Friday, June 23, 2006

401Ks: still unproven?

I was curious about whether 401k plans actually work. What I mean is, since they were only "invented" in 1981, has anyone actually retired yet whose entire working life was spent contributing to a 401k, with no pension from their employer?
This is probably way over-simplifying things, but here's what I'm thinking: it used to be that most people worked for companies that offered a pension, by which I mean a defined-benefit retirement plan. The longer you worked for a company, the more you'd be paid each month as retirement income. Then in the 1980s, employers started phasing out pensions in favor of 401ks, a defined-contribution plan. Retirement savings became optional, with employees choosing whether or not to save, and how much to save, with employers chipping in various amounts of matching contributions. Employees also had some choice over how the funds were invested. When the employee retires, he or she has whatever balance has accumulated in the 401k account to live off in retirement. So who comes out ahead? The average retiree with a defined-benefit pension or the average retiree with a 401k? I don't think we know yet.

Some companies manage their pensions badly, and their retirees end up pretty much screwed (see United Airlines, for example). But assuming the company puts enough money into its pension plan, most large companies have professional investment managers running things, who, one would hope, given their salaries, know what they are doing and can make better choices, or at least spread risk out more than your average Joe Blow who picks a few mutual funds for his 401k and then forgets about it. But some other average Jane Schmoe might save diligently, invest really well, and be lucky enough to beat the pros, I suppose-- that is certainly what we all hope for, right?

At my first job, I was part of a pension plan, but they were already trying to phase it out, so I also had a 401k. At every other job since then, employees who had been there longer still had some kind of pension, but everyone was shifting to 401ks. So I'm guessing that for the past couple of decades, most retirees have had some combination of a defined-benefit plan and a defined-contribution plan to live off, but in the next few years, we will start to see growing numbers of people retiring on just their 401k plans. Will it turn out that they managed their savings well and have an adequate nest egg? Or will there be millions of people who, through bad planning, bad luck, or both, don't have enough money to live on?

12 comments:

LAMoneyGuy said...

I have seen people amass several hundred thousand in 401k plans. On average, of course, they were high income individuals who had maxed out their plans for at least the last 20 years or so. Even for them, it, alone, is not enough for retirement. Most have homes paid off, or significant other resources in order to retire comfortably.

Anonymous said...

I've been in the work force since 1976. I've been contributing to 401k plans since around 1987. With the company matches included I have amassed a balance of about $500k in my 401k accounts. But this is only a portion of the retirement funds I think I will need before I move into the retirement phase of my life.

I also have close to the same amount in a taxable investment account.

The equity in my home and cash accounts makes up another equal chunk. My goal for retirement is a a total net worth of $2.5 million (including home equity.) When I have achieved that level for 6 months running, it will be time to retire.

bluebird said...

See Alicia Munnell's Coming Up Short. It analyzes the question of how 401(k)s compare with traditional pensions.

You can get the Hedonic Adjustment review here.

Natalie said...

Well, considering how irresponsible most people are with their money, I wouldn't be surprised to find that 401ks don't work as well because they require some amount of vigilance and a willingness to contribute out of one's paycheck. There many who prefer to have the money now. And let's not forget what happens when you leave a job...don't you have the option to pull out of your 401k at a penalty? Sad, but people do it.

Anonymous said...

Of course, this ignores the fact that pensions only work if you stay at the same company for 30 years, which absolutely no company guarantees, and likely leads to less desirable career options and growth for people.

True, pulling money out of a 401k when you leave a job is dumb, but when you leave a job with a pension, for the most part, you get basically nothing, unless you were there for a very long time.

Average tenure at a job these days is under 3 years. There is no pension plan ever built that supports this.

Penny Nickel said...

Take a look at this interview from Brooks Hamilton, who was active in promoting the swtich to 401(k)s, and now regrets it: http://www.pbs.org/wgbh/pages/frontline/retirement/interviews/hamilton.html Among many other things, he talks about the "yield disparity" between lower-paid workers and higher-paid workers. It's a fascinating and troubling read.

(It's via this post from Make Love Not Debt: http://www.makelovenotdebt.com/2006/05/are_401k_plans_discriminatory.php)

And anonymous (@ 8:38pm), pensions must be vested after no more than 5 years (if it's all at once, or partial vesting that starts at 3 years and is full by 7 years). Obviously you're not going to get as much after 5 years as you would after 30, but if you have 5 years at one place, 5 at another, 10 at another...

Anonymous said...

Vesting after 3 years, or 5 years, does not help if the average tenure is closer to 2 years per job. That, and the amount a pension is worth after 5 years is incredibly small, given the pension math.

I'm not saying 401ks have everything solved, but the idea that pensions have any place in the modern workforce is not accepting the reality that people do not work for long stretches for the same company. Which, BTW, is a great thing for the economy, since the rapid growth of new companies is directly related to the ability of great people to switch to new companies that didn't even exist five years ago.

I think you'll find that 5 years at one place, 3 at another, 8 at another, etc would leave you with a pension that pays next to nothing.

Bitty said...

When I came to work at MyU four years ago, I signed up for the defined benefit plan. The human resources folks kept asking if I was SURE (and apparently I still get one more chance to convert to 401k-like system if I choose), but I was very sure.

Why?

Several of my relatives lived to be quite elderly; my grandmother recently died at age 93. I may not live that long, but I doubt I could accumulate enough wealth to cover more than 20 years of retirement, so I'll happily go with a plan that will guarantee me 40% of my base income after 20 years of employment. (Unlike some other workers, my movement from job to job is behind me unless they toss me out, which is unlikely.)

Maybe this is naive. Maybe. If I die at an early stage of retirement (or pre-retirement), I suppose I blew it.

But all of life is calculated risk, yes? And we base that calculation on what we know; I know I come from hardy genes.

Anonymous said...

bitty,
I hope that 40% guaranteed income is indexed for inflation. Otherwise, the payments will effectively decrease each year, to become virtually worthless if you end up living a long time.

Sep said...

"Average tenure at a job these days is under 3 years. There is no pension plan ever built that supports this."


Yes, but the absence of a pension may be a contributing factor to job hopping.

Anonymous said...

"Yes, but the absence of a pension may be a contributing factor to job hopping."

True. However, I would rather hop to a better job rather than being tied down to a lousy job by a pension. My father went through that.

samerwriter said...

The typical 401K account has a pretty serious shortcoming if you plan on leaving your estate to children.

If you die and leave your 401k to a non-spousal beneficiary, that beneficiary is generally required to take a full disbursement (and pay income tax on...) the entire account. Let's say you're paying a marginal 25% income tax rate while contributing to the 401k, and the person who inherits your 401k is paying a marginal 45% rate (federal + state). That's considerable value lost.

Even worse, estate taxes are determined by the pre-taxed portion of the 401k (though partially offset by an IRD deduction).

For this reason, it seems prudent to move funds from a 401k to a traditional IRA whenever the opportunity presents itself (generally when leaving a job). The traditional IRA can be passed on in a tax-advantaged fashion to beneficiaries.