Are 401k's a Failure?

August 10, 2018

I moved to Warsaw with my parents in the summer of 1977, and it is pretty amazing how Warsaw has changed and improved over the last 41 years.  Over that same period of time, the way that Americans fund their retirement has changed drastically as well.  For many, this change has been fantastic.  But for others it has put a comfortable retirement out of reach.

The first private retirement plan was established by The American Express Company is 1875. (Source: Employee Benefit Research Institute) It was what is know as a defined benefit plan, commonly known as a pension.  With a defined benefit plan, the retiree receives a certain payment at certain intervals with the amount determined by predictable factors.  Usually, it comes in the form of a monthly check for life based on salary history and years of service.  A pension makes retirement planning easy, because the amount of the monthly check is easy to estimate, even decades before it is received.  By 1970, more than 45 percent of all private sector workers were covered by a pension. (Source: Employee Benefit Research Institute)

Pension plans put all the investment risk and responsibilities on the employer.  The employer knows that at some point in the future it will have to pay out the pension to the employee.  It will save and invest money annually to be able to do that, but the amount it must invest will be partially determined by the investment results they are able to achieve.  If the employer obtains a high return, they can invest less and vice versa.  The returns are immaterial to the employee.  No matter what, the employee’s benefit is determined by the formula.  If the employer hasn’t saved enough, that’s the employer’s problem.

Because the employer bore all the risk, they hired the best professional managers they could find.  In fact, the Investment Advisors Act of 1940 required that investing responsibilities could only be delegated to qualified advisors. (Source: Employee Benefit Research Institute) However, the stagnant stock market of the 1970s and continually increasing life expectancy made pensions a big expense for employers.

The Revenue Act of 1978 changed everything, but not overnight.  Section 401(k) allowed for the creation of accounts in which certain employees could defer compensation until retirement and it would not be taxed until retirement.  These new 401(k) plans were an instant hit.  By 1985 there were 30,000 plans with 10 million participants.  By 2015, the number of plans had grown to 638,000 with more than 89 million participants.  (Source: US Dept. of Labor) Defined contribution plans are popular with participants because they allow participants to cultivate pools of wealth that can be passed on to the next generation. Defined contribution plans are popular with employers because the employer’s liability is limited to their contribution.  All the investment risks and responsibilities have been transferred to the employee. 

Unfortunately, employees are often ill-equipped to manage the investments and often don’t sign up even when they are eligible.  Many times, employees will choose their investments based on the previous year’s returns, instead of a well-developed asset allocation plan.  This is understandable, because the employees are experts at their particular job, not the job of constructing and managing investment portfolios.  The difficulties employees have in managing their accounts is reflected in the results.  The median 401(k) balance in 2017 was $24,713.  For the 55-64 age group, the group closest to retirement, the median balance was just $66,643.  (Source: Vanguard)

The changes in how America funds retirement have been beneficial for many, but not all.  Some employers offer online tools to help guide their employees in managing their accounts.  Other 401(k) participants will have to seek out their own guidance.  Either way, the effort it takes to get some advice may help to improve success. 

Similarly, the changes in Warsaw over the last few years have been both positive and negative.  I love Culver’s and Ritter’s, but I sure do miss the Flagpole!

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Securities and financial planning offered through LPL Financial, a registered investment advisor.  Member FINRA/SIPC