"The 401(k) will turn out to be the greatest systemic financial hoax ever perpetrated on an unsuspecting public."
- William Wollman, The Great 401(k) Hoax
Like most people I was told to plow as much money into my 401k as possible. So like millions of other workers out there, I did as I was told. By 2003 I had accumulated a nice little nest egg...that I couldn't touch.
Then one day I was in a bookstore and I happened across a book called The Coming Generational Storm. What I read about 401k's that day made me immediately stop all contributions.
Since then I came to realize that the 401k model is hopelessly flawed and will lead an entire generation to despair.
Author Laurence J. Kotlikoff made two points that were simply too logical for me to ignore:
1) 401k money is tax-deferred, not tax-free. Therefore, by putting money into a 401k and getting the tax break now, you are making a bet that taxes will not be significantly higher a couple decades from now when you retire.
Will taxes be significantly higher when you retire? Unless the federal government simply defaults on its Social Security and Medicare promises then taxes will have to be raised significantly. Even if they aren't, 401k's are a very questionable investment for the lower and middle class.
The lifetime tax increase and spending reduction experienced by low and moderate income
households from participating fully in 401(k) and similar tax-deferred vehicles arises for three main reasons. First, withdrawals of tax-deferred balances push households into higher tax brackets in old age. Second, contributions to tax-deferred retirement accounts lowers one's tax brackets when young and, consequently, the size of the tax break from itemizing mortgage interest and other deductions. Third, and most importantly, withdrawals of tax-deferred balances when old can trigger much higher levels of Social Security benefit taxation under the federal income tax.
As can be verified in Table 12, for a young couple with $50,000 in initial annual earnings that earns a 6 percent real return, partaking fully in the typical 401(k) plan raises lifetime tax payments by 1.1 percent and lowers lifetime expenditures by 0.4 percent. The lifetime tax hike is 6.4 percent and the lifetime spending reduction is 1.7 percent for such households if they receive an 8 percent real rate of return. These figures rise to 7.3 percent and 2.3 percent, respectively, if taxes are increased by 20 percent when the couple retires.
Kotlikoff then goes on to elaborate that couples making $300K a year get a larger tax break (as opposed to middle-income earners) from participating in a 401k. This disparity is a legacy from the Reagan's Administration, where they cut progressive income taxes, while raising regressive payroll taxes.
2) All of those Baby-Boomers are expecting to use those stocks and bonds to fund their retirement. To put it another way, starting next year and increasing every year after that for more than a decade, the number of people who were buying stocks and bonds are increasingly going to be selling those stocks and bonds (the WSJ estimate $300 Billion a year, every year).
For someone like me, still more than two decades away from retirement, that means all my investments on Wall Street are going to be coming under increasing selling pressure. What kind of return on investment (ROI) can I really expect when the number of people only selling stocks and bonds increases by several million every single year? Some say that foreign investors will snatch up those stocks and bonds. But with almost all of the industrialized world (and China) aging at the same time, the context isn't rational.
The simple fact of the matter is that the bull market in stocks and bonds of the 1982-2000 period isn't going to be repeated in our lifetimes. Instead, a long-term bear market is much more likely.
The Problem With 401k's
401k's were meant to be a supplement for pensions, not a substitute.
So the question arises: what if he lives longer than average? This is the beauty of a pension or of any collectivized savings pool. The pension plan can afford to support people who live to 90, because some of its members will expire at 66. It subsidizes its more robust members from the resources of those who die young. This is why a 401(k) is not a true substitute.
The drawback to 401(k)'s, remember, is that people are imperfect savers. They don't save enough, they don't invest wisely what they do save and they don't know what to do with their money once they are free to withdraw it. Quite often, they spend it.
And spend it they do. Companies are now offering 401k Debit Cards. Like home equity, the 401k has now become just another ATM.
What most of these workers don't know is that fees, rebates and revenue-sharing agreements among employers, 401(k) administrators and mutual funds -- many of them buried in the fine print or not disclosed at all -- are slowing the growth of their nest eggs. The U.S. Department of Labor lists 17 distinct 401(k) fees, including ones for record keeping, legal services and toll-free telephone numbers.
Hidden fees of 1 percent can reduce a worker's 401(k) returns by about 15 percent over 30 years, says Stephen Butler, president and founder of Pension Dynamics Corp. in Pleasant Hill, California, a 30-year-old retirement plan consulting firm.
"The 401(k) system today in the United States has been an acknowledged failure."
- Alicia Munnell, director of the Center for Retirement Research at Boston College's Carroll School of Management.
