Thursday, October 22, 2009

Could a Change In Tax Law Save the 401(k)?

William Bernstein writing for Barron's foresaw the future of the 401(k), this country's most ubiquitous retirement plan. “The 401(k) is likely to turn out to be a defined-chaos retirement plan.” And so it goes. Almost nine years after that comment was penned, the 401(k) has, for the most part, turned out to be a failure for most, a disappointment for some and far too much work for those who use it to its fullest.

The Investor Class and The Rest of Us
This is based on numerous reasons, almost all dealing with our own, largely undefined and for the most part, beyond description approaches to investing. We are all over the place, trying to attach method to our madness and sound reasoning where there is none. This means that there is an investor class and the rest of us.

Unfortunately, we don't have to be exiled to the outside. But keep in mind, despite your best efforts, you will never be completely admitted to this elite group. Don't worry, many of those who are members are there by accident, something time will uncover and because of the nature of the class, they too will be kicked to the sidelines. In many respects, we are simply spectators.

Pensions are not dead although they are quickly becoming something of the past, relegated to the obviously smarter workforce, the union laborers. These folks admit to not knowing about where they should put their money, so instead of directing their own fortunes, many let trusts operate the investments.

(This is where a group of concerned folks gather, the employers and the union and determine where the best place to invest is. And statistics have shown, that in many instances, they do better than companies do when they hire "professionals". Also damning any chance at success is the interest the company has in the pension and how it relates to their balance sheet.)

This is sort of a forced retirement with the laborer giving up pay increases for pension contributions. And in the case of the trusts, it generally works like a charm. There are exceptions, particularly during labor disputes and troublesome negotiations when the welfare of the member is often second to the economics of the contract.

The Retirement Calculation
And in the three decades since its inception, we have proven the concept more or less incorrect. We are forward looking creatures that mistakenly attribute possibility to reality. In many instances, we have pre-determined how much we will need, how much we will need when we retire and how much we will need to save to get there. We have the whole plan sown up. That is until there is a bump, or in some instances, a really big bump jostles our fragile framework to the core.

Companies have shirked their fiduciary responsibility time and again. They enlist plan sponsors who are hellbent on squeezing every dime they can from every nickle invested. These fees, some hidden, some acknowledged are often higher than the individual investor might pay. And because the funds you choose form are locked inside a structured plan, shopping around is limited to what is on the shelf. In the land of choice, the plan that needs to have the most options is closed to competition.

The 401(k) appeals to our herd mentality, driving up our gains (at least on paper as we chase the hot funds and the sizzling picks our cubicle neighbor has chosen) and driving our losses further as we try and stop the bleeding. We look at these accounts as money saved (which it isn't) and add to the debacle and withdraw or borrow against these accounts.

And we like to blame. It is also in our natures. Which is why some feel as though the 401(k) hasn't been given enough time to work. Yet those who have a pension, what I have referred to as the great economic stabilizer for many Americans who have them, have seen their fortunes in their post-work years remain stable. You have to realize, these plans were designed for those who had nowhere else to go with their high level of earnings. This tax-deferred portion of the tax code was custom made for this group. And it would have been for us as well except that we don't have enough time in the plan to make it work the way it was designed.

We haven't contributed enough either. To reach the portion of pension payment using your 401(k), you would have to retire with three times your current balance, provided you took advantage of all the free (matching) funds and maxed the plan out. Now the matches have gone away and fewer people bother with the maximum contribution. The catch-up clause is just wishful thinking.

Fix what is Broken
So can this thing be fixed? Yes and no. If 401(k)s are only worthwhile when you retire, why then do the changes to these plans, improvements that make it easier to keep invested and stay invested have to come from the government? Talk has been shifting towards some sort of government run pension plan or an exchange where employees can by some sort of guarantee (adding a new player to the retirement game, the insurance company). Neither of these is feasible.

Nothing says participate like less taxes and this sort of incentive offers some easily projected numbers that are easy for even the lay-est of investors to understand. Matching contributions may not have lured sideline investors because it meant money out of "pocket" or less in the budget.

The IRS could act to make all 401(k) plans more tax friendly.

Based on the fact that 401(k)s are essentially tax events, the wrong agencies are stepping in to try and fix an IRS problem.

Here is what I suggest: Consider making the tax deferred deduction on the 401(k) contribution twice what it currently is and you will, in essence, give the employee a raise. You could force a minimum contribution and surprisingly, it might not even be noticed. As many of you already know, 5% barely changes your take home pay. But getting an additional deduction would.

The IRS could take it one step further by then fixing the withdrawal tax table. Many of us don't know what we will be taxed when we retire because we don't know what we will be able to withdraw. The IRS could place a 5% cap on anything under $20,000 a year, 15% for all additional annual draw-downs. Upper tier investors would want to pile in and this would have the net effect of raising all investor boats. (To recover much of this lost taxable revenue, reducing the contribution limit by a thousand dollars to $15,500 would force those who could invest that sort of money to pay the taxes and put the money in a Roth. My roughest calculations show that it would add $10 billion a year to the coffers, offsetting the increased deductions.)

The IRS could also penalize those tax returns (in the nicest way possible) and tax any over payments in excess of $500. This would be directed to a group 401(k) that would be directed towards a state sponsored target date fund (even though I don't like them much, for this purpose, they may be custom made). When the person applies for retirement benefits, this fund would be added to their benefits and because it was already taxed, it could not be taxed again. Applicable tax rates for 401(k)s would also apply on any interest gained.

Harsh medicine? Perhaps. But the end result would be more money to spend now, more money to spend later and more money that many would not have. All by changing the tax code.

Paul Petillo is the Managing Editor for and a fellow Boomer.

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