401(k) Reasons to be Skeptical
The devotion people have towards their 401(k) plans approaches the religious – commentators on television offer tips upon managing it, many different gurus say different things about it in mountains of books, beliefs in it don’t always work out as planned, and any time the beliefs are questioned someone writes a rebuttal urging the faithful to hold on just a bit longer because the Rapture-tirement is coming and we’ll need to be prepared for it. The parallel is frighteningly exact.
Few skeptics, however, seem to question financial matters like the 401(k) – which is odd because we all deal with them daily. In many ways it’s difficult to conceive of something more relevant to modern life than finance, atheists may get along without religion but nobody can get along without money. It is the glue that holds modern life together, and as such the lack of attention paid to it is peculiar. In particular, one can pose serious questions about the utility of the 401(k) plan as a method of retirement preparation.
The benefits of the 401(k) are trumpeted so often as to make them readily recognizable: tax-deferred contributions and employer matching. Tax-deferred contributions essentially means that all contributions to the plan are paid with pre-tax income, meaning that if you contribute $5000 out of a $45000 salary, you will only pay taxes upon $40000 worth of income. This allows for more money going in to the investment vehicle (usually a mutual fund) you select. Employer matching means that the employer will match the amount you contribute to your 401(k) plan, doubling the overall amount of money going in to the plan each year.
These seem like excellent advantages to have, but some analysis leads to different conclusions. The tax-deferred contribution approach is nice, but requires payment of taxes upon withdrawal of the money – essentially forcing one to abide by the fond hope that taxes will not go up. Over a 40-year working life, this seems very unlikely. There is also no guarantee that your employer will match the exact amount you contribute (this is handled individually by each employer), some will match up to a certain percent of your yearly salary while others have a flat cap. Using the $45000 salary from earlier, an employer willing to match up to 5% of a yearly salary will pay in $2250 – significant certainly, but much less compelling than “doubling incoming money” would sound.
One of the main advantages to financial discussion is that numbers matter, for money is valued entirely by them and not by words. This allows for mathematical depictions of points of contention, so I have created a spreadsheet which depicts a fictional 401(k) scenario. I make no particular claims about its resemblance to the situation of any real person, in fact in many ways it is too good to be true. What mutual fund, for example, could guarantee 10% returns per year for 40 years? If you find one willing to make this guarantee, let me (and everyone else) know.
The “Don’t Give Up Yet” article mentioned above makes one rather peculiar claim, which is that “if you lost less than a third of your portfolio (in the recent bear market), you fared reasonably well.” Taking this claim at face value, one-third of the spreadsheet account’s total value after 40 years is $879,941.71 gone. In the best-case scenario, this is the approximate value gained by the 401(k) over the most recent four years of its growth. In the worst-case scenario, this is equivalent to approximately twenty-eight years of work.
Or is it? I submit that analysis of the money gained by the 401(k) from contributions versus that gained from interest leads to the inescapable conclusion that the magic of compounded growth is at work. Consider the numbers in the spreadsheet again: the account reaches approximately $1.3 million, half of the ending value, after thirty-three years of work. This exponential growth pattern is a clear indicator that the operating variable is time. Further, by the eighth year the total value of employer and employee contributions represents less than one eleventh of the total value of the fund, and by the thirteenth year this percentage has shrunk down to approximately one-twentieth.
I humbly suggest that the 401(k) does not represent financial planning, in fact it represents the polar opposite. Very little planning is actually being done by the account holder, and what there is generally runs along the line of “I should open a 401(k).” Once the account has been opened, it is managed by someone else, which further isolates the holder of the account from the funds contained therein. Further, the recent bear market has realized several tactical weaknesses in the structure of the plan that seem to have passed many by during the 401(k) boom. I submit that it is demonstrably clear that the 401(k) plan cannot be relied upon to provide a stable retirement income acting alone. Any attempt at saving for retirement may use a 401(k) plan as an element, but relying solely upon it no longer seems wise, if it ever did.
And then, of course, there are the 401(k) plan fees…
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More than just 401(k)s, you have to be skeptical about all financial advice — particularly stuff you see on television, in books, in magazines like Time, in blogs, and from financial advisors you talk to. There really is no substitute for learning about investing and human psychology (particularly your own).
