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Have you ever done something in the past and years down the road realized how impactful that decision was? Oh, and then regretted it and wished you had done something differently? I am reasonably sure we’ve all done this at some point. However, this is not an experience I want to have when it comes to my retirement savings.
Failing To Protect Your Retirement Today
This exact sentiment describes Ted Benna, the “father of the 401k.” It’s how he feels about creating the 401k and how it is used today versus what he envisioned.
The 401k has become the standard for employer retirement plans in the private sector. For many employers, this has become the only retirement benefit that they offer their employees. We’ve been trained to believe that a 401k is the primary method to save for retirement. It has become our sole employer-sponsored retirement option. However, this was not the intention when the 401k was born.
Benna was looking for a way to save money with the tax code that would allow people to supplement their pension plans. In the past, many workers planned to receive a pension from the company they worked for. However, over time, these pension plans have become far less common and are now practically non-existent. This is because a pension is a defined benefit plan, whereas a 401k is a defined contribution plan.
The difference between the two is who holds most of the risk. Being a defined contribution plan, the 401k shifts that risk from the employer to you, the employee. With a 401k, the employee bears the burden of risk. We will dive into this idea more in a moment.
The Death Of Pension Plans
Many pension plans have been phased out and eliminated by employers because of the immense burden it places on the company. The disadvantage is that the employer is responsible for offering the defined benefit, or a guaranteed income once the employee retires.
Due to this financial burden, employers shifted the risk away from themselves and onto the employees when it is time for the employee to retire. They were especially eager to do this as life expectancies continue to increase.
With a pension plan or defined benefit plan, the employer bears the risk of having to supply the employee with lifetime income. However, in a 401k plan, the employee assumes all of the risks and responsibilities to ensure the 401k produces lifetime income.
This can be a mighty tall order, especially for someone with no investment or finance experience. Benna initially saw an opportunity with the 401k. However, its original purpose is not how it is being used today, not by a longshot.
The Transformation Of The 401K
In the early 1980s, 401k plans were only available at a handful of large companies. Today most employers offer a 401k as a benefit to their employees. There is even the solo 401k.
On the downside, 401k plans carry much more risk for employees than defined benefit pension plans. As stated earlier, there are no guarantees a 401k will increase in value, or that you will have enough money in your 401k at retirement. There are a lot of variables in the 401k equation, and if something goes wrong, it can sabotage your retirement.
A Lack Of Retirement Training Or Guidance
Most 401k plans are invested in the stock market and most commonly invested in mutual funds. Employees are also seldom offered any reliable advice from a fiduciary in regards to investing in their 401k’s. Instead, employees must decide what they should invest in from a long list of funds. Also, most mutual funds hide their fee structures from people without investment experience.
Aside from the expenses within each mutual fund, 401k’s also have administrative and plan fees. These fees are charged by the investment company to administer the plan to you and your co-workers.
Benna says the 401k plans have become so confusing and filled with hidden fees that they are more beneficial to the brokers than they are to the investors.
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This is a massive problem as the average American’s 401k balance at age 65 is less than $195,000. This is not even close to being within range to fund the average retirement of 18 years.
Regretting The 401k Plan
He’d created a plan that no longer represented what he envisioned. The 401k “monster” had taken over retirement plans as a whole and no longer beneficial to the investors. “We went to three options, then to six, then to seven, then to 15 – it is far beyond what most participants were able to deal with,” Benna says. He did not agree that overcomplicating retirement was a benefit to the investors.
Benna realized his invention actually made the rich richer and didn’t benefit the line-level employees. This is one of his biggest regrets.
Read more of the Wall Street Journal article here.
Pension plans have become increasingly rarer, while the 401k has taken over most company retirement plans. Retirement is no longer the responsibility of the employer and instead has been pushed onto employees who are not financially educated.
Because of this employees are paying higher fees than they should and not properly protecting their retirement nest eggs.
Sadly, many people are blindly investing money into a 401k plan simply because it is offered through their employer.
Stock Market Volatility
It is also essential to understand that market-based investments carry certain degrees of volatility depending upon your specific investments. This is simply knowing that the market will go up and down at any given time. Unfortunately, many hope they retire during a time when the market is up.
However, a retirement plan built on hope is destined to fail.
