Wednesday, March 9, 2011

A Birthday Not-so-jubilantly Celebrated: Your 401K turns 30

It seemed like a good idea. But you have to consider where we were in terms of retirement when the line in the tax code was uncovered. We had pensions and companies didn't much like the idea. These defined benefit plans were designed to keep employees in one job over an entire career and add to that, they were costly and unpredictable. For the employee, the time needed to vest was often long, sometimes as much as ten-years, and the pension once vested, although it was yours, could not be brought with you should you find a better job somewhere else.

The pension also represented the ability to increase your retirement income as your pay increased. This trade-off from human capital in the first years of employment to retirement capital in the later years, made the company liable for the investments and the guarantees that the money would be there. Higher paid workers, often in much higher tax brackets than we have today, were allowed to also save money after those taxes.

When Ted Benna found this line in the tax code (section 401(k) 30 years ago, he realized that this was the answer to what his higher paid clients were looking for: the ability to put money away on a pre-tax basis and if the company so chose to do, it could match those dollars. Business saw this as a way to shed those obligations of managing their pensions and shift the obligation of retirement to the employee.

Sure, the company said, we'll help. We'll hire some experts to set up a plan, we'll load it with a bunch of investments and we'll act as fiduciaries. Heck, they said, we'll even provide the incentive of a match - even though these companies would lace it would all sorts of caveats much like the vesting period of the pension. Yet it would, in their minds, be the answer to a question they had not asked but possibly should have.

Even better, these new plans would be portable. You could take the money you had put aside with you when you left. Once again, this was more a win for the company than the employee, who often left before they got the fully vested match and was forced to roll the money into their own IRA. The fully vested match is often something that happens over time, sometimes as long as ten-years, more commonly over five years.

It can work in a number of ways and this information is part of the Investment Policy Statement that every plan has and few people read. During your first year, you might get the company match - in theory - but if you were to leave, it would not go with you; only the money you had invested would be yours. Perhaps by year two, the company would allow you to take 25% of the company match, and each successive year, a little more. Some companies give the full 100% after five years. So consider the employee who finds a new and better job opportunity and decides to quit a week before the five year waiting period is up. They would lose five years of company matching funds simply because they didn't wait.

This line in the tax code also created a multi-layer business to accommodate this plan, from mutual fund houses to insurance companies to brokers at the investment level to third party administrators and lawyers to help with the legalities. This line in the tax code also created some huge problems for the worker.

Now they needed to find investments in those plans to give them the best retirement. They needed to participate beginning as early as possible and stay involved as long as possible. They needed to get historic returns and be disciplined in an endeavor they had little or no knowledge about prior to this shift. It was a great social experiment in self-help that has failed many people. It also helped a great many people who might not have had much otherwise.

But the plan has problems that have never been suitably addressed, in part because of the belief that people wouldn't allow these provisions. One problem that should have been better adressed was the portability part of the plan. Mr. Benna in a recent interview with the Baltimore Sun bemoaned this ability to "take the money with you". He knew that our natures would get in the way of the right choice. Too many people would cash the plan out, pay the penalties and the taxes and squander the early start that these plans depend on. He thinks that the employee would be better served being forced to leave the money at the old employer.

He also knew that if the 401(k) allowed for a borrowing provision, people would use it. Mr. Benna's redesign of the 401(k) would include auto-enrollment and auto-deductions that would begin at 4% and increase until they reached 10%. He also admits to the problems in target date funds (which we have discussed here in previous essays) but thinks the idea is right. People make emotional choices with their investments and target date funds are designed to take that emotion out of your hands.

Of course you could opt-out but history has shown that few people do. He also suggested that this plan should be, in a perfect world, a supplement to a pension plan. But he was quick to point out that companies still have problems with the predictability of pension costs. Much the same way 401(k) investors have difficulty with investment risks.

In either case and even if you are fortunate enough to have both types of plans, the responsibility of your retirement is still with you. Arriving as close to it debt free is still the best approach to retirement. Investing as much as you can and then more, perhaps twice what you think you can afford, is a better plan. Think of retirement as a storm that is approaching. You wouldn't gather enough supplies to last for a day or two. You would get more than you need. Most folks have not filled their retirement pantries with much more than a loaf of bread and a jar of peanut butter. How prepared are you for a storm that is likely to last for thirty years?

Paul Petillo is the managing editor of and a fellow Boomer

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