle that they expect will see them through old age.
For the past several years, there’s been a movement to fix the 401(k), or at least make it work better for average people — that is to say, almost all of us — who are bound to make some mistakes along the way.
Reformers want the 401(k) of the future to look very different. But even the program’s biggest critics concede that the system that was unwittingly launched in 1978 is here to stay.
Broadly speaking, companies help workers plan for retirement in two ways.
Defined benefits, often called pension plans, guarantee workers a certain amount annually when they retire based on earnings in their final years and how long they’ve worked at the company. The employer must set aside the money, invest the funds and pay employees, regardless of what happens in the market.
In a defined-contribution plan, which includes 401(k)s, the employer diverts money from the employee’s paycheck — while perhaps chipping in some to an account owned by the employee, effectively creating a savings account. There are restrictions on when the money can be drawn. The employee owns the account, though, and can move the money from employer to employer.
The 401(k) was created by the Revenue Act of 1978, which also reduced individual income tax rates and the corporate tax rate and created flexible spending accounts.
But years before the law, companies had defined-contribution plans that were precursors to the 401(k). Firms — banks in particular — created accounts in which employees could put their bonuses rather than collect the money in cash. The accounts allowed employees to defer the taxes they would owe immediately with a cash payout.
The IRS was wary of this setup, but Congress gave it the rubber stamp. In the 1978 law, Congress added 401(k)s to the tax code, formally allowing employees to put a portion of their salary in these tax-deferred accounts. Three years later, the government issued official regulations, and companies including Johnson & Johnson and PepsiCo were among the first to adopt the new 401(k).
The number of companies offering the plan exploded in the 1980s and 1990s.
In 1990, about $384 billion worth of assets had been saved in 401(k) plans. By 1996, the number surpassed $1 trillion. The mutual fund industry flourished with all the new business.
In the meantime, companies rolled back their pension plans.
‘If you want to drive a car . . .’
Let’s say a worker making $50,000 contributes 6 percent of her annual salary with a 3 percent employer match. By the time that person retires, she should have about $320,000 saved up, according to calculations by Munnell. But reality rarely plays out that way. People forget to enroll, or they don’t save enough, or they wind up withdrawing money to cover a financial emergency. The result: Individuals nearing retirement have closer to $78,000 saved, according to the Federal Reserve’s Survey of Consumer Finances. (And that number is rosy; the last regular survey was done in 2007, just before the financial crisis.)
“The old-style 401(k) before automatic enrollment came along was basically telling people, ‘If you want to drive a car, you have to be able to repair it and maintain it yourself,’ ” said William Gale, director of the Retirement Security Project at the Brookings Institution. “If the 401(k) is supposed to be the primary retirement vehicle for the average American worker, then it needs to be consistent with the information and financial ability of the average American worker, who is just not prepared to manage funds like that over the course of a lifetime.”
Whatever the 401(k)’s flaws, freedom has been a selling point as people work at multiple companies in their careers and need to move their retirement savings with them.
“I think there’s a reason people do tend to like these things,” said Peter Brady, senior economist at the Investment Company Institute, a mutual fund industry group. “They much better match up to people’s work histories . . . and I think they like having control over their investments.”
Some of the fixes proposed involve diminishing the do-it-yourself nature of the 401(k), or at least nudging people toward better decisions.
The Pension Protection Act of 2006 paved the way for companies to offer automatic enrollment in 401(k) programs. Many firms have also added automatic annual increases in how much employees contribute. Half of the companies surveyed by the Profit Sharing/401(k) Council of America in 2010 offered automatic enrollment. Of those, about 40 percent also offered automatic increases.
Many companies automatically enroll their workers to contribute roughly 3 percent — more than they might save if they didn’t enroll at all but probably not enough to build a secure nest egg.
This year, the Treasury Department offered new rules that would make it easier for employers to offer annuity options to workers who are retiring. This way people are not left having to manage a lump sum but can instead count on a steady stream of payments.
In a way, these changes try to bring the best features of pension plans — their steadiness and predictability — to the 401(k).
“It’s kind of like we ran all the way to the cliff to D.C. [defined contribution] and then looked over the cliff and decided to make them more like D.B. [defined benefits],” Gale said.
Gale predicts that in the future there will be “hybrid” systems in which employers are still leaving much of the retirement saving to workers but plans are less overwhelming to manage.
At the core of any reform, Munnell said, there has to be massive education of employees on how to plan for retirement. Many people think that saving 6 percent with a 3 percent match, for example, is enough. Not so, according to the Center for Retirement Research.
As a baseline, the group estimates that a household earning at least $50,000 needs roughly 80 percent of its earnings to maintain its pre-retirement lifestyle.
To pull that off, a person who is 25 and earns $43,000 needs to be saving 15 percent a year in order to retire at 65, assuming a 4 percent rate of return on his investments. Wait until 35 to start saving, and the necessary savings rate creeps up to 24 percent.
