Retiring on Time: The 401(k) Accumulation Problem

There have been numerous reports over the years that we have a problem with self-direct retirement plans such as the 401(k). These reports suggest that we are not taking full advantage of the process and worse, we underestimate how much of what we may have accumulated in these 401(k) plans will be available as a percentage of our retirement income. In other words, we simply have not used the plans the way they were intended and we haven't invested enough.

Accumulation
Everyone who has a 401(k) has heard this before: invest at least what your company matches. The company match is the best way a business can help their employee invest in the future. There is no obligation to do this, just as there was no obligation (unless contracted through a labor organization) to fund a pension. As pensions disappeared and 401(k)s stepped in to replace these defined benefit plans, companies began helping employees direct their savings by offering a matching contribution of up to, and sometimes more than 3%. That meant, in order to get the full company match (the free money the business was going to deposit into your account) you needed to put at least 3% of your pre-tax income away.

For most folks, 3% is not even missed. In fact, many people could contribute up to 5% without changing their take home pay. Because the contribution to the plan is done before taxes are taken out, the after-tax take home is almost identical to what it would be had you had 5% taken out before taxes.

So why are so many of these plans not only underfunded but under-invested? I believe that there are two reasons, neither of which has been fully addressed. One is the fact that company stock is, for the most part, what is offered by the matching contribution, not the funds in available for investment. Far too many companies saw their generosity as simply creating a larger shareholder base. These "shareholders could not sell the stock and because of that, were forced to hold what they may have wanted to sell or redirect into other more lucrative investments in the plan's portfolio of offerings. Eliminating this practice may have saved hundreds of millions of retirement dollars. Two is the lack of understanding about that pre-tax math benefit I just mentioned.

According to a recent report from Boston College, which opens with the caveat that what is being reported may no longer apply in light of the economic downturn, suggesting that it might be worse rather than better, they found "In theory, a typical worker who ends up at retirement with earnings of about $50,000 and who contributed 6 percent steadily with an employer match of 3 percent should have about $320,000." That $320,000 potential account balance was, for the sake of the study considered simulated. Why? Because the report continues with this fact: "actual holdings of $78,000 for those 55-64 are dramatically lower than those simulated for the hypothetical worker." (As low as $54,000 on average.)

Add a thirty percent loss due to the market downturn, the possibility that job loss or other financial hardship forced some folks to tap those accounts for day-to-day needs, and the chance that like so many folks I have spoken with recently, switched all of their holdings to a target-dated type of mutual fund (one that picks a retirement year and readjusts portfolio holdings from risky but only mildly so to conservative as they age and near the target date) and you have a real problem on the horizon.

Generosity Wains
With six million people out of work and more yet, disparaged, business realize that this benefit (along with insurance in many instances) is not worth maintaining. Losing this match is not the end-all for this type of plan. Although it does make it more difficult to grow without the free money.

Not impossible but somewhat harder. More companies than ever are suspending the matches until they see some sort of economic change. Some have reduced the dollar for dollar basis to half of that amount, contributing fifty cents for every dollar contributed. Some have explained that halting the company match is better than cutting the workforce by 3%.

While it is difficult to determine whether this employer generosity will ever resume to the pace it was on prior to 2008, some things have not changed. The employee who still had a job was not likely to change their contribution rate based on the news. And less than half of those eligible for these plans, used them. The good news: the last time we had a similar downturn (2001), the suspension of company matches was only temporary.

Match or no match, you must keep putting money into these accounts.

Match or no match, you should, if possible increase your contribution.

Match or no match, you should not withdraw any of these funds no matter how bad things get.

Match or no match, the report concludes that: "The time may have come to consider returning 401(k) plans to their original position as a third tier on top of Social Security and employer-sponsored pensions."

Trash Talking Mutual Funds

As I drift around the web, I inevitably end up on some other blogger's site as they talk about investing, mutual funds or retirement. While everyone is guaranteed an opinion online, these missives may be as balanced as a morning spent watching Fox News.

And sometimes, I leave a comment of my own. Today, was one of those days.

Dr. Scott Brown, Ph.D., a.k.a. The Wallet Doctor, is a successful futures trader, real estate investor, and stock investor. Dr. Brown who hold a Ph.D. in finance from the University of South Carolina wrote: "These funds are also sold and managed on pure hype, short term trading, and with key information withheld from the public."

He continues after explaining briefly the history of how mutual funds grew, leaving out key tax code changes that created the 401(k) and the IRA during the time frame in question. He adds: "Many mutual funds are able to cheat the public with excessive fees because investors don't understand how these big costs destroy their profit. Mutual funds have no interest in educating investors because it is easier to hoodwink the ignorant!

"Don't put your trust in mutual funds unless they are fully indexed." And even though Mr. Brown suggest that he knows what the SEC really thinks about funds, he never does tell us what they are doing to regulate the industry.


So I asked Dr. Brown: "Tell me I am wrong":

Indexed mutual funds are too tax efficient to be locked inside a retirement account such as a 401(k).

While the low costs (fees) are always attractive and can lead to more profits, all index funds are not created equal nor do they charge the same fees. Some make up for their low fee structure by charging the individual investor $3,000 or more to make an initial contribution - far more than anyone would suggest the average investor plunk down at any one time.

Mr. Levitt did have a great deal of trouble back in 1993 (he referred to the former SEC chairman's divesting of common stock into mutual funds and some of the difficulty he had with transparency). But the industry has come a long way since and while it has further to go, the journey is at least headed in the right direction.

