Was the 401(k) a Mistake? How an obscure, 45-year old tax change transformed retirement and left so many Americans out in the cold.
Was the 401(k) a Mistake? How an obscure, 45-year old tax change transformed retirement and left so many Americans out in the cold.
How an obscure, 45-year-old tax change transformed retirement and left so many Americans out in the cold.
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So my employer did this thing where new hires automatically got enrolled in a 401k. If you did absolutely nothing to your 401k, each year it would automatically up your percentage to a max of Y. Is that common or uncommon? And in this world of 401k over pension, should that be more of a norm to help protect people that don't know better build retirement savings. It doesn't solve the problem of folks not having enough money and needing to use 401k for emergency funds...
It's getting more common; which I think is a good thing.
It's common among good employers, but unfortunately a lot of companies don't do it. We should be encouraging more of this because people tend to suck at preparing for retirement.
And while it doesn't solve the emergency fund issue, people tend to adjust their spending based on how much lands in their account. This is called the hedonic treadmill, where people adjust they lifestyle to fit their means on the way up, but they struggle to adjust it back down. Automatically increasing investments just reduces the impact of a raise, it doesn't actually reduce your actually income since it just pulls 1% out of your normal raise (probably 3%).
The proper solution is for people to learn to properly budget and cut out things that don't provide enough value, but that's a much harder problem to solve than automatically increasing investments.
But isn't the point of this article highlighting personal responsibility can't solve the larger social issue we are facing.
Maybe. But the article is mostly highlighting the fact that we do a poor job of educating people about investing and budgeting. For example:
She also knows that markets don’t always go up. During the 2008 global financial crisis, her 401(k) lost a third of its value, which was a scarring experience.
I'm guessing she sold when the market went down and locked in losses, and then didn't buy again until stocks rebounded. So the classic "buy high, sell low" strategy.
The proper approach is to buy and hold until retirement. See the story of Bob, the world's worst market timer for an example of how buying and holding will work even if you buy at all the wrong times. Bob was fine in retirement because he never sold.
larger social issue
The proper solution here isn't to go back to pensions, it's to provide sane defaults and simplify the programs so everyone can understand it will enough to use it properly.
There are lots of retirement account types
Do you know how many retirement account types there are (not investments, not plans, but account types)? Here's a few off the top of my head (not exhaustive):
- 401k - most common employer plan
- IRA - universal option
- 403(b) - government/education plans
- 457 - government/military plan
- SIMPLE IRA - small company plan
Each has a different set of features and caveats, as well as (in)compatibility with other plans. If you change sectors (e.g. you go from public school to private school), you may have completely different retirement options. Some employers can offer multiple of the above as well, and each employer has different rules for their plan.
Add to that three different contribution options (pretax, Roth, and after tax), and the average person is rightfully confused. It's the same problem as the tax system generally, it's too complicated.
My proposal to unify retirement accounts
- Consolidate all of those plans into the IRA and Roth IRA, increasing limits as needed
- Allow employers to contribute to and create IRAs, just like they already do with HSAs
- Require employers to contribute a certain amount by default into an account, unless the employee opts out; perhaps start at 5% and increase by 1% every year up to a cap of 15% of salary, or the max employer portion, whichever is lower
- Create a standard for brokerages to inform employers about plan limits so they don't over-contribute
- Require brokerages to invest customer funds by default into a low-cost target date index fund, unless the customer opts out
- Disallow account closure or transfer fees, though free transfers can be capped at one/year/account - customers should always be able to move funds without penalty
- Consider preventing withdrawals of gains for 10 years from account opening; contributions can be withdrawn whenever (life happens)
This:
- preserves choice
- provides reasonable defaults
- gives most people a good outcome, unless they opt into poor choices
I'm very much against pensions because, as an insurance product, they'll provide worse value vs a defined contribution plan, assuming the defined contribution is invested according to best practices (aggressive early on, then more conservative as you get closer to retirement; i.e. a target date fund).
In fact, I'm convinced we should replace Social Security with a Negative Income Tax (essentially means-tested universal basic income) to ensure that everyone stays out of poverty. Social Security doesn't do that, but that's kind of how many think of it. I don't understand why we're giving benefits to wealthy people, we should be concentrating those on the poor. In fact, this safety net shouldn't be just for retirees, but anyone below a certain income threshold, though we can certainly start with an age limit that reduces as people move out of the current SS system.
