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What went wrong with the 401(k)?

by Don Kuehn

THE 401(K) WAS STARTED 30 years ago. At the time, it was thought this was going to be a supplemental investment program to support Social Security and private pension plans, one that would encourage workers to invest on their own with a little incentive from the boss. In effect, 401(k)s would form the third leg of the proverbial "three-legged stool" needed for a safe retirement: Social Security, a pension and personal savings.

The traditional pension plan (you know, the kind your father or granddad might have gotten for his years down at the plant) is technically called a defined-benefit plan. Payouts (benefits) at retirement are certain (defined) based on an actuarial calculation that takes into account the demographics of all  the workers covered in the plan.

On the other hand, a 401(k) is a defined-contribution plan (the 403[b] arrangements that a lot of public employees are eligible to participate in can also be placed in this category). Here, the only thing that is guaranteed is how much money you (and possibly your employer) pay into your account each month—not how much you'll pull out after you stop working.

What once was seen as a supplement has become a panacea for employers and municipalities whose traditional pension funds are running below expected reserves. They are ducking their obligations under more expensive defined-benefit plans and shifting the burden for a secure retirement onto employees.

Look, I don't have to convince most readers of this column that there is an all-out assault being waged on public employees. Politicians are trying to make hay out of the myth that their pension plans are bankrupting the states. We've seen it come to a head in Wisconsin and other states this year. What these critics know, but won't admit, is that virtually all states are experiencing hard times funding future payouts under their defined-benefit plans. It's not because workers don't pay enough into the plans (workers' contributions and investment returns equal about 73 percent of all public pension money) but because there was a major market meltdown that started in late 2008. Remember?

Oh, and where there has also been an attack on the collective bargaining rights of state and local workers, they fail to acknowledge that, in many places, the negotiators they demonize have actually bargained waivers allowing employers to skip or delay their payments into the plans, in favor of keeping jobs or gaining much-needed raises or keeping health benefits. They felt it was safe to do so because they knew the markets always "revert to the mean" over time, and the time would come when balances would recover and employers would be able to resume payments with little long-term damage to the plans.

One thing is clear: The government's history of making its legally required contributions is a major predictor of how solvent a plan is. Employees have their share taken from their checks automatically while employers can "float" their payments, skip them altogether or otherwise dodge their obligations. What a shock that the plans seem underfunded!

I didn't mention that it's the trustees of these plans who hire the investment managers who make the decisions on what stocks and bonds the employer-employee contributions are invested in. Geez, if my investment advisers were performing below average, not meeting future goals or making bad decisions on market timing, I think I'd look for new advisers—not punish the participants in the plan.

So, getting back to what went wrong, once these 401(k) plans started gaining some traction in the workplace (mostly among the better paid, more-astute investors), employers saw them as a way to slash their pension costs. In the 30 years since the plans were unveiled, the number of defined-benefit (traditional) pension plans has shrunk by two-thirds. Today, the number of 401(k)-style plans exceeds traditional plans by a staggering 12-1 ratio.

The fact that the stock market doubled in value in less than five years after the advent of these plans also helped convince employees that there was something to be said for the plans. Another "double" by July 1993 came during a time when it seemed the sky really was the limit. Even the most inexperienced investors were euphoric. It looked like all you had to do was buy something and sit back and watch it grow. And since the boss was chipping in, why not buy?

I'll admit to a couple of things, right here: I have consistently advocated participating in 401(k) and 403(b) plans if they are available to you; there are still many good characteristics to the 401(k) design that favor investors who educate themselves in the ways of their plan; I was fortunate in the timing of my own retirement in that I was working during the greatest bull market run in history (1984-2000)—one I'm afraid will never be repeated. And that's part of the problem; to work as hoped, there would have to be another giant run-up in the markets, and even the most optimistic observers don't see that coming.

However, the question is, if not these kinds of investments, what? If not taking advantage of an employer's contribution, what? I still have to say that you should be investing (if you can) in any plan available to you, especially if your employer is contributing on your behalf.

One sign of failure is that, even with employer contributions figured in, the average balance in the 401(k) plans of workers nearing retirement is a measly $64,000—and 60 percent of workers near retirement have 401(k)-style plans. If you want an income of $30,000 a year after retirement—and keep your eye on the prize here, retirement is the goal—you would need a minimum balance of almost seven times as much, or $445,000!

Here are a few more reasons these plans have failed to produce the secure retirement they promised:

  • It took too long for many people to accept the notion that they should be participating, so they started too late. And they haven't saved enough. Today, you'll find responsible advisers suggesting that between 10 and 20 percent of salary should be invested toward retirement planning, nearly double what was accepted dogma 30 years ago.
  • Most people are too busy living a challenging life to spend the time necessary studying the markets and various investment possibilities to become disciplined investors. The result is that they fail to regularly diversify or rebalance their portfolios, and they tend to panic when there's trouble.
  • It's a given that the stock markets are more roller coaster than merry-go-round. There always will be ups and downs, winners and losers. If a market cycle swings up just as you are about to retire, you win. If the markets swoon at or just after retirement, you lose. Cruel as that may seem, with a 401(k) plan, the risk is all yours. That isn't the case in a traditional pension plan because the risks are spread among all of the workers in the plan, regardless of age, and it doesn't matter what the markets do in the months or years before you retire. Based on the reality that over time, the markets revert to the mean (i.e., get back to their normal growth pattern), everything averages out over the whole population.
  • Today, almost 2 million people live past age 90. That should increase to 9 million by 2050. It's called longevity risk. That's the danger that you will outlive your savings. In a traditional defined-benefit plan, that can't happen because your lifetime benefits are derived from a pool of investments made by professional money managers with the contributions of all workers who will ever work for your company or employer. They're not determined by your investment skills alone.

A March 2012 Associated Press story noted the doubling of the stock markets from Dow 6547.05 at the bottom in 2009 to Dow 12922.02 exactly three years later. Accompanying the story was a photo of an older couple with a caption stating that the couple took "a big hit to their retirement accounts in 2008 and 2009, pulled most of their money out of stocks and have been leery of putting it back in."

And therein lies the problem. When the average novice, or casual investor, sees the balances in their accounts fall dramatically, they panic. The problem the couple in the AP story (and millions of others) now faces is that they locked in their losses when they sold into a distressed market. In reality, they sold at the lows and now have to buy back at significantly higher levels. The opposite of the proven adage: buy low, sell high.

I usually close by saying, "it's your money," but in this case, it's the money of almost everyone who's at risk if the trend toward 401(k) plans, and away from traditional pensions, continues unabated. Keep these defined-contribution programs as a supplement to the traditional plan. If you have access to one, use it. Become a knowledgeable investor. Make the best of your situation, and don't build your future on any one leg of that three-legged stool.


Don Kuehn is a retired AFT senior national representative. For specific advice relative to your personal situation, consult competent legal, tax or financial counsel. Comments and questions can be sent to