Actively managed mutual funds are far better for the average investor than buying individual stocks for three reasons: they can offer diversity and research; they can offer the ability to purchase new shares without charging each time you do, and they take they mental maniac out of the investor experience - the one that wants to sell on the way down, buy on the way up and mostly fails at determining their own risk tolerance.

Yes, far too many funds chase the same stocks. But it is the ETF that causes the wildest, end-of-the-day trading and market gyrations - not mutual funds.

Most folks equate the failure of 401(k) retirement accounts on mutual funds when in fact, more folks were invested in their own company stock, often upwards of 50% of the portfolio and often because this was the only way to get the company to match.

The creation of so many mutual funds is a result of the mimic effect. Those 500 funds that were in existence in 1980, that grew to over 8,000 by 2003 were the result of marketplace diversification. They sliced and diced the markets down into ever increasingly specific areas. Yet you fail to mention the same sort of slice and dice market done by the ETF markets.

Now that the SEC is back in the hands of an administration that cares, I expect their job will be much more focused and far less scattered than it was over the last eight years.

Mutual funds, while not perfect are much better than they were and are improving all of the time.

SIMPLEs and UNI-DBs for Small Businesses

When the tax laws were written for small businesses, they were often much more generous. For instance, an employer with only him/herself as an employee can save enormous amounts of money for their retirement - far more than the employee or business owner at a much larger company.

Today we discuss the SIMPLE IRA and the Solo or Uni Defined Benefit Plan for small business in the last of our three part series.

The SIMPLE IRA, named because those letter stand for savings incentive match plans for employees, are a much cheaper and far less complicated way for small employers to establish and administer than a traditional 401(k).

This type of plan is indeed easier to manage and implement but there are a few rules you need to keep in mind before choosing a SIMPLE IRA plan for you and your employees. You are required to make a contribution for every worker who receives $5,000 or more in compensation. It doesn't have to be a lot but it has to be something up to but not exceeding $11,800 for the calendar year 2009.

The contributions may resemble an employer match, just like those used when larger companies match employee contributions to their defined contribution plans (401(k)) But the employee must first elect to contribute to the plan themselves and your match to their contribution can not exceed 3% of their salary.

Employers may also choose to make the contribution on the employees behalf, contributing up to 2% of each worker's wages, whether the worker contributes to the plan or not. This "non-elective" mandatory company match of 2% is required to be made on behalf of every employee.

Aside from the fact that the plan cost less to administer, the strings that tether the SIMPLE IRA might not be right for you or your company.

SIMPLEs have a built-in special tax penalty of 15% that is added to the 10% early withdrawal penalty for SIMPLE IRA withdrawals made within the first two years of opening a SIMPLE plan. Although your retirement plan should not be considered a source of income, this penalty can make it more difficult to access that money in times of dire emergency. (But please, consider every other option first before withdrawing built up investments in these plans.)

Because of that string, a SIMPLE IRA can be much less flexible than a 401(k) plan for the average small business. Keep in mind the following while considering this type of plan. Will you be the only employee? If so, a Solo 401(k) might be best. If you are planning to grow your business slowly, adding employees on as needed, you should consider that contribution requirement. An employer must make contributions for all eligible employees and while they are doing so, no contributions can be made to other qualified retirement plans.

The contributions you make to the employees plan belong to the employee immediately after they are posted. This immediate vesting can be troublesome for some seasonal type of employers who do not expect to retain employees or demand their loyalty for a long period of time.

Should you as an employer decide to end the plan, you must wait until the calendar year is completed and while you are waiting, you are obligated to continue with payments to the employee's plan. And here is something else you should consider: no loans are allowed.

If you however fit this profile: older than 50 and earning more than $120,000 per year, have no more that four employees, been in business for at least three or more years and are willing to make mandatory contributions to the plan for three consecutive years of $45,000 or more, there is possibly no better plan on the planet better than this one.

But these plans can be quite a bit more complicated and require you have help with the legalities. But you will find it well worth it especially if you are earing or expect to earn those sums now and in the near future.

KEOGH plans were put to the wayside with the creation of SIMPLEs. If you still have a KEOGH plan in place, the paper work to rollover the plan is relatively straightforward but still must be done by a plan professional. But I believe that if you do rollover a KEOGH, you, your employees and your retirement future will much better off for the effort.

FEATURE	Solo or Self Employed 401K	Solo-DB	SEP-IRA
Eligibility	One person only. (Multiple owners and spouses allowed, but no other employees)	Business owner and up to 4 employees	No limit on number of employees. (most organizations prefer the 401K )
Key Features	Low Cost ($0 to $25/yr) Contributions to plan are discretionary. IRS form 5500-EZ filing required for balances over $250,000 Roth 401k feature	Annual Fees (about $1600/yr +) Offers the largest tax- deductible retirement contribution permitted by law Mandatory contributions for at least 5 years	Very Low cost (about $15/yr) Contributions to plan are discretionary. contributions are made for one employee they must be made by the employer for all eligible employees
Loans	Loans are allowed	Loans are allowed	No Loans
Contribution Limits *	See Self Employed Owner Only Calculator or Contribution limits for max contribution limits.
Deadline to open plan	December 31 or End of company’s fiscal year	December 31 or End of company’s fiscal year	Up to time of tax filing
Deadline to contribute to plan	Employer contributions must be made by the employer's tax filing deadline plus extensions	Employer contributions must be made by the employer's tax filing deadline plus extensions	Before the employer's tax filing deadline plus extensions