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The New Threat to Your Life Savings

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You know selling in a panic won't help your investments. But Congressional lawmakers didn't get the message -- and they're putting your savings strategy at risk.

After passing the $700 billion rescue package two weeks ago, some representatives have turned their eyes toward reforming Wall Street. Yet the target they've chosen is the foundation for retirement security for millions of workers: tax-favored 401(k) plans.

House leaders held hearings last week to discuss the possibility of getting rid of the tax deductions for contributions to 401(k) plans. Citing statistics that show high-income taxpayers get a disproportionate benefit from 401(k) deductions, as well as the recent steep declines in most workers' retirement-plan balances, leading politicians believe that alternatives could better serve the purpose of helping all workers have a secure retirement.

Forcing investors into bonds
One proposal, from New School economics professor Teresa Ghilarducci, recommends replacing 401(k) plans with government-managed retirement accounts. Under Ghilarducci's plan, workers would contribute 5% of their pay, and the government would add a fixed amount above that -- similar to matching contributions from employers now, although not necessarily as large.

The real difference between 401(k) plans and a government-managed alternative is in the way your money gets invested. Under the proposal, savers would be forced to invest in bonds similar to existing inflation-protected bonds, also known as TIPS, that would guarantee a return 3% above the inflation rate.

A convenient scapegoat
It's not surprising that legislators are upset with the problems in 401(k) plans now. With stocks under nearly constant attack and people seeing their life savings at risk, it's easy to blame the stock market for every economic problem we're facing now. Workers at companies such as Morgan Stanley (NYSE: MS  ) , Citigroup (NYSE: C  ) , and Ford Motor (NYSE: F  ) with company stock in their retirement plans have suffered huge losses. And with gargantuan outlays for government-sponsored initiatives to help preserve the financial system, the effective tax increase from eliminating 401(k) deductions looks like a rare opportunity to raise at least a little bit of revenue.

But the plan has several flaws. The most important one is that the government's plan won't give workers enough savings for them to retire. With inflation historically running at 3%, a 6% total return on retirement savings simply isn't enough for many workers to reach their financial goals. Consider: Someone with a $60,000 salary would save $3,000 under the plan. If the government adds $600 as a match, as Ghilarducci suggests, that comes to $300 per month. Over 40 years at 6%, $300 in monthly contributions would yield around $600,000.

That sounds like a lot. But the purchasing power of that $600,000 would have been reduced by nearly two-thirds in 40 years, making it worth less than $185,000 in current dollars. If you use a standard rule of thumb that allows you to withdraw 4% per year from your retirement savings -- a rule that might not work with an all-TIPS portfolio -- that means you'd get just a little more than $600 per month in current-dollar purchasing power from your portfolio. Combined with what Social Security will pay, that won't put you in the lap of luxury.

In contrast, even if you think returns on stocks will be lower in the future than the 10% they've averaged in the past, you'd still end up way ahead. With an 8% return and similar contributions, you'd end up with more than $1 million -- and when you combine the value of the tax deduction on top of company matches that are often 50% or more, you could finish with a lot more.

Moreover, over periods of 30 years and more, many stocks have put in better returns than 8%. Here are a few:

Stock

30-Year Average Annual Return

Wal-Mart (NYSE: WMT  )

23.5%

DuPont (NYSE: DD  )

9.3%

Coca-Cola (NYSE: KO  )

14.3%

IBM (NYSE: IBM  )

8.4%

Source: Yahoo! Finance.

You can do it
Perhaps most importantly, the message sent by eliminating 401(k) plans would be devastating: It would suggest that most people can't be trusted to invest their own money. As hard as it's been for workers to become independent from disappearing company pensions, the move from company-run pensions to 401(k)s has made all of us learn to be responsible for our own retirement. In my view, that's an empowerment that no one should try to take away.

In contrast, reversing that course by telling every single worker in the nation that the stock market is too risky for his or her retirement savings would be ridiculous -- and would deprive millions of any chance at a comfortable retirement. That's too high a price to pay. The financial panic has put a big dent in 401(k)s -- but getting rid of them entirely would be a huge, panic-driven decision by lawmakers, with dire consequences for the financial security of working America.

For more on the panic of 2008:

If you need help managing your retirement money, come to the experts at our Motley Fool Rule Your Retirement newsletter service. Lead analyst Robert Brokamp gives you advice you can use each and every month, including specific investing tips, strategies, and cost-cutting ideas that can make every dollar go further. Best of all, you can take a look free right now with a 30-day trial.