Using A 401k To Your Advantage
Investing in a 401k can also carry some benefits if done correctly. One benefit is the employer match. For example, if your employer is offering up to a 3% match, take advantage of it – that’s free money! But educate yourself and choose investments that suit your needs and goals.
Let’s take a closer look at this. If you have a salary of $75,000 and your employer will match 3% of your 401k contributions, this means you will earn an immediate 100% return on your money. This is because if we contribute 3% or $2,250 and our employer matches it, we now have $4,500 in contributions for the year.
However, contributing over the employer match rarely carries any extra benefit, and those excess contributions can usually be put to work better elsewhere. We must still be prudently investing our hard-earned money within the 401k.
What To Do With Old 401k Plans?
I am also often asked, “what should I do if I have an old 401k from a previous employer?” In most cases, it is wise to transfer funds out of an old 401k you are no longer contributing to.
You can do a direct rollover or transfer into an IRA where you can better control the investments, reduce or eliminate plan fees, and continue to contribute if you’d like. It is important to remember that you must still pay administrative and fund fees in an old 401k even if you are no longer with that employer and no longer contributing. This can erode your account value over time.
The bottom line is, in most cases, you will have far more control over your retirement funds in an IRA.
What Can Employees Do?
One positive development for retirement accounts is the allowance of annuities within 401k plans. Under the SECURE Act, which was passed in early 2020, 401k plans may now offer annuities.
An annuity acts more like a traditional, defined benefit plan. This is because an annuity is a contract with an insurance company and can provide fixed rates of return, fixed income, and lifetime guaranteed income payments in some instances.
A fixed annuity is the closest thing to a defined benefit plan that you will find in a 401k today. These options are just now being phased in. However, it is a step in the right direction that will alleviate some of the burdens from the 401k owner.
Benna’s New Retirement Strategy
Benna recently announced that he’d put a large portion of his own money, “probably the biggest part of my wealth,” into another kind of savings plan, namely, high cash value life insurance.
These alternative savings plans are guaranteed to grow every year and do not fluctuate like the stock market. They also do not have age restrictions for penalty-free withdrawals, nor do they force you to withdraw money at age 72 as part of your required minimum distribution (RMD).
Read what CSMonitor had to say about the 401k and Ted Benna here, and why the ‘father of the 401k’ says he regrets pushing the 401k retirement plan.
Wrapping It Up
The takeaway is that if you invest in a 401k, read the fine print. Understand what fees are being charged, hidden, and not hidden. Only certain fees require disclosure. You read that right; there are hidden fees. Find out what stocks or bonds are being purchased within those mutual funds in your 401k. Educate yourself on how your money is being invested.
…And, like Benna, my clients and I, learn about what alternative investment options can do for you in conjunction with your 401k. You only get one shot at getting the retirement puzzle correct, so be sure to educate yourself and make decisions you won’t regret later when you want to retire. By that time, it will be too late.
401Ks & Target Date Funds
Your 401k money is likely invested in something called a Target Date Fund (TDF) – even if you didn’t authorize it or request it – and that should concern you.
Approximately 98% of all employer-sponsored 401k plans use TDFs, and 90% have it as the “default option” for their plan. This means they automatically invest your money there unless you specifically direct them to do otherwise.
The problem is that almost no one changes their elections. This is because there is rarely any education provided on the different investment options, and confusion often leads to indecision. This leads to, “I’ll just do what everyone else is doing.”
TDFs are supposed to dial back risk as you near retirement, but in practice, that has not happened. In 2008, some TDFs designed for participants expecting to retire in two years lost as much as 40%.
Target-date funds attempt to use a diversification strategy that has not yet been shown to be successful. Target-date funds worked well in recent history, but so has every other investment. However, times change, and retirement investment strategies must follow.
401Ks and Exchange Traded Funds
Most target-date funds are actively managed Exchange Traded Funds (ETFs) that are designed to automatically adjust their risk profiles as retirement nears based on a target retirement date (i.e., 2030, 2040, 2050, etc.).
One of the greatest fallacies of target-date ETFs is that most investors in the funds also own other securities – such as stocks and bonds. This can automatically skew their portfolio diversification. Without knowing it, they overweight all the asset types.
Just because your employer or 401(k) plan administrator automatically does something with your precious retirement funds, this does not mean it’s good for your wealth or in your best interests.
As B.C. Forbes, founder of Forbes magazine noted: “Refuse to be stampeded! Do your own thinking.”