401(k) is For LosersPosted by Badger Coach on May 2nd, 2014
In an attempt to satisfy wealthy corporate executives, Congress passed The Revenue Act of 1978, which contained an obscure provision known as Internal Revenue Code (IRC) Sec. 401(k). This new tax law allowed corporate executives to defer taxes on their profit-sharing plans, and to supplement their defined benefit (pension) plan on a pre-tax basis.
The 401(k) Fathers Speak
However, 401(k) plans were never designed to become an employee’s primary retirement vehicle, much less her at-risk, high fee, do-it-yourself retirement plan. Critics of the 401(k) plan state that this type of a retirement plan is a failure. John C. Bogle, founder of Vanguard mutual funds said in a Morningstar investment conference interview “Now the problem with 401(k)s are a couple. The big one for me is, it’s a thrift plan that we’ve tried to redesign into a retirement plan. It was never created, the 401(k), to be a retirement plan.” And employee benefits consultant Ted Benna, known in the industry as the “Father of 401(k), and the salesman who single-handedly pushed 401(k)s onto the market place, who now says of 401(k) plans “I would blow up the system and restart with something totally different,” when interviewed by SmartMoney.com. Richard Stanger also takes issue with 401(k). He is credited with actually writing the 401(k) law and now says “401(k)s were a good idea… if anyone had known how important 401(k) would become, the Joint Committee on Taxation never would have let me, a 28-year-old junior lawyer, write it.” And finally, Diane Kennedy, CPA and author of Loopholes Of The Rich says “The biggest reason of all to not use a 401(k) plan is that a 401(k) plan turns portfolio income into earned income. That means you are turning money taxed at 15 percent into money taxed at 35 percent.”
The bad news is that 401(k) plans have become the primary way in which we invest for retirement. Unlike pension plans, the do-it-yourself 401(k) retirement plan requires participants to become savvy investors and responsible for accumulating enough money to support themselves throughout retirement. Unfortunately, this system offers no guarantees other than high risk, high fees, and claw-backs on the deferred income taxes. These issues are covered in an excellent 2013 PBS documentary titled “The Retirement Gamble.
Since corporations have discovered that they could reduce their long-term legacy liability exposure by replacing their defined benefit (pension) plan with a defined contribution 401(k) plan, investors should not look for much to change for the benefit of the employees, as this plan provides better tax incentives for small business owners and corporations than it does for their employees.
However, to make the 401(k) more attractive to employees, tax incentives in the form of tax deferrals and tax deductions are touted by financial salespeople who have overdosed on the 401(k) kool aid. The pitch is that employees can contribute a portion of her income on a pre-tax basis to her 401(k) plan, and a portion of that contribution would reduce her taxable income by the percentage of her marginal tax rate. Meanwhile, the benefit for employers, unlike their employees, is that they can deduct their contributions as a business expense and never have to worry about repaying the tax deduction.
The downside to 401(k) plans—or its 403(b), 457, or Thrift Savings Plan cousins—is that any tax deduction taken during an employees working years will be recaptured by Uncle Sam during her retirement years. And it gets worse. She will also have to pay fees and taxes on her employers matching contribution as well as on any investment earnings. So much for employer matching contributions being called “free money.” It would only be free money if she did not have to pay taxes or fees on her employers’ contributions.
Another problem with the 401(k) plan is its shareholder performance. Data obtained from Employee Benefits Research Institute (EBRI) show that out of 24 million 401(k) participants, only 8 percent of the employees with at least 30 years of tenure had an average account balance of $224,287 at the end of 2012. The average account balance for all participants in this study was $63,929, while the median account balance was $17,630 at the end of the same period.
An additional marketing incentive used to promote the advantages of a 401(k) plan is the stock market’s past performance. While it is true that the stock market from 1926 to 2013 has averaged a compounded annual growth rate of 10 percent per year, do not confuse average return with annual return or median return, nor should investors assume that past performance is likely to repeat itself. However, for investors, the returns have been much lower and can be directly attributed to excessive management fees, turnover trading costs, turnover taxes, marketing fees, soft-dollar arrangements, and investors buying and selling at the wrong time.
To those who say that the 401(k) plan works over the long term and use the EBRI data to support that claim, I will show you what the numbers from EBRI do not show. And that is the long-term pre-tax profits of an employee.
