I’m tired of all the people saying bad things people are saying about 401K plans. I don’t mind if you say that fees can be too high (they are in some plans) or that your investment choices may be too limited (again, guilty as charged for some plans), but don’t say that they are not as good as standard pension plans, and certainly don’t say that Social Security is better. As with most anything having to do with investing, and especially retirement investing, the problem isn’t the plan, it’s the actions of people using the plans. People do dumb things and then blame the 401k plan idea when they get to retirement with no money.
The truth is, a 401k plan is far safer than a traditional pension plan because you are in control, and no one has your best interests in mind as much as you do. Pensions are often seen as safer because they have a “guaranteed benefit,” meaning that they are supposed to pay out a specified amount when a person is retired, where a 401K is a “specified contribution” plan, where the company puts a certain amount into the 401k plan and then the benefits are whatever money is in the 401k account when you retire. The ability for a pension plan to make those guaranteed payouts, however, depends on the company you are working for doing its part and making contributions to the plan as needed. Just as with individuals, when things get tough contributions to the pension plan may lag as they divert money to keep the lights on and suppliers paid. It also depends on you holding onto your job until retirement since most of your retirement payout will often depend on your salary a few years before you retire. If your company goes under, lays you off, or just decides to change the rules on the pension plan, you may receive hundreds of thousands of dollars less in retirement.
In many cases, the ability of a company to pay out benefits from a pension plan also depends on the stock market since many plans invest in the stock market. (This is actually probably better than them investing in their own company since when that is the case you’d have all of your retirement in a single company – not a good idea!) It is true that pensions are guaranteed by the government should the company fail and not be able to meet its obligations, but the benefits guaranteed by the government can be pennies on the dollar since there are limits to the coverage the government provides. With many public pensions in trouble and the $18T in public debt outstanding, not to mention the wave of retirees now drawing Social Security and Medicare, the huge amount of health benefits and premium subsidies being paid under the Affordable Care Act and expanded Medicaid, the dangerous nature of the world caused by weakness by the US that may result in an expensive and prolonged wars, the ability of the government to continue to serve as a backstop for pension plans also needs to be called into doubt.
The rate of return for pension plans is also at best equal to the mediocre returns you will get in a 401K plan if you invest heavily in bonds and income assets throughout your working career. With proper investing for your age, meaning being mainly in stocks and growth assets until you are within about 10 years of retirement, you can enjoy a lot more wealth when you are ready to retire with a 401k plan. It is in the company’s best interest to invest in such a way to preserve capital in a pension plan since they will need to add a lot more money to make up for shortfalls should the stock market fall and then drag for a number of years. They will therefore tend to have a lot of money invested in bonds and solid income producing stocks, much as a sixty-year old would do, and a limited amount fo money invested in the young growth stocks that should play prominently in a 20-something’s portfolio.
An investor in a 401k, however, who is in his twenties or thirties could (and should) have most or all of his money in growth stocks since it means nothing to him if his 401k value doesn’t grow at all for several years. That just means that he can buy more shares at lower prices, knowing that eventually the growth in the companies in which he is invested will cause share prices to rise. As the investor ages, and particularly when he is a few years away from retirement, he needs to start putting more money into cash and income investments to preserve the wealth he’s created and generate the income needed for expenses.
So, why do 401k’s get a bad name? The answer is generally that people don’t use a 401k as they should. Here are common behaviours that lead to a retirement of cat food
1. Making withdrawals from a 401k before you are retired. I can’t count the number fo times I’ve read an article in Money magazine about someone who had quit their job to start “the business of their dreams” when they were in their forties or fifties. And where did they get the money to start this dog grooming business or tiki bar? They withdrew the money from their 401k, paying all of the taxes that come from jumping their income by $100,000 in a year plus a 10% penalty for withdrawing the money early. Given that most small businesses fail, this means they are probably back at their old job five years later but with no 401k savings. They then only have 15-20 years to rebuild their retirement savings instead of enjoying the phenomenal growth that occurs when you have a couple of hundred thousand dollars invested and start making tens of thousands or even hundreds of thousands of dollars per year on good years. You wouldn’t be able to go and withdraw your contributions to your company’s pension plan, so why would you think that making such a withdraw from a pension plan would be a good idea?
2. Putting money into money markets and other bank investments before the age of 55. You may think that having your money in the bank is safer than being in the stock market, but there is a little thief called inflation that is taking 1-2% of your money away each year that you have it in bank assets. Worse than that, by being in the money market option, you are foregoing returns that will average between 10% and as much as 15% over long periods of time (10 years or more). Returns like this will double your money about every 7-10 years, versus waiting 35-70 years for your money to double in a bank account. There will be years when your portfolio balance is way up or way down, but over time you’ll do a lot better being invested primarily in stocks than in bank assets.
3. Being too aggressive going into retirement. Being too timid when you are young is bad because it allows inflation to rob you of the money you’ve put into your 401k plan and reduces the return you’ll get on your investments dramatically. Being too aggressive when you are nearing retirement age exposes you to the risk of a big loss that could dramatically affect your ability to raise needed money from your 401k account during retirement. An investor who was 50% in stocks and 50% in bonds during the 2008 market meltdown would have seen about a 20% drop in his account value. One who was 100% in stocks would have seen a 40% decline. One who had put five year’s worth of expenses in a money market fund could have simply used the cash during the next year or two while the market recovered to its previous highs. Unless you have way more in your portfolio than you need to sustain you through retirement, like you have $10M or more, you’ll need to pare back your exposure to stocks when you’re nearing retirement. Between five and ten years out from retirement is the time to start raising the cash you need for the first several years of retirement and/or shifting into income assets like bonds to generate income and reduce the effects of gyrations in the stock market.
So get smart about your 401k investing and stop blaming the plan for dumb behaviour. Quit using your 401k like a piggy bank, be aggressive when you’re young, and be timid when you’re old.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.