That said, don’t be too quick to dismiss 401(k)s. They may be over-hyped, but I think that’s largely because they are under-utilized: there is a significant number of people who are eligible for them that don’t enroll, and most of them also don’t use any other method for setting aside money for retirement… which is even more foolish. Even a mediocre 401(k) plan is better than not investing for your retirement at all.
The main reasons I can think of for treating a 401(k) as essentially a “no-brainer” are that it automatically deducts money from your paycheck (so you can’t spend the money instead of investing it), and the employer match (if your employer offers such a match – it is essentially “free” money, even if it’s not much). The tax advantages may not sound too compelling if you’re not already in a high tax bracket, but since future tax rates are essentially unpredictable, I wouldn’t worry about that so much. You’re probably still better off over the long run because the money you invest today that would otherwise have been paid in taxes would have more time to work for you (via that not-so-magical compounding). Enhancing your spreadsheet to compare pre-tax vs. after-tax returns should show a significant difference.
And yes, anyone trying to sell you an investment opportunity that claims to return 10% consistently over 40 years is probably a scam artist. Fortunately, there are tools out there that can run much better simulations, although even then, you have to review the assumptions in the models they use and examine the results skeptically. Those simulations should at least give you a range of results based on varying levels of returns over time, and should also account for inflation, which is your real enemy in retirement investing.
Anyway, I think your main point is a good one. If there is anyone out there who believes that just opening a 401(k) account is sufficient for ensuring a comfortable retirement, then they are misinformed. As with most things in life, it’s a lot more complicated. Perhaps someone should start a skeptical investing blog… or is there one out there already?
I’m not sure I agree with your contentions about 401(k)s, Mr. Madison, nor do I think I am being “too quick to dismiss it” – in fact, this dialogue most probably represents more discussion about 401(k) plans than most people ever have. It’s sold and apparently handled as a “start and forget” plan using these automatic deductions you mention, and for this I think it a very strange idea to begin one. As someone who contributes to the under-utilization you reference by not having one, I’d like to explain more why I don’t have, want, or intend to get one.
First, what exactly constitutes “free money” in this context? I was surprised by this choice of terminology since it’s hardly free – you’re still working for it, unless you’ve found an employer who’s willing to pay you for not working. Arguably it costs you, because it’s money the employer can’t pay you as it’s going into your 401(k). It’s not “free” so much as it is “protected,” but the idea of my money being protected from me is certainly a peculiar one. To be honest I’m not sure how to respond to the claim of “automatic deducting is an advantage” – if one lives in the present by refusing to control one’s spending habits, why worry about investing at all? In this specific instance automatic deducting appears to be a negative rather than the positive.
Secondly, invocation of time (as you do when suggesting “future tax rates”) invariably results in inflation becoming a problem. Assuming a 3% inflation per year, the value of a 7% return is cut nearly in half, and more still once the fees are assessed. This does not leave much room for tax calculations, but I think you would agree that the unpredictability of tax rates makes it equally foolish to assume they will go down?
The idea of simulations that you promote is interesting, if probably impractical for the home user. It seems logical that a large investment firm would be able to afford a better simulation, and the people to run it, than I would. Further, “reviewing the assumptions in the models they use” requires a phenomenal understanding of both computer programming and the stock market – if I had both of these, I’d think I could invest better on my own than I could with a 401(k).
~ Matt
Employer matching funds are “free” inasmuch as they are paid to you without you having to do any additional work. I don’t see how it can be that hard to understand. Funds in the 401(k) do belong to you, even if you can’t spend them immediately.
If you aren’t concerned about how you’re going to pay for your living expenses when you retire, and only worry about living for today, then I suppose automatic deduction could be considered a negative. If you’re lucky enough, for example, to have a rich uncle who is going to leave you with enough money to live on for 30+ years while you can’t work, then yes, you probably don’t need to worry about a 401(k) or any other retirement savings.
Income tax rates have gone down in the past; they’ve gone up, too. It really is entirely impossible to predict what they will be. But rates going up or down isn’t really relevant to the tax advantages of a 401(k) or an IRA. If you do all your investing in a regular, taxable investment account, you will be paying income taxes on any dividends and capital gains when they happen. So your investments have to be earning enough to pay those taxes, and beat the current inflation rate, to be making any money for you in real terms.
