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The Real Problem With 401(k)s

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As the aging baby boom generation faces the challenge of saving for retirement despite inadequate preparation, 401(k) plans have earned the scorn of countless critics. Yet few people really focus on the primary problem with 401(k) plans: that they allow workers to cheat themselves out of a decent retirement.

Making financial survival optional
For decades, the traditional pension system took care of workers by ensuring them a fixed monthly payment for the rest of their lives after they retired. By providing pensions to their workers, companies assumed the responsibility for setting enough money aside and investing it well enough to be able to meet their obligations to their workers years or even decades into the future. Put another way, companies had to do the same sort of retirement planning as individuals, except on a much more massive scale that aggregated thousands of workers who expected to retire at vastly different times.

By contrast, 401(k) plans were designed to avoid any guarantee of a certain monthly payment for workers after they retired. Instead, they allowed for fixed contributions to retirement plan accounts, leaving the eventual future value of the plan assets in doubt.

From a corporate perspective, there was certainly value in making the shift away from traditional pensions. In the mid-2000s, Verizon (NYSE: VZ  ) froze pensions for more than 50,000 of its managers, while IBM (NYSE: IBM  ) froze pensions for more than 100,000 workers back in 2008. More recently, General Motors (NYSE: GM  ) and Bank of America made plans earlier this year to implement their own pension freezes. In each case, companies enjoyed more predictability in pension costs.

If that had been the only motivation behind the changes, then companies could have taken steps to make workers equally well off under 401(k) plans. Specifically, they could have taken the money they otherwise would have put toward pension-plan contributions and directed all of it toward employer contributions to 401(k) accounts. By doing so, they would have left workers with a benefit of roughly equal value, at least on a theoretical basis.

A hidden pay cut
Instead, most companies minimized employer contributions after eliminating pension plans. Bank of America's plan, for instance, involved making an additional annual contribution of 2% to 3% to 401(k) accounts. Yet when you consider the numbers, the roughly $1,000 to $1,500 in annual expenses that B of A will take on for a salaried worker making $50,000 won't come close in all likelihood to earning enough to replace the lost monthly pension that worker would have received under a traditional pension. Moreover, during tough times, many employers didn't hesitate to eliminate contributions like employer matches, with American Express (NYSE: AXP  ) and JPMorgan Chase (NYSE: JPM  ) among dozens of companies that temporarily suspended matches before bringing them back when conditions improved.

Employers would argue that 401(k) plans give workers the ability to decide for themselves how much to save for retirement. Yet according to a recent Towers Watson survey (link opens PDF file), fewer than one in six employers believes that most of their employees use retirement and investment planning resources well, while only a quarter think their employees have realistic expectations about their eventual retirement prospects.

If employers really cared about making sure their workers saved enough for retirement, as nearly three-quarters of them say is their primary purpose in offering a 401(k) plan, then they have an option at their disposal to ensure that: Cut salaries and direct every penny to making adequate employer contributions to workers' retirement plans. By essentially taking the savings decision out of the hands of workers, employers could allow 401(k)s to achieve their original purpose of helping ensure an adequate amount of retirement savings.

Not gonna happen
But rather than bringing the implicit pay cut involved in shifting from pensions to 401(k)s out into the open, employers are much more likely to simply let prevailing trends take their course. That leaves workers in the position to discover for themselves just how much they lost when their pensions were replaced, and they'll have to negotiate hard if they want to come up with the money to replace those valuable benefits. Those who don't will be in for a rude awakening when retirement approaches.

It's not too late to take steps to preserve your retirement. The key lies in saving as much as you can and then investing your money better. Our popular special report on retirement includes three smart long-term stock plays that can boost your financial prospects. It's absolutely free, but don't miss out -- click here and read it today.

Fool contributor Dan Caplinger owns warrants on JPMorgan Chase. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of JPMorgan Chase, IBM, and Bank of America. Motley Fool newsletter services have recommended buying shares of General Motors, writing a covered strangle on American Express, and creating a synthetic long position in IBM. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy isn't a problem for anyone.


Read/Post Comments (14) | Recommend This Article (8)

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 09, 2012, at 11:40 AM, DividendsBoom wrote:

    Article makes me gag a bit. Excuses for a lack of personal responsibility. It isn't an education deficit. It is a values deficit.

  • Report this Comment On October 09, 2012, at 12:48 PM, habaco wrote:

    Thank you for that direct, honest article on 401k's. Workers r not investors... money is not they're expertise. 401k's have been a scam from the get go. Scandalous. Why should busy workers be forced to become financial experts in order to protect themselves from their employers' selfish, self directed,k self-interested choices re the 401k's they're offering.

    Your insight is much appreciated.

    And to have written this article in this insane political season.....I commend your bravery !!

    Diana

    Florida

  • Report this Comment On October 09, 2012, at 4:38 PM, TheRealRacc wrote:

    Ignorance causes the lack of personal responsibility to managing your 401k. If you are a worker, you should consider yourself an investor. You invest your time and skills in a job. Managing a 401k is probably easier than most, if not at all, jobs on the market. Learn the simple, minimal rules to managing a 401k. It really isn't rocket science, nor requires any expertise in finance.

  • Report this Comment On October 09, 2012, at 4:38 PM, TheRealRacc wrote:

    The title of the article should be, "The Real Problem With The American Workforce."

  • Report this Comment On October 09, 2012, at 4:40 PM, TheRealRacc wrote:

    Fidelity has knowledgeable representatives who are more than happy to answer all questions finance- and tax-related. I urge people to spend a 20 minutes using their online chat with their respective 401k firms and you will have improved your retirement dramatically.

  • Report this Comment On October 09, 2012, at 5:16 PM, TMFGalagan wrote:

    @DividendsBoom - I'm all for personal responsibility and much prefer the 401(k) system to an employer-based system. If companies had made the shift solely on personal-responsibility grounds, though, they would have funded it equally. Instead, they used it as a way to make huge compensation cuts, many of which workers never perceived. Workers do indeed deserve some of the blame for not knowing the full implications of what was happening to them, but it still represented a marked reduction in the value of their work.

    best,

    dan (TMF Galagan)

  • Report this Comment On October 09, 2012, at 6:46 PM, sheldonross wrote:

    I agree with it being a personal responsibility issue.

    Working does not imply retirement. Somehow this country has come under the entitlement mentality that if I simply work long enough, I should be able to retire.

    If you want to retire, you should prepare for it utilizing whatever avenues you have available for you.

    Is the employer supposed to wipe our bottoms too?

  • Report this Comment On October 09, 2012, at 6:56 PM, Borbality wrote:

    ha, and we'd all shy away from investing in companies that offer full pensions like the good old days too.

    Some of us are young enough to have never even considered the possibility of a pension. No sympathy from us, either.

  • Report this Comment On October 09, 2012, at 7:49 PM, wolfman225 wrote:

    <<If employers really cared about making sure their workers saved enough for retirement....>>

    Pardon, but it's not my employer's job to babysit me in my retirement, nor to manage my current financial life (for me own good, of course).

    <<[They could] Cut salaries and direct every penny to making adequate employer contributions to workers' retirement plans....essentially taking the savings decision out of the hands of workers....>>

    Again, it's not the employers' responsibility to ensure future financial security for their employees. They aren't able to establish what contribution would be "adequate" to ensure the employees financial future. It's an impossibility on it's face.

    Secondly, reducing an employee's current paycheck in any economy, much less this one, is a sure path to employee revolt. Or do you really think workers are going to accept that the reduction in pay will be used to guarantee their future (trust us, we know what's best for you)? Anyone who has been around more than 30 years can see just what we've gotten in the way of "security" from the S.S. "lockbox". We can't trust our financial futures to a company that may or may not be here in 50 years anymore than we can rely on a government that has already decided that we don't have any individual right to the money in our Social Security "account".

    Finally, I don't want anyone (employer, politician or government) "taking savings decisions out of my hands". If I decide that I want to take some of my savings to go on vacation, I don't want some boss or bureaucrat telling me I can't because I need to save more for retirement. If I do my due diligence and decide that Company A is where I want to invest my money, I don't want some nanny stater overruling my decision and putting my money into Company B to keep it "safe".

    I believe that the transition from traditional pensions to 401k plans is/was inevitable. We've seen just how much a burden legacy costs have been for businesses such as the airlines and steel mills. Once we became engaged in a global marketplace, businesses were forced to look for ways to lower costs in order to compete with the lower costs of operation for competitors overseas.

    The only "problem's" with the 401k system are the laziness of the American worker when it comes to saving a sufficient percentage of their income for a sufficient amount of time to give themselves a shot at a secure retirement and the risk we all take; whether we're individual investors, whether we have a pension plan, whether we're reliant on the government; we're all relying on the performance of the market and the economy going forward and there are no guarantees.

  • Report this Comment On October 09, 2012, at 9:53 PM, TMFGalagan wrote:

    @wolfman225 - The fact that there was no revolt when workers lost their pension plans -- which was a truly massive economic loss for workers -- stands in the face of your assertion that there'd be a revolt if wages were cut. How much leverage do you think workers have right now? Obviously, it depends on the company, but with high unemployment, you can't afford to be too revolutionary in response to pay cuts.

    As for it not being employers' responsibility to provide for retirement, why bother having 401(k)s at all then? The fact that 401(k)s are linked to employers - with all the hidden fees and costs that come with them - suggests that employers intend to play a useful role in helping workers save for retirement. Make those employers be more helpful, or else disband the whole 401(k) system and just raise IRA limits to let people have complete control of their retirement themselves.

    best,

    dan (TMF Galagan)

  • Report this Comment On October 09, 2012, at 10:30 PM, Chuck2010 wrote:

    it is joke to say that employees did not revolt and it is their fault for not revolting. TMF Dan, workers have been held with flat wages in real terms for how long? how many jobs were shipped overseas? how many H1Bs were brought in rather than allow existing programmers to retrain in new languages? there were plenty of screams as company after company converted those pensions into fixed contribution schemes. but the idealized market of everyone just picking up and quitting those companies is a not how it works in the real world. an IBMer in Poughkeepsie does not have another high tech company to jump to like folks in silicon valley. even there, an IBM employee could only jump to another silicon valley company that had no pension plan at all. 401K's were never meant to replace pensions in their original form but instead became the only thing offered to most of the work force.

  • Report this Comment On October 09, 2012, at 10:45 PM, wolfman225 wrote:

    <<The fact that there was no revolt when workers lost their pension plans -- which was a truly massive economic loss for workers -- stands in the face of your assertion that there'd be a revolt if wages were cut. >>

    Not at all. Cutting potential future benefits doesn't have anywhere near the impact of threatening a man's (or woman's) ability to provide for the immediate needs of their family. We have a tenuous grip on the future. At most, it causes us to worry sometimes. After all, the future hasn't happened yet and there's always a chance to evade fate.

    Telling a worker that you are going to reduce his ability to provide for his/her family and withhold even more of their earnings, on the other hand? Especially on the basis that you (the employer) know better than they how to handle their money? Right. I know exactly how I'd react to my employer saying that he was going to withhold an extra 20% of my check because, in his opinion, I'm too stupid to be trusted to handle my own money.

    <<...why bother having 401(k)s at all then? The fact that 401(k)s are linked to employers - with all the hidden fees and costs that come with them - suggests that employers intend to play a useful role in helping workers save for retirement.>>

    It means nothing of the sort. The move to 401k's was simply a means to the end of reducing current expenses and future obligations. Employers couldn't simply eliminate pensions altogether overnight, so they took advantage of this intermediate step. (No, I don't have proof, just supposition)

    The reason for the early establishment of pensions was a way to attract and keep the best workers, no more, no less. Just the same as businesses today put together other benefit packages to attract talent. "Intending to play a useful role in helping workers save for retirement" has little or nothing to do with it. It's a minor detail in the big picture.

    <<...or else disband the whole 401(k) system and just raise IRA limits to let people have complete control of their retirement themselves.>>

    Sounds good to me, as long as I can be assured that the government won't come after any gains I may make in order to take care of those who didn't prepare as well in the name of "fairness".

  • Report this Comment On October 10, 2012, at 11:47 AM, wolfman225 wrote:

    Also, not every revolt involves torches and pitchforks or mass walkouts. Worker apathy, shoddy workmanship, increased absenteeism, even internal sabotage of the company are all possible actions that can be taken by disaffected employees.

    They can also damage the company's reputation by word of mouth and anonymous postings on public forums. Such things have led to costly, and in some cases irredeemable, PR and financial consequences for company's that consistently fail to treat their employees fairly.

  • Report this Comment On October 10, 2012, at 5:50 PM, wolfman225 wrote:

    This just in: Employee revolt in progress against world's largest private employer. 1st ever work action against Wal-Mart begins to spread nationwide.

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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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