A few weeks ago, I wrote on this topic. I have been kind of consumed with it lately, as it’s the topic of my next book and where my practice is focusing at the moment. The reason is because it’s where I think I can provide the most impact. After all, who isn’t confused about their 401k?
As you may imagine, when I initially published this column, I got feedback. Not much of it was friendly, though some was. Mostly though, people were confused. “If they’re so bad, why do so many people have them?” was a common thread. As was, “what about tax deferral?” And, “shouldn’t I max out the company match?” It began to dawn on me – sometimes I’m a bit slow – that perhaps more clarification is warranted.
So, in order. Why do so many people have them?
Easy. Money. Trillions and trillions of dollars. $14.2 trillion, in fact, including traditional IRAs, SEPs, and the like. Call them investor-directed defined contribution plans. Money is clearly why we have them. When the 401k language was included in the Revenue Act of 1978, Congressman Barber Conable was doing a favor for Xerox and Kodak, two large employers in his district. They wanted to provide a benefit to their senior executives, and were looking for a tax shelter that allowed them to defer compensation until they retired and were in lower tax brackets. That’s why it was introduced, not to create a new model for retirement.
It wasn’t until benefits expert Ted Benna discovered the language, and approached the Reagan administration to include all employees as well as tax deductions on employee and employer contributions, that these began to take hold as something for the masses. But it was all about money. Companies adopted them because they saw a way to get out of unaffordable and unfunded pensions. Benefits specialists started marketing them because they recognized the opportunity. Besides, if you could sell a company rather than just a single individual, you got many clients for the same basic effort. In addition, they were still able to leverage the fees; the average plan administrator charges around 1%, the same charges the typical advisor charges individual clients, with less work. What’s not to love? The mutual fund industry saw a natural fit and potentially bottomless well of renewable money that could go on for decades. Congress was on the receiving end of billions in lobbying money. And we were sold on the idea of control of our destiny using tax deferred assets, and getting free money from our employers to boot.
So how has it worked out? The average 401k in this country has $18,000, and the average 65-year-old something under $100,000 put away. But what about all those trillions? Well, there are 70 million of us baby boomers getting ready to retire. If everyone had $200,000 saved, that’s $14 trillion. And obviously it’s more than just boomers who own them.
We have also discovered we are not very good at investing. Dalbar, a Boston-based research firm which reports on investor behavior each year, reports that the 30-year return from the S&P 500 is 10.16%. The average equity investor came in at just 3.98%. Fixed income investors didn’t do much better. The Bloomberg Barclays Aggregate Bond Index showed a 6.34% average return during that time frame. Again, the average investor came in way below: .57%. So, tell me, why are we paying the financial industry so much of our money in fees? What are they doing to earn 2% – 5% a year—the common estimates, including 401k administrators, mutual fund companies, individual advisors and brokerage firms, and everyone else who has their fingers in this massive pie (this includes the 2%-plus the industry owns up to charging, plus the hidden fees and costs it does not. But that’s not the only cost we bear.
Tax cost is huge. Tax deferral made a lot of sense back in the late 70s when the top marginal tax rate was 70%. This was a plan put in for the highest earners at two of the country’s largest employers, so it made a lot of sense that they wanted this. But when your effective tax rate is only around 15%, how much does this help, or even hurt? I recently did an analysis for a high-earning client. They had started contributing to a 401k about 20 years ago when they were in their mid-40s. At the time, they were making around $95,000, and today are something north of $170,000. Over the years, they have been contributing about 10% to their 401k, and have a 4% match (one-half of the first 8%). What’s the net benefit?
Total taxes saved while working was around $67,000. Total company match, compounded at 7% (the standard estimate of market returns over time) was around $272,000. That’s a total benefit of $339,000. Pretty good. Now, however, we have to look at the cost of that benefit.
Their plan is to withdraw about $50,000 a year from their 401k. Add to that one-half of their Social Security, and you get a provisional income of about $83,000. That’s over the $44,000 threshold for married couples, meaning 85% of their Social Security benefit will be taxed. Taxable income is therefore projected to be around $83,000 with deductions, and expected to grow at around 3% a year. If tax rates stay what they are today, after 20 years, they will pay $323,784 in taxes. Subtract from that the $339,000 in savings, and it nets out to a little under $17,000 in lifetime benefits. Not much to show for a lifetime of limited access, high risk, and high fees, which were not even calculated into this. And, if the company match had been any less, they would have had a net negative, not a net positive, less any fees, losses, etc., they may have incurred.
The bottom line on all of this is the 401k was not designed for what it is being used today; a retirement plan. It was designed as a tax shelter for wealthy people at the top of a burdensome tax structure from four decades ago. If you want to have a retirement plan that makes sense, you might be better off finding a program that was designed to be one.