The solution for many people, Munnell said, will be to work longer. If that 25-year-old doesn’t retire until 70, he would only have to save 7 percent a year.
“Our whole retirement system’s too small,” Munnell said. “When you put together Social Security and these 401(k) plans, it’s just not going to provide enough for retirement income. . . . The question is, can you fix it by fixing the 401(k)s?”
No, you can't fix a metastasized pension tumor by throwing a bone at it. The problem with 401(k)s is simple, they aren't defined-benefit (DB) pensions. They were created to supplement pensions, not replace them!
At the heart of every well managed, well governed DB pension is a promise to deliver specified monthly benefit on retirement that is predetermined by a formula based on the employee's earnings history, tenure of service and age, rather than depending on investment returns. It is 'defined' in the sense that the formula for computing the employer's contribution is known in advance. The very best DB pensions are managed by professional pension fund managers whose oversight is delegated to independent, qualified investment boards.
I've long argued that pensions are sacred and should be considered a public good. Those of you who've studied political philosophy know all about Rousseau's Social Contract. It argued against the idea that monarchs were divinely empowered to legislate. Rousseau asserts, only the people, in the form of the sovereign, have that all powerful right.
In today's modern world we don't have monarchs and slaves. Instead, we have financial oligarchs, banksters and an electronically lobotomized population obsessed with the latest tablets, smart phones and Apps to distract them from the legalized theft that is robbing them blind of a safe, secure and dignified retirement.
This statement might sound outlandish but those of us who understand modern day financial warfare being perpetrated against labor are disturbed by the secular shift toward defined-contribution plans, effectively placing the retirement burden entirely on individuals ill-equipped to cope in this highly manipulated wolf market dominated by big banks, their big hedge fund clients, and high-frequency trading platforms with a license to steal.
In essence, the trend toward pension poverty will continue unabated unless governments realize that pensions and healthcare are public goods and start treating them as such by expanding coverage of defined-benefit pension plans to all citizens.
If done properly, this will alleviate the pension burden off private companies and individuals and place it on well managed, well governed public defined-benefit plans. Companies can go back to focusing on their core business and workers can have peace of mind knowing that no matter what happens to the company they work for, their pensions are portable and they will enjoy a decent and secure pension just like their public sector counterparts.
Debt skeptics will cry foul, warning of a "Pension Ponzi" which will bankrupt already stretched taxpayers, but the real pension experts are warning of another catastrophe which will place a significant burden on the social welfare system. They are openly making the case for boosting defined-benefit pension plans, highlighting these facts:
- Well managed, well governed and properly funded defined-benefit plans are cheaper and outperform defined-contribution plans.
- Large DB plans are able to pool resources, lowering costs, and manage assets internally as well as externally by investing in the best global funds in public and private markets.
- While it is rational for companies to shift out of defined-benefit plans, it's not rational for governments to do this with public sector employees as they shift the retirement risk onto the social welfare system, which will end up costing taxpayers a lot more in the long-run.
- Finally, and most importantly, in countries like Australia, the nation-wide shift away from defined-benefit pension plans has led to widespread senior poverty.
Despite these facts, skeptics abound, pointing out to how large public DB plans in the United States are increasing their risks in alternative investments like real estate, private equity, and hedge funds, falling short of their return target while doling out exorbitant fees. The problem there isn't DB plans, it's the fact that for the most part, U.S. public pension funds are poorly governed, especially when compared to their Canadian or Dutch counterparts.
Worse still, most U.S. public pension funds still use an unrealistic high discount rate based on rosy investment assumptions to value their liabilities. When it comes to pensions, all stakeholders, including unions and governments, need to realize that compromises need to take place to ensure the long-term viability of a pension plan. The latest results from Ontario Teachers' Pension Plan, one of the best DB plans in the world, demonstrate that stakeholders cannot solely rely on exceptional investment gains to close the funding gap. Tough political decisions need to be taken.
Finally, I'd like to make a distinction between soft vs. hard austerity. I see the shift away from defined-benefit plans as a form of 'soft' austerity. It's regressive and will exacerbate economic inequality. In countries like Greece, however, we're witnessing the effects of hard austerity where wages and pensions are being slashed.
A few days ago, a pensioner's suicide shook the country. It remains to be seen what the legacy of this suicide means for Greece, but what worries me is that similar suicides are taking place in Italy and other austerity-weary countries. Is this the future we want for our seniors? Do policymakers realize the enormous social, economic and psychological costs that brutal austerity is placing on our most vulnerable citizens?
I think we've done enough to help the banksters and their hedge fund and private equity clients on Wall Street. It's high time policymakers do a lot more to help Main Street by protecting the sanctity of jobs, healthcare and pensions for all citizens, not just public sector workers and elected officials. If they don't, the great pension slaughter will disrupt the lives of millions of vulnerable citizens (watch below).