With a 401(k), not only do you not pay income tax on the money you set aside from your paycheck (or any employer matching funds), the gains made on the investments also accumulate tax-free. Only when you reach retirement and start withdrawals do you start paying any taxes – regular income tax only on the amount you withdraw. Even if you don’t wind up in a lower tax bracket when you retire than the one you were in just before retiring, it’s probably still a good deal, tax-wise. A Roth IRA is generally considered an even better deal, since they have the same tax-free gains as a 401(k) (or a traditional IRA), but withdrawals from a Roth IRA are not taxable (because you fund a Roth with money you have already paid taxes on). But not everyone qualifies for a Roth IRA, and the contribution limits on IRAs are substantially lower than on 401(k)s.
My employer’s 401(k) has been run by a couple of different investment firms, and they both have had retirement planning tools that do the kind of simulations I was talking about. Yours may, too. The ones I’ve used spell out, in English, the assumptions that are made in their models, so you don’t have to be a computer genius to understand them. You do have to have some understanding of money and investing, but you don’t have to be an expert. Investment companies usually offer IRAs, too, so check on-line and look at the retirement planning section of their web sites; you may be able to get access to the simulation tools without even being a customer.
As I said before, I agree with your fundamental point that 401(k)s aren’t the be-all, end-all of retirement planning. They are one of a number of ways one can save for retirement. What options are available to you, and which of those makes the most sense to use, will vary based on your specific situation — income level, years until retirement, specifics about the 401(k) plan your employer offers, etc. It is complicated, and not something you can set and forget. It’s something you have to review and adjust periodically and as your specific situation changes.
So be skeptical about it — and that means being as informed as you can, and not just buying into a 401(k) because of the hype, *or* rejecting 401(k)s because you’re suspicious of the hype. Make the right decision for the right reasons.
After posting my last comment, I noticed that the second paragraph sounded a bit glib. Obviously, if you are just making enough money right now to cover basic necessary living expenses, then saving anything for retirement should come after those necessities. Of course, different people have different ideas about what they consider necessities, too, but that’s another topic altogether.
My employer’s plan offers an age-indexed fund that allows lower-confidence folks a more viable form of “set it and forget it”. For example if you are going to retire between the years 2020-2025 you can choose a fund that is intended to reduce the risk as the year 2020 gets closer. The funds that have a longer period are more aggressive. I’m sure it is not perfect, but as Matt said it is better than not saving for retirement at all.
I assure you, Mr. Madison, that I quite comprehend what you are attempting to say. I think, however, that we vastly disagree upon our definition of “free” – I maintain that it is hardly “free money,” at best it might be argued that employer matching is more akin to a bonus that’s invested for you. I think it very possible to question how good of an investment it really is, however.
Further, I am not sure how I am “rejecting 401(k)s because (I’m) suspicious of the hype” – I’m rejecting it based in large part upon the spreadsheet calculations mentioned in the article. I do not see how this qualifies as a “good investment” under those terms, in fact it seems pretty bad – and I would wager that the spreadsheet is overgenerous with regards to returns. I am not inclined to accept less than what is possible.
Be very cautious, Allecher, when seeing the phrase “risk reduction” – far too often it involves offsetting risk with gains, meaning that just when the fund is growing the most your percentage returns will lower. Admittedly there are other ways to reduce risk in a portfolio that don’t directly cost gains, in many plans the profit percentage can’t much strain. Many people are afraid of risk in a portfolio, seemingly desirous to ignore that risk always exists. I should think it far better to learn to manage risk…
mehacton: I can only say again – do some more research. Look at some real calculations, not the simple spreadsheet that you worked up. It isn’t telling you much of anything useful, and it sounds to me like you made up your mind and then created the spreadsheet to confirm your conclusion, rather than really addressing the issue skeptically. I could be mistaken about that, of course, but I’m basing that opinion on what you’ve written and how you’ve responded, which is really all I have to go by.
I am not sure what you mean by “real calculations,” Mr. Madison, but it is clear you dislike my spreadsheet because it is “simple.” Indeed so – in fact, I specifically referenced that it was probably unreliable and too good to be true. Very well, if you don’t like my numbers let’s try Bloomberg’s.