But the point is we can't trust personal responsibility. If a significant volume of the population is basically guaranteed to not invest and save voluntarily for retirement that is always going to be a social problem. Also, there's the problem of employers voluntarily providing retirement programs. Sure, I think there's a question of what or how that savings is invested for retirement (pension, 401k, etc), but it seems there needs to be more mandate to require employer's of a certain size to support retirement plans. And possibly even more mandate to require contributions to retirement plans. The article describes this in Australia: "Australia’s Superannuation Guarantee requires companies to contribute the equivalent of 11 percent of an employee’s monthly pay to an investment account that is controlled by the worker, who can also put in additional money. The “Super,” as it is known, includes full-time and part-time workers and has proved to be enormously successful. With its relatively small population — just 27 million — Australia now has the world’s fourth-highest per capita contributions to a pension system, and almost 80 percent of its work force is covered."
it seems there needs to be more mandate to require employer’s of a certain size to support retirement plans
Pretty much all companies over a certain size support retirement plans, that's not really the issue. The issues are:
- employees don't enroll: solution - enroll by default
- small companies can't afford the nice plans: solution - allow them to use the IRA, which have better funds anyway
- employees don't understand the plans they have: solution - simplify retirement plans
The reason the 401k is so complicated is because brokerages want to keep it that way. They literally get paid to "customize" a plan for the company, but what that really means is charge a ton for compliance paperwork nonsense and limit options. A lot of the crappier plans have super expensive funds and are almost worse than forgoing the tax break and just investing in a regular brokerage account.
Australia’s Superannuation Guarantee requires companies to contribute the equivalent of 11 percent of an employee’s monthly pay to an investment account that is controlled by the worker, who can also put in additional money.
Yeah, that's pretty much what I'm talking about. Extend the IRA (already exists) to allow employer contributions (like the HSA) and increase the limit to match 401k limits. Then eliminate the 401k, 403(b), and a handful of others to just use the IRA that employees already control. This does lose some features, such as loans, and I suppose those could be supported by IRA plans if wanted (ideally, loans against retirement plans wouldn't be allowed to prevent people from shooting themselves in the foot).
The big retirement firms are going to fight tooth and nail though, just like Turbo Tax fights against tax simplification. But that would get us 80% of the way to what Australia has. The last 20% is a minimum contribution, which I think isn't needed, and instead we should try using defaults (e.g. contribute 5% for new hires, 1% for existing hires minimum by default, and increase 1% per year until 10% or whatever). A lot of companies already have a matching program that works well, and it's honestly not worth fighting companies over what the minimum should be.
I aways assumed a 401k was what americans called pensions, like gas and petrol. What is a 401K if not a pension?
They're similar in that you use it for retirement.
But, 401ks you contribute to and the value depends on the stock market.
Pensions you don't contribute to and the amount you get is fixed.
More here: https://www.forbes.com/advisor/retirement/pension-vs-401k/
Oh interesting, where I am both of those are pensions but one is called defined benefit pension and the other a defined contribution. Mt wife has a defined benefit whereas I have contribution.
Benefit is definitelt better, knowing what you will definitely have is ideal and you can still take full advantage of a DC scheme if you want.
You'll generally get less from a defined benefit plan vs a defined contribution plan. A defined benefit plan is an insurance product, so the managers are encouraged to be more conservative with investments to limit risk. A defined contribution plan is an investment product, so the managers are encouraged to maximize returns.
Would you rather have a 5% yield guarantee or a very high chance at 10% return? (as in, 10% has been consistent in the past) In almost every scenario, a defined benefit plan will have much lower usable cash and no inheritance vs a defined contribution plan.
The US actually has both. Social Security is a defined benefit plan, and a 401k is defined contribution. Social Security is intended to replace ~40% of pre-retirement income (more for lower income, less for higher income), and the 401k is intended to fill in the gaps.
I think the "Pensions you don’t contribute to and the amount you get is fixed." is a bit murky. If you have a pension that probably means you have a lower salary compared to an equivalent non pension job, because part of your labor value goes into funding the pension. But the main thing is 401(k) puts a lot of responsibility on the individual. And as this article points out, if you put a lot put retirement financial planning on the individual, that creates a larger social problem since many people can't sufficiently do that themselves, even if they are being responsible with what they earn.
Yeah see the only different here is if the benefit is defined or the contribution is. Employers still give decently toward the DC and they manage the scheme. They have group schemes that all empkoyees are a part of and you cant leave it unless you leave the job or decide not to contribute.
I dunno, myself. But I did find this.