Doing the Math
The problem with the way most financial salespeople calculate 401(k) plans is that they only focus on the accumulation phase and not the distribution of the assets. This strategy will always show pre-tax contributions to have larger ending account balances when compared to after-tax contributions during the same time period. However, if distribution or income comparisons are made using the same tax bracket, fees, and rate of return, an employee contributing a smaller amount of money on an after-tax basis may actually be able to withdraw the same amount of money net of taxes when compared to a person contributing to a 401(k) plan.
Additionally, astute financial professionals have known for decades that the average rate of return on investments for mutual fund shareholders is not 8 to 10 percent per year as many financial salespeople often recite; it is closer to 2.5 to 3.5 percent per year, according to a recent Dalbar QAIB annual report. Furthermore, when an employee’s capital contributions and all-in plan fees are factored in, it is very difficult for a mutual fund shareholder to achieve high single- digit much less double-digit annual returns.
While it is easier to measure the past or current performance of an investment by its rate of return, a more accurate measurement is to focus on annual profits, as profits are all that really matters. To calculate your annual profit or loss in your 401(k) plan, add up your personal contributions and fees paid over a 12-month period and subtract that number from your account value. The remaining difference is your profit. Do this at the end of every 12-month period to see if you have made any money.
When analyzing the aforementioned 2012 data obtained from EBRI, it appears that 34-year tenured 401(k) participants were only able to average an annual $1,270 per year in pre-tax profits. This amounts to an average rate of return of approximately 1.3 percent per year. In short, of the $224,287 account balance, only $43,183, or 19 percent of the account balance came from investment earnings and employer match. And of the remaining $181,187, approximately $74,000 in fees were extracted.
It should be noted that this lower investment return does not factor in the taxes that will continue to compound once the 401(k) has been transferred to an IRA nor the taxes on any withdrawals, which if added would reduce these returns and profits even further. It is for these reasons, and for reasons outlined in a recent study (Retirement Inequality Chartbook) by economic policy institute (EPI) economist Monique Morrissey and research assistant Natalie Sabadish, that 401(k) plans create more losers than winners. The only winners are the financial salespeople, the employer, the investment companies, and a very small handful of long-term, high income, 401(k) participants.
If you are still certain that 401(k) plans may be the most sound or best way to grow assets for retirement, consider this—for many participants, the all-in 401(k) plan fees can be greater than her tax deduction, employer match or both. Ouch! And one more point to consider–many 401(k) participants will not get back more than what they put into their retirement plan, creating a net loss on their investment.
Something to Think About
At the end of the day, we as a society have to ask ourselves—are we being fiscally or socially responsible when we ask an employee to understand modern portfolio theory, standard deviation, beta scores, portfolio overlap, glide paths, economic indicators, and other technical investment jargon when tasked with accumulating enough money to last throughout retirement? Unfortunately, financial advisors are not going to take the time to explain this information to each client. They are too busy finding more money to manage. Secondly, does it make sense for an employee to contribute to a 401(k) plan when she is paying more to service her debt than she is earning in her investments? Thirdly, does it make sense to contribute to a 401(k) plan when the participant does not have at least one year of her income saved in a risk-free savings account? And finally, if over the long term, the overwhelming majority of 401(k) participants are unable to break-even from a cost-benefit viewpoint when fees and taxes are factored in, who profits the most from this type of plan?
In conclusion, as I mentioned earlier, the 401(k) was intended to benefit business owners and the top five percent earners. However, there are 401(k) alternatives that may be more suitable for the bottom ninety-five percent of earners. These types of retirement vehicles are offered on an after-tax basis instead of a pre-tax basis, may be simpler to understand, may have less risk, and may have fewer fees. But buyer beware, as many of these alternatives are sold by financial salespeople who do not fully understand what they are selling themselves, and who are simply selling conceptual ideas—instead of providing a cost-benefit analysis and risk assessment—to garner perpetual annual fees or up-front commissions. For more information, enjoy reading my blog entitled–The 401(k) Tax Trap.
The opinions expressed are those of the author, are for educational purposes only, and not to be construed as tax, investment or insurance advice. To ensure compliance with IRS Circular 230, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (i) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer, or (ii) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein. Please consult with a qualified tax professional before making an decisions to change, liquidate, rollover, transfer, or withdraw funds from your tax qualified retirement plan.