Our topic this week is the 401(k). (Not $401k...) The 401(k) is a retirement savings account which gets it's name from a section of the tax code: Section 401. I'll let Nancy explain the plan in her 2005 column. Enjoy!
It's a scary world out there for someone approaching retirement. Lay-offs and forced early retirement, corporate scandals and disappearing stock value, shrinking pension benefits, and, now, a Social Security system heading for hard times. What's a body to do?
The most valuable asset anyone can have is their ability to work and earn a living. For those who are already retired, the scariest thing is knowing there are no more paychecks to be had. Whatever you generate must come from assets you have built up through a lifetime of saving and investing. What if you didn't save enough? What if you picked the wrong investments? What if rising healthcare costs eat into your stash? What if inflation skyrockets and leaves your earnings in the dust? It's a scary world out there.
In 1950, General Motors started the first pension plan for its employees. The idea was simple. GM would set aside a certain amount for each employee, investing it, and adding to it until the employee retired. Upon retirement, the employee would receive a monthly check from GM until his death. Company loyalty was rewarded with guaranteed payouts in your old age.
Taking the risk
Sometime in the 1970s, companies started offering 401(k)s and profit-sharing plans. As an employee, you would set aside money from your paycheck, choose investments, and add to it until retirement. Upon retirement, whatever had accumulated in your account is what you had to live on in your old age. This change marked a shift in risk. In the old plans, the employer took all the risks. In the new plans, the employee took all the risks.
When the employer was shouldering the risk, there was a need for some sort of protection. So, the Pension Benefit Guaranty Corporation (PBGC) came into being. This is a government agency, which acts as an insurance company on pension plans. Should a company go bankrupt, PBGC would step in to cover those guaranteed payments to employees. This seemed like a no lose proposition.
Then, times changed. The steel industry went through hard times, and, time and again, the Pension Benefit Guaranty Corporation was called on to fill the gap. Tough economic times combined with tough times in investment markets leave many pension plans in a pickle. The latest company to fall back on PBGC is United Airlines. PBGC has $39 billion in assets, but now owes over $62 billion in benefits to 1.1 million people. Although United States retirees will continue to receive a check thanks to PBGC, many are finding that check reduced considerably.
Getting the opportunity
Many old line companies offer both types of plans, but newer companies only offer 401(k)s or profit-sharing plans. There are no guaranteed payouts, only an opportunity to save and invest at will. As scary as the situation is with the old pension plans, academics are concerned about employee behavior with the new plans. When those employees retire who only have a 401(k) and Social Security to depend on, will it be enough? Will those employees cry foul, saying the didn't know enough to handle the risk thrust upon them?
In studying employee behavior in these plans, research has found most people to be lacking in knowledge. The average contribution rate is only about 4%, a rate which will leave many in poverty at retirement. Also, most adopt a fund selection strategy called conditional naive diversification. No matter how many funds are offered within a plan, employees, on average, select three or four funds. That may not be so bad. Any more than that can be difficult to track, but most employees simply divide their contribution evenly among all chosen funds. If you select four funds, you tend to allocate 25% to each fund. Here's something interesting researchers have found... if you select only three funds, the math is not so easy (100% divided by three), so, instead employees put more in one fund, then divide the rest equally between the other two. So much for a reasonable allocation among cash, stocks and bonds based on time horizon and risks. Just split it up evenly and run with it.
We also know that few people change their original allocation. They rarely adjust to accommodate changing markets or their own aging. They're just not paying attention. Also, if company stock is offered within the plan, employees consider that separately. They don't even think of that in light of the allocation to other funds. It's just something extra.
Enron and WorldCom employees know the danger of depending on company stock too heavily. Should the company disappear, your retirement goes down the tube. That may not be so horrible if you're 30 when it happens, but what do you do when it happens at age 50? Throw in the solvency problem with Social Security, and we're back to a scary world. What should you do?
Words of wisdom
The best thing is to follow the old adage, "Don't pull all your eggs in one basket." Don't give up on those pension plans, but invest outside of them, as well. Invest in your company 401(k), but do it wisely. If you need help, find an advisor. Give your plan an annual check-up to make sure it's doing what you want it to do. Don't load up on company stock. Invest outside of retirement plans, too. Add to regular savings on a disciplined basis. Save and invest like you'll never draw another paycheck. One day, that will be the case.
And last, but not least... don't factor in Social Security. Think of it as icing on the cake. If it doesn't come through, you won't go hungry.
--Nancy Lottridge Anderson, Mississippi Business Journal, May 30 - June 5, 2005