Sunday, August 11, 2013

The 401(k)ship Society

In the New York Times in May, frequent Matt Taibbi whipping boy Thomas Friedman announced: 

We now live in a 401(k) world — a world of defined contributions, not defined benefits.
If you are self-motivated, wow, this world is tailored for you. The boundaries are all gone. But if you’re not self-motivated, this world will be a challenge because the walls, ceilings and floors that protected people are also disappearing. That is what I mean when I say “it is a 401(k) world.” Government will do less for you. Companies will do less for you. Unions can do less for you. There will be fewer limits, but also fewer guarantees. Your specific contribution will define your specific benefits much more. Just showing up will not cut it. 

Companies, unions, and government certainly do less for us than ever before.  Well, less for the vast majority of us, anyway.  But before we too readily agree with Thomas Friedman about the state of the world, let us focus on the 401k in specific.  

An Examination of the 401(k) Defined Contribution Plan

Created in 1978, 401ks were undiscovered until the mid-1980s.    
401(k) are "defined contribution plans" with annual contributions limited to $17,500 as of 2013. Contributions are "tax-deferred"—deducted from paychecks before taxes and then taxed when a withdrawal is made from the 401(k) account. Depending on the employer's program a portion of the employee's contribution may be matched by the employer.  
The 401k offers two major benefits to the employee: tax-deferral and matching employer contribution.  


Tax-deferral allows the employee to reduce her income for her tax return when she pays into the 401k.

For example, a worker who earns $50,000 in a particular year and defers $3,000 into a 401(k) account that year only recognizes $47,000 in income on that year's tax return.
The employee then pays tax upon distribution.  Notably, the considerable compounded income within the 401k becomes taxed at ordinary income rates.  So, the employee pays her distribution taxes at rates more similar to Warren Buffet's secretary rather than Warren Buffet's own lower long-term capital gains rates.  The IRS penalizes early distributions and also taxes them.  

Employer Contribution

The employer contribution may be the more seductive lure.  Employers may contribute as much as $51,000 each year, or 100% of the employee's salary, whichever is less.  As you may imagine, employers rarely contribute so much.

The most common 401(k) employer matching contribution is 50 cents for each dollar the employee contributes, up to 6 percent of their pay. That means that the maximum possible match an employee can get using this formula is 3 percent of pay.

Thus, employees may shelter no more than roughly 3-6% of their pay into their 401ks, in addition to up to $17,500, plus whatever amount the employer matches as its contribution.  

The 401k program includes various other provisions, including a maximum deferral for highly compensated employees (HCE) pegged to the contributions of lower paid employees as well as an oft-praised automatic enrollment provision which allows employees to opt-out rather than refuse to enroll.  

The Managed Market

401k contributions go into market investments.  But they do not enter the stock market directly.  Instead, employer-selected firms manage these contributions for a substantial fee.  

Most defined contribution plans allow participants to select from a menu of investment options, largely mutual funds. The question is, who decides what's on the menu? About three-quarters of the time, these decisions are made by a mutual fund company acting as the plan's trustee.  And (surprise again!) mutual fund companies are more likely to push their own funds onto employees than other companies' funds--despite the fact that they are legally obligated to act in the best interests of plan participants.
Let's say such a fund has a bad year. If plan trustees are acting solely in the interests of their participants, we would expect the identity of the trustee not to affect the chances that the fund is dropped from the investment menu. But that's not the case: a poorly-performing fund is much less likely to be dropped from a menu controlled by its sponsoring fund company than from a menu controlled by a third party. Fund companies are also much more likely to add their poorly performing funds to plan menus that they control.
In addition to the subtle conflicts of interest, managed funds charge significant fees which are often concealed from employee-investors.
Mutual fund returns in 401(k) plans are normally reported as net returns, meaning that fees for managing your investments are subtracted from your gains or added to your losses before calculating the annual return. Other costs, such as administrative and record-keeping fees, are often divvied up among plan participants but are not explicitly listed on individual investment statements.
This lack of transparency is frustrating for investors . . . "Under the expense column, my 401k statement said I was paying zero.  But in reality, I was paying about $1,500 a year on an account balance of about $120,000, even though the bulk of my investments were in very low-cost index funds.
These fees add up over the life of a 401k.  They can ultimately eat away the entire value of the tax deferment benefit.  
Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.
401ks are unremarkable in this regard, as most managed funds suffer from these kinds of fees.  Self-directed 401k plans are available, but even these involve significant fees of some kind.  

