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WEALTH MANAGEMENT - December 2004
Let’s get back to basics. Named after the Tax Code section that defines it, the 401(k) allows workers to put away their own money for retirement. Companies usually help by “matching” employee contributions – generally giving somewhere around 50 cents for every $1 the worker contributes. In the 30 years since the plans were introduced, they’ve appeared nearly everywhere – about 90 percent of large companies offer them. But a recent survey by Fidelity Investments found that only 66 percent of eligible workers were saving through the plans, compared to 68 percent a year ago. The same survey found that participation rates have fallen by nearly 10 percent in the last six years. Other studies have come to similar conclusions, although some asset managers say the numbers seem to have leveled off. Explanations for the drop off are varied, ranging from stock market jitters, to consumer debt, to corporate distrust and so on. Some say it reflects the greater number of Gen Xers entering the workforce, a group that’s less likely to save for retirement. Whatever the reason for decreased participation, it’s a good time to review why the 401(k) still makes a lot of sense. The Bush Administration has moved Social Security reform to the front burner. We’ll skip the speculation for now about how it will be “fixed.” Suffice it to say that even Washington is admitting how under funded the program really is, and that you may not get as much from Social Security as you think. As we’ve seen illustrated in the airline industry, many workers can’t rely on their employers to provide a pension. And the Pension Benefit Guarantee Corp. - the federal agency that protects employee pensions when companies can’t pay them - is more than $23 billion in the hole. To be sure, there are plenty of traditional pensions plans that aren’t in trouble. Many are fully funded and operated by healthy companies that can absorb slight downturns in stock or bond markets. But the number of under-funded plans operated by foundering companies is large enough to threaten the whole system. Compared with successful traditional pension plans, the 401(k) doesn’t perform as well – in theory. The traditional plan is managed by a professional who makes extremely informed investment decisions. Section 401(k) plans, on the other hand, are run by everyday Joes who may or may not know the first thing about money management - in other words, folks like you and me. But a recent study by benefits consultant Watson Wyatt Worldwide found that both types of plans have performed equally well over the years. From 1990 to 2002, traditional plans returned 10.84 percent a year, while 401(k)s raked in just slightly less at 10.77 percent a year. That makes sense, since most people put their 401(k) money in mutual funds, which are by nature “professionally” managed. Though they have their shortcomings, 401(k)s are generally the most effective and reliable way for most workers to save. They have real benefits. For one, contributions are taken out of employees’ paychecks before taxes are computed. Younger workers – the ones who will be most affected by Social Security’s woes decades from now – are the best poised to benefit from 401(k)s. Take Sarah, a 25-year-old earning $50,000 a year. She decides to save six percent of her salary, or $250 a month. But assuming she pays 30 percent in federal and state taxes, her out-of-pocket cost is only $175 a month – $250 minus the $75 she would have otherwise paid in taxes. Including the employer match, her savings increase by $375 each month. Let’s say Sarah earns an average investment return of seven percent with a diversified portfolio of stocks, bonds and cash. