4 Reasons Americans' 401(k) Balances Are Too Small

Only around half of all households have 401(k) accounts. Even for those who do, the median 401(k) balance for those approaching retirement was just $135,000 in 2016. With few employees having access to defined benefit pension plans to provide guaranteed income, and with average Social Security benefits providing an income just above poverty level, it's clear there's a retirement crisis in America. 

The Center for Retirement Research identified four key reasons why 401(k) balances are too small for most Americans. Fortunately, it's possible to overcome the challenges causing 401(k) balances to be too small and to save much more than the median. Let's take a closer look at those four items, along with some suggestions for individual investors to solve their retirement saving problems. 

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1. Less than full participation

One of the key reasons the median 401(k) balance for Americans is too low is that too few workers contribute to retirement plans. 

Only around half of all workers in the private sector were offered access to a workplace retirement plan, and less than half of all 401(k) plans in the U.S. automatically enroll workers. This puts the onus on employees to sign up for 401(k) accounts, which they often don't do.

Participation rates in plans without auto-enrollment declined from 2013 to 2016, even as participation rates rose in workplaces where employees were enrolled by default. With the decline, just 80% of workers with access to 401(k)s contributed in 2016. 

Solving this one is simple: sign up for your workplace plan if you have access to one. If you don't have access to a 401(k) at work, you can still use an IRA. IRAs allow you to invest up to $5,500 with pre-tax money in 2018 (or $6,500 if you're 50 or older) provided your income isn't too high. There are also additional retirement saving choices for people who have self-employment income, and you can also invest in a tax-advantaged health savings account (HSA) with pre-tax funds to set aside money for healthcare costs during retirement if you have a qualifying high deductible health plan. 

Signing up for a 401(k) at work is simple; just talk to human resources and opt in. Signing up for an IRA and HSA can also be easy. Select a brokerage firm or use a robo-advisor service where you pay a small fee to have it invest for you.

When you sign up at work or open a brokerage account, set up automatic contributions to your account from your paycheck to ensure participation. You can contribute up to $18,500 to your 401(k) in 2018 and can make additional catch-up contributions of $6,000 if you're 50 or older. Your employer may also provide matching contributions, which is essentially free money. 

2. Contributions that are too low

Employees contributing too little is another big reason why 401(k) balances are too low in America. The Center for Retirement Research explains average contribution rates actually declined between 2015 and 2016. This decline was attributed to auto-enrollment.

While auto-enrollment prompts more workers to sign up for 401(k)s, most plans set default automatic contribution levels at just 3% of income or less. Fewer than 40% of plans offering auto-enrollment also auto-increase contributions, so most people simply continue to invest 3% of their income. 

This is far too little. In fact, while conventional wisdom suggested that you invest 10% of your income for retirement, people are living longer and returns are lower now so this 10% rule no longer works. Instead, if you want to ensure you have enough money to retire, aim to invest between 15% and 20% of income for retirement. 

To boost your contributions, automatically increase them as soon as you get a raise before you get used to living on the extra money. Create a budget that allows you to prioritize savings, and consider taking steps to boost your income such as negotiating raises or taking on a side gig.

While you may have to gradually work up to saving 20% of your income, even a small amount of money makes a big difference. This chart shows how much adding $1,000 to your annual retirement contributions each year will impact the savings you end up with, depending upon the age when you get started, if you earn 7% annual returns. 

Chart source: Author

3. 401(k) fees that are too high

Target-date funds have made it easier for investors to allocate investments appropriately because investors simply specify their risk tolerance and the age at which they wish to retire and will be invested automatically in a portfolio that's periodically rebalanced so risk tolerance is appropriate for their age. 

Unfortunately, while target-date funds have made it easier for 401(k) investors to choose appropriate investments, the problem of high fees is still lowering account balances. Mutual funds are the primary investment vehicle in 401(k) accounts and fees on many of these funds are high. In fact, the expense ratio in 2016 was 0.51% for bond funds and target date funds, 0.63% for equity funds and 0.18% for money market funds. An expense ratio of 1% over 40 working years can cause a reduction of close to 20% in the value of assets at retirement.

To make sure you don't end up with a retirement account that's significantly smaller than it should be thanks to high fees, check expenses and costs carefully on all investments. If your 401(k) offers only high-fee choices, invest only as much in your 401(k) as necessary to get your full employer match and invest the rest of your retirement savings in an IRA with a wider array of investment options.

You can consider low-fee ETFs as an alternative to mutual funds to build a well-balanced portfolio with minimal effort, and may end up with much more money by not paying a fund manager. 

4. Leakages from 401(k) plans

Another problem causing 401(k) balances to be too low: people are taking money out before retirement. This occurs when 401(k)s are cashed out -- which comes with huge penalties -- as well as when people take hardship withdrawals or borrow from 401(k)s and default on the loans. 

Taking money out of a 401(k) before retirement is almost always a really bad idea because you typically get hit with a 10% early withdrawal penalty. Even taking a 401(k) loan is usually inadvisable -- even though it may seem smart to borrow from yourself, there are big risks including the fact the loan may need to be paid back immediately if you need to change jobs. 

To avoid leakage, keep your money where it is once you've invested. If you run into financial hardship, a personal loan that doesn't put your retirement at risk is usually a better bet, even with paying interest to the bank. 

You can beat the median

While the median 401(k) balance in America is too small, yours doesn't have to be. Get started today on investing more and investing smarter and you can retire with a nest egg large enough to provide you with real security as a senior.