Here’s a trivia question: what does Jay Leno, prescription drugs, the iPhone and the 401k all have in common? Answer: they’ve all appeared on recent covers of Time Magazine. Although I can sing lots of praise for my iPhone, I can’t say I share similar enthusiasm about 401ks and other retirement accounts like it.
Surprising to many, the 401k was never designed to be the vehicle meant to carry people through their retirements. Quite the contrary, the 401k was originally only meant to be nothing but a cash supplement to pensions, not a replacement of them.
Back in the seemingly ancient days of pensions, many workers retired with their pensions well intact but a problem existed in that they often had limited cash reserves to supplement their monthly checks. To solve this problem, back in the late 70s Congress created what was supposed to be nothing but a minor provision in the tax code that allowed employees to take a percentage of their income, contribute it into a 401k and defer the tax so that when they retired, they’d have this “side fund” of savings to draw from.
The theory of giving workers a retirement side fund sounded great until corporate America found a self serving opportunity nested within it. After all, designing and managing pensions required additional staff, they were costly, risky and carried lots of responsibility. As such, many corporations found a way to cut costs and risk by shifting the responsibility of lifelong retirement income to their workers through the framework of the 401k (and other types of IRS qualified plans such as 403bs, TSAs, etc.).
I don’t know about you but if I wasn’t in the profession I’m in, I highly doubt I’d have much time to understand how to essentially be my own pension manager. To place this responsibility into the hands of the public who understandably has limited time and resources to be their own pension managers is just simply unfair and negligent. Furthermore, as we’ll soon find out, even if someone does successfully manage their own 401k to perfection, the chances of success are minimal at best given these plans are now being asked to do a job they were never intended on doing in the first place.
Let’s take a closer look.
1. INADEQUATE INCOME
Let’s take a hypothetical 40 year old named “Dave” who earns $80,000 per year and who is doing a heroic job of contributing the maximum amount allowed into his 401k. Contributing $16,500 per year (inclusive of a match) and miraculously achieving a steady 7% return each year less fees (soon to be discussed), at retirement age 65, Dave should end up with around $780,000 in his 401k.
Once retired, an important question then arises: how much income can he expect to receive from his account without outliving it?
The answer can be found in something called the “Withdrawal Rate,” a general rule of thumb that market historians and financial planning professionals generally agree to. The answer as to how much income one could safely generate from their account without outliving it is approximately 4% of its value. Any more than that percentage, then the chances for success are significantly decreased. True, an account might very well earn higher returns, but one needs to maintain a cash cushion for the bad years as well as the good, hence the lower-than-market-average Withdrawal Rate.
With the Withdrawal Rate in mind, the income Dave can expect to receive comes out to approximately $33,000 per year, which comes in at far less than a typical pension would have likely produced at around $58,000 per year (70% of his current income of $80,000; less if the pension is also established to cover a spouse).
If you’re interested in some quick rules of thumb that can help you determine the end result of your efforts, just follow this simple guideline:
Assuming a 7% growth rate less fees of 1.5%, simply take the amount being contributed into the retirement plan, then follow the math:
* If retirement is 15 years into the future, the gross amount of income you can expect to receive is 1x the amount being contributed. As an example, if $10,000 is being contributed, based on the 4% Withdrawal Rate and other assumptions just mentioned, you can expect to receive a before-tax income of $10,000 in your first year of retirement.
* If retirement is 20 years into the future: income will be 1.5x the contribution amount.
* 25 years in the future: 2x the contribution amount.
* 30 years: 3x the contribution amount.
(If there is a company match, simply increase the results by the match percentage).
Although not perfect and exact, the results will at least give you a general idea as to the results your efforts can generally be expected to produce. Of course, all this should be considered hypothetical and for example only.
Doesn’t sound too good? … It doesn’t end there. There’s something else that obviously needs to be taken into account:
2. TAXATION
The above income is all before-tax. Given money withdrawn from these plans and others like it are usually fully taxed as ordinary income, let’s assume when Dave retires he is in a modest 30% bracket. With this factored in, the net income for Dave would be somewhere around a mere $20,000, which basically equates to purchasing power of around $10,000 when adjusted for 3% inflation.
What chances does he have to survive on this level of income? The answer is most likely, “not much,” and hence, the conclusive reason why even in his near perfect situation of maxing out his contributions and achieving steady market returns without loss, using a supplemental plan such as a 401k to replace a pension can’t be expected to yield much success.
3. MARKET RISK
In a recent segment addressing the problems with 401ks, 60 Minutes summarized the risk issue quite well when asking, “What kind of retirement account allows people to lose 50% of their money the moment they are due to retire?”
4. COSTS
Different sources report varying costs but if I had to filter through all my research, I feel comfort in estimating total annual costs in the typical 401k, 403b, TSA, etc. coming in at around 1.5% – 2% per year. In many cases I’ve seen much higher. Just check out this astonishing Bloomberg report. To some, 2% might not sound like much, but if you earn an average gross return of 7% each year, 2% of those earnings equates to giving up nearly 30% of your gains. Ouch.
5. PERFORMANCE
Most retirement accounts such as 401ks, 403bs and others are comprised of a menu of professionally managed mutual funds. While I am not here to say negative things about funds, the fact of the matter is that the majority of them fail to outperform the static, low cost and unmanaged indexes they are benchmarking their returns to.
SOLUTIONS?
Some say pointing out the problems is easy, but what about the solutions? I have a couple of ideas to share, some of which are basic and others I know are creative and things you may have not heard before.
Stay tuned. I’ll detail them in my next post soon to come….
The entire three-part series of The Trouble With Retirement Plans appeared in the American Institute of Certified Public Accountant’s newsletter. You can download the entire three-part series here: The Trouble With Retirement Plans
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Dude… good post! I might actually even listen to what you are saying. Overall your whole blog is great… I am digging it. Peace!
Thanks for making my day