Inconsistent Overall Market Performance

Obviously, 401ks are subject to market risks.  This distinguishes it from its government counterpart, Social Security.  Thus, 401ks were hit badly in the financial downturn.  Although the market has largely recovered to pre-crisis levels, many retired within those five years and began receiving distributions during that time.  

The chart above shows why equity markets continue to hold the attention of those who plan for retirement.  Over the last twenty years, growth has been uneven but exponential.  Nevertheless, timing can be everything. Thus, 401ks should never be the entirety of one's retirement strategy.  The more interesting question is whether the 401k should ever become a core component of the retirement strategy.  

The 401(k) and American Society

Let us return to Friedman:
We now live in a 401(k) world — a world of defined contributions, not defined benefits.
. . . 
Government will do less for you. Companies will do less for you. Unions can do less for you. There will be fewer limits, but also fewer guarantees. Your specific contribution will define your specific benefits much more. Just showing up will not cut it. 

Friedman presents the New World(k) Order as a trade-off, but it appears the 401(k) world simply offers us fewer benefits and less choice.  

If governments, companies, and unions will do less for you, then they may become unbound by their constituencies.  Assuredly, there will be fewer guarantees. But Friedman supposes too much when he states that the fewer guarantees will mean fewer limitations.  

Social Security compared with the 401(k)

The 401(k) is a creature of statute.  Thus, the government may remove this incentive at any time.  Social Security is no different in this respect.  For Social Security, at least, the government mandates that employers match their the contributions of employees at a rate of 100%.  That's a guarantee.  In this specific way, the 401(k) is more limited than Social Security, and the choices are these: 

  • For employers, do you want to match contributions 100% or less?
  • For employees, do you want to accept the employer's 401(k) or not?  If so, for how much?

Social Security also guarantees a predictable benefit amount, dependent largely on whether retirees begin distribution earlier or later in their life.  But the 401(k) offers no such guarantee, as the value of your 401(k) depends generally on the value of the equity and bond markets and specifically on the stocks and bonds in your portfolio.  

The 401(k) also limits productive contributions.  Employees can only expect to place as much as 6% of their income into 401(k)s because that is the limit to which employers match their contributions.  

The 401(k) offer one true choice which distinguishes it from Social Security: it allows high-earners to contribute more money.  

Social Security taxes are levied only on the first $113,700/year in income, to a maximum of $14,098.80/year (half from the employer and half from the employee).  Thus, an employee who earns $200,000 in 2013 pays $7,049.40/year into payroll taxes and will receive a $14,098.80 benefit upon retirement, exactly the same as someone who earned $115,000 that year or $1,000,000 that year.  The million dollar earner, however, may have more choice with the 401(k).  Remember that an employer may pay as much as $51,000/year in matching contributions, up to 6% of an employee's pay, but the government limits an employee's contribution to $17,500/year.  Thus, the $1,000,000/year employee can contribute up to 6% of $291,666.67.  
Note: those over 50 may contribute an an additional $5,500/year, to a maximum contribution of limit of $23,000/year due to 'catch-up' plans.  

So, the 401(k) is markedly preferable to Social Security, provided you are a high-earner.  Roughly 10% of U.S. earners met or exceeded year 2012's Social Security cap of $110,000.  Thus, the 401(k)ship society primarily advantages higher-earners.  

Advantage: High-earners

Your specific contribution will define your specific benefits much more. Just showing up will not cut it. 

The promise of the 401(k)ship society lies in its lack of limitations.  Yet, the 401(k)ship society provides its real freedom from limitations only to high-earners.  This could be fair, but only if you believe, as Friedman seems to, that one's greater contribution will result in higher benefits.  Since governments, companies, and unions will all be doing much less, why should we believe they will properly compensate contribution?  

You must work in a number of fields which allow you earn the income and prestige commensurate with generous 401(k) plans and the high-income to take advantage of their benefits.  Otherwise, you are just showing up.  And in the 401(k)ship society, showing up just will not cut it.  

Update:  A commenter adds the following; The tax deferral discussion overlooks a couple of important points.  The vast majority of 401K users will not take their distributions directly from their 401K plans.  Instead they will perform a tax-free rollover into an IRA upon leaving their employer, either for retirement or another employer.  Typically distributions from an IRA will the occur during the retirement years when the tax bracket is much lower.  For example, a retiree once in the 25-28% tax brackets when working could later find herself in the 15% tax bracket. 
There is one case where it is to one's advantage to keep her funds in a 401K upon leaving.  If one loses her job and has not found another employer and she is 55+ years of age, she can access her 401k funds without penalty.   At that point, one can roll an 401k into one's IRA.

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