Does the 401(k) “Suck?”
May 09, 2013A friend of mine recently sent me an article titled “It’s a 401(k) World and It Sucks.” I realize that the 401(k) is not perfect (but what is?) and the author does make some good points. But that being said, “sucks” is a pretty strong word about the vehicle that has encouraged more retirement saving than anything else, especially considering how much we need to increase those retirement savings. Let’s take a look at each of the author’s main arguments:
“Poor people get absolutely nothing.” – It’s true that some people earn too little to pay federal income taxes and don’t benefit from the tax subsidies. But many of them work for companies that offer an employer match. Is the ability to earn a 50% or even 100% guaranteed return on your money worth “nothing?” After all, a person making $18k a year, contributing 6%, and receiving a 6% match, would be earning over $1k a year in employer matching contributions. At a modest 6% average annualized return, that could grow to an additional $164k over a 40 year career.
The author also leaves out one of the biggest benefits: the convenience of payroll withholding. How many people would contribute as much if they had to write a check every pay period? Finally, many 401(k) plans also provide access to low cost investment options and even advice.
“Wealthy people who would have had large savings anyway get a nice tax cut that offers no meaningful incentive effect.” – Many of the wealthy people we talk to make it a point to max out their 401(k) contributions for the tax benefits. For example, a couple earning $250k can drop from the 33% to the 28% tax bracket by contributing to their 401(k) plans. Even if they wouldn’t otherwise be inclined to save for their retirement ($250k can be easily spent living in a place like Manhattan), the tax savings might make them think twice.
“For people in the middle, the quantity of subsidy you receive is linked to the marginal tax rate you pay—in other words, it’s inverse to need.” – Fair enough but that’s true for most tax deductions.
“A small minority of middle-class people manage to file the paperwork to save an adequate amount and then select a prudent low-fee, broadly diversified fund as their savings vehicle.” – Good for them!
“Most middle-class savers end up either under-saving, over-trading, investing in excessively high-fee vehicles or some combination of the three.” – Would getting rid of the 401(k) actually help with any of these problems? Let’s focus on ways to increase savings (employer matching contributions, automatic enrollment, auto-escalation, retirement calculators), decrease over-trading (many employers encourage “one stop shop” funds like target date funds to minimize the need to trade and some employers even restrict their employees’ trading ability to certain times of the year), and decrease fees (more low cost investment options). Financial education can also play a key role with each of these.
— “A small number of highly compensated folks now have lucrative careers offering bad investment products to a middle-class mass market based on their ability to swindle people.” – Without the 401(k), these same folks would just sell more of those products to people directly as many do now.
Here are some ways to make the 401(k) work better for you:
1) Contribute at least enough to max the match. Otherwise you’re leaving free money on the table.
2) If you have a Roth 401(k) option, use a calculator like this to see if it would make sense for you or just do a mix of both.
3) Choose diversified, low cost options. If you’re not sure which funds to pick, consider an asset allocation fund or see if your employer or plan provider offers access to financial advice or guidance. Just be careful of fees.
4) Once you’ve built up an adequate emergency fund and paid off any high-interest debt, use a retirement calculator to see how much more you need to save to reach your goals.
5) If you can’t save that much now, see if your plan has an auto-escalation feature to have your contributions automatically increase over time until they reach your target rate.
6) Try to resist the temptation to become more aggressive when the market is doing well and more conservative when the market is doing poorly. Instead, make sure your portfolio is re-balanced at least once a year.
7) Try not to touch your 401(k) in the form of loans or hardship withdrawals. They may seem costless but with a loan, you lose the earnings on that money, and with hardship withdrawals, you face taxes, possible early withdrawal penalties, and the inability to contribute for a period of time.
Unlike Social Security and traditional defined-benefit pension plans, the 401(k) allows you to take control and responsibility over your own financial destiny. Whether you like it or not, this is the direction things are going. So yes, it’s a 401(k) world and yes, the 401(K) is not perfect. But whether it sucks or not, depends on if and how you decide to use it.