Here's a list of the most common fees:
a) Management fees
b) Administrative fees
c) Distribution fees (the top three usually averaging about 1% a year)
d) Sales loads (often averaging 1.4% a year)
e) Trading costs (averaging .5-1% in an actively managed fund)
f) Excess capital gains taxes when a portfolio is turned over
"More and more Americans are relying on 401(k) plans to provide their retirement income. In spite of that, there are few requirements for fund managers to tell participants how much they are paying in fees."
- Wisconsin Democrat, Herb Kohl
Of course that isn't anywhere close to being a complete list.
The 401k financial industry actually defends their right to keep you and me in the dark.
The American Benefits Council, which represents sponsors of the plans and the companies that administer them, says it's not a good idea to tell investors too much.
"If they're overwhelmed by the amount of information they receive, there is the danger that some won't participate," says Jan Jacobson, legal counsel for retirement policy at the council.
I don't know about you, but the gall of someone telling me that I should stay ignorant for my own good just burns my chaps. Do you think the tobacco companies tried to rationalize smoking in the same way?
All these fees are a mystery to an overwhelming majority of Americans.
According to a poll sponsored by AARP, 83% of workers don't know how much they pay in such fees -- and most do not realize they pay any fees at all.
To assess the toll of such fees, consider the case of a 30-year-old worker with $25,000 in a 401(k) plan. If that account earns 7% and incurs fees of 0.5% a year, without another contribution, the total payout to that worker at age 65 would be $227,000. However, if that same account incurs fees of 1.5% a year, the extra 1% would shave off $64,000, or 28%, of the payout, which would be reduced to $163,000.
Of course fees of only 1.5% is an optimistic scenario. Of the nearly $3 Trillion in 401k funds last year, there were $89 Billion in fees. That comes out to about 3%.
The complaint, filed in U.S. District Court in East St. Louis, Illinois, alleges that in addition to $1.2 million of disclosed fees that International Paper pays for its workers' 401(k) plans, employees pay $3.6 million through undisclosed fees plus millions of dollars in revenue sharing.
The vast majority of 401k cash is invested in mutual funds. As Gregory Baer and Gary Gensler explain in their book "The Great Mutual Fund Trap", this is not good news for the small investor.
"Over a five-year period, only about 20% of actively managed stock funds perform well enough to earn back their fees and loads. In five more years, it will be a different 20% that accomplished the same task."
"Stock and bond funds impose $100 billion in costs annually on their shareholders in the form of management fees, sales loads and Wall Street brokerage fees for trading."
Another problem with using a 401k to fund your retirement is the simple lack of available profits in corporate america. As explained in "The Great 401(k) Hoax": "The top 1 percent of the population owns just under 50 percent of stocks; the top 10 percent owns 85 percent...the amount of dividends available to the rest of the population is a scant $55 billion. This equals roughly $225 per person, per year."
The biggest problem with 401k's in my opinion is the illiquidity of them. Once you have money in there you can't get it out without leaving your job. And even then you are faced with daunting penalties. No professional trader would ever put his life savings somewhere that he couldn't cash out when he needed to.
What do I do?
Right before the Republican Congress was voted out, they decided to make that decision for you.
Late Thursday night, Congress passed a pension-reform bill that will transform significant aspects of how these plans can operate. Named for the section of the tax law that created them, 401(k) plans let workers sock away part of their paycheck tax-free until retirement. The problem is, too many people are making bad decisions, such as leaving their money parked in low-yielding investments instead of more suitable choices.
Hurray! We have been freed of making bad choices. And here's the good part.
Meanwhile, the Labor Department, which regulates the plans, is on track to let employers automatically put their employees' money into riskier, but higher-yielding, stock and bond funds rather than low-yielding money-market funds that have long been the default option.
Boy, I'm relieved. I was going to invest in something safe, but now my employer can buy, say, higher-yielding, subprime, mortgage-backed securities with my money without bothering to tell me ahead of time.
Before I go any further, I haven't mentioned matching funds. If your employer matches your 401k contributions, then many of these numbers can be thrown out the window. For instance, if your employer matches 100% of your contributions then fees are not longer an issue because your employer covers that and much more.
OTOH, if you work for an employer like mine, you don't see any matching done and those fees become a huge issue.
In the end it comes down to a personal choice: Do you trust your own instincts and ability? Or do you trust Wall Street? Wall Street is betting on you being lazy.
Once people are in a savings plan, that same inertia might work to keep them there.
"It takes some effort to look up a phone number and call someone in the plan and say no," said John Matthews, senior vice president for human resources at retailer Costco's headquarters in Issaquah, Wash. "Most people won't."
They could be right. Because if you weren't lazy you would realize that you could invest your hard-earned money better than they will, and at a discount. But you have to educate yourself first. Will you?