Fool contributor Dan Caplinger's 401(k) balances are down, but he's not crying about it. He doesn't own shares of the companies mentioned in this article. Wal-Mart and Coca-Cola are Motley Fool Inside Value recommendations. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy won't panic on you.


Read/Post Comments (7) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 16, 2008, at 1:40 PM, NightBengal wrote:

    Hmm.... The Government takes 5% of your pay, the employer or the government contributes a matching fund amount, and the whole thing is invested in bonds until it's needed. I know I've heard of something like this before... let me think... ... ...

    ... oh yeah! Social Security! Now, THAT makes me feel better!!

    Seriously, even if it isn't a pay-as-you-go system, it still makes people's REAL retirement funds (as opposed to teh supposedly temporary, basic benefit SS was to provide) subject to every kind of flaw of the current system... including the Government ATM Card for dipping into our funds.

    Thanks, but no thanks.

  • Report this Comment On October 16, 2008, at 5:05 PM, GHB59 wrote:

    One major issue with this proprosal is you can condense the pro's in a 30 second sound bite and make it sound so good. However, the con's take much longer to argue and require knowledge and logic to understand. This makes the sell so easy.

  • Report this Comment On October 17, 2008, at 11:41 AM, garyc27 wrote:

    What a fabulous idea! A 401-K brought to you by the folks that manage Medicare/Medicaid {a health insurance plan}, Social Security {perceived retirement plan},an Affordable Housing plan via two mortgage giants that failed which has resulted in an economic situation not seen since 1929. The same people who believe that mediocrity is far better than individual achievement!

    Never mind.

  • Report this Comment On October 17, 2008, at 3:07 PM, LisaPA wrote:

    Dial it back, guys. You first say this is one proposal. Then you say it's "the government's plan." Conflating the two to write an anti-government screed isn't really necessary or helpful. I'd also like to point out that this plan appears in no way to restrict you from investing in the stock market outside the plan, so you could still get those great returns, you'd just be taxed differently on them. What are the other proposals? How popular are they with the various committee members? How about a substantial article comparing the merits?

    As an aside to Morgan628, Medicare is the most efficient government program in history. You may disagree with it anyway, but that doesn't make it mediocre or badly managed.

  • Report this Comment On October 17, 2008, at 11:30 PM, thedofca100 wrote:

    I don't know where to start. Most people don't know how to invest their money and never will. Read the statistics for the amount people have saved for retirement, how much they take out of their 401K everytime they change jobs, and all the rest of the statistics. Great for you if you feel you can do so much better than a guaranteed return by somebody. Most people can't. We've kept our retirement out of the market completely and watched our friends earn what they tell us is 25% on their money. We are the only people today who aren't looking for a job. You people aren't being honest about the situation.

  • Report this Comment On October 18, 2008, at 5:24 PM, DrBob66 wrote:

    8% average return per year? Yeah, and the DJIA will be at 80,000 in thirty years, right?

    This is overly optimistic (some might call it dreaming). Buy-and-hold stock investing hasn't been kind to investors over the last ten years...what makes you think that the next ten (or the ten after that) will be better?

    Wishful thinking is not a good strategy for retirement planning.

  • Report this Comment On November 06, 2008, at 3:20 PM, lorimckay wrote:

    Are you serious? A good chunk of you are asking for more governement involvement because you feel people can't handle their own finances????? And you think the Federal Government is a vast improvement?

    Do you know anyone on Social Security? Medicare? Medicaid? or at a VA Hospital?

    So we will turn over our 401k and they will combine it with SS.... I can see the speach now... "OH Gee Federal 401K is now bankrupt we needed to borrow the money for bailing out Social Security because we cut the social security deduction to spread the wealth around. Oh and we had to setup 401k plans for all those people who were getting Social Security Cuts it was only fair."

    Thanks but NO THANKS! I may not always choose the right thing but I'm making the choice not some corrupt politician! There is only one choice FREEDOM of choice.

    This is a money grab pure and simple! They see untaxed cash mounting up and they want it pure and simple. If you want the governement to handle your retirement go for it but I'll pass. This program will be forced you won't be able to opt out don't kid yourself. It won't be for just "the stupid people"

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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