Contributing $2000 a year for 30 years at a $40000 annual salary, the Bloomberg calculator concludes that one would have $627,964.71 left in retirement. If the plan is begun at 22 and the person retires at age 52, he can expect to have $627,964.71 in his plan. Simple division suggests that this is enough to sustain the plan’s creator for roughly 15.7 years. This will last him until approximately age 68, at which point he will have, on average, ten years of life remaining with no 401(k) money. This hardly seems like a good idea to me, but admittedly most of the problems are caused by the time duration (as, again, I mentioned in the article). If retirement is delayed by ten years, the value of the plan jumps to 1,636,273.54, further suggesting that the magic of compound interest is at work. Some more division provides that this is sufficient for roughly 41 years of 401(k) money, well beyond the average age of demise. Clearly, time matters a great deal.
It seems to me, Mr. Madison, that you quite unfairly criticize me for not doing sufficient research. I should point out to you that, throughout this entire discussion, it has been me providing research and numbers, while you at best provide joyous words of praise for employer matching and dicker with me about the definition of “free” with regards to money. This seems a most unfair criticism, and essentially resolves down to “you disagree with me so you’re not skeptical like I am” – something I hope we are both far above. Further, I suggest that many of the people in the “Why It’s Time to Retire the 401(k)” article also hoped a 401(k) would benefit them in retirement. For your sake, I hope you’re right.
~ Matt
The research and numbers you are providing do not support what I thought your argument was: that 401(k)s are generally a bad investment vehicle, relative to other options for building one’s retirement savings. You haven’t mentioned what options are available or how they compare against each other qualitatively, and the numbers do not compare a 401(k) against another type of retirement account (or a regular taxable investment account).
Or perhaps I misunderstood your point? Since you quote the Time article again, are you contending what that article appears to be about, that bringing back defined-benefit pensions and expanding social insurance programs would be better overall than individuals taking responsibility for funding their own retirements?
You seem to expect a good deal, Mr. Madison, of an article on the internet. Given the wide array of potential options for retirement savings plans, and the wide array of potential readers, far be it from me to individually scrutinize each one and offer a customized personal opinion about financing their retirement – for that, I suggest you consult a financial advisor. There are no one-size-fits-all retirement plans, which is how the 401(k) is normally sold – it’s this idea that the article speaks against, or tries to. I reference the “Why It’s Time to Retire the 401(k)” article to demonstrate that reliance upon a 401(k) doesn’t always work out in one’s favor, and perhaps to encourage incidental thought about the ramifications of them upon retirement.
Your second question is somewhat offbeat, I think. No, I certainly believe it better for individuals to fund their own retirement plans and assume responsibility for same – but I think it extremely questionable exactly how much “responsibility for funding (my) own retirement” is involved with opening a 401(k). Once I open the 401(k), I really don’t have to think about it again – automatic deductions take care of my contributions for me, while whatever fund I select is managed by someone else who is actually responsible for acquiring any gains that I may receive. Further, once compounded interest begins to accumulate my individual contributions and any employer matching become less and less vital. It could be argued that the aim of the plan is to reduce actual employee responsibility as much as possible.
The 401(k) program appears to halfway solve the problem of retirement savings, in that it strives to provide a mechanism for greater investment but denies one the ability to invest in different things if one can find a better deal. Admittedly a “better deal” is entirely determined by an individual, however, but I would point out that many other investment opportunities exist rather than just mutual funds. For just one example, the minimum percentage return I normally consider “worth it” is 16%, slightly lower than the maximum value available in my state for a tax lien sale. The chance of walking away with the property for just the taxes owed is quite nice. For more information about this subject, I highly recommend Joel Moskowitz’ “The 16% Solution.”
I do not mention these to suggest any sort of financial wizardry or skill on my part, but merely to demonstrate that it is possible to find other investments offering much higher returns than normal mutual funds. It may further be the case that tax lien sales are a bad idea for you personally – I don’t know why that would be, but I’m willing to admit the possibility. However, if you find that it is a good deal for you, it’d certainly be nice to have the option of investing that 401(k) money into them.
My apologies, the link in the previous comment goes to the old version of the book. Here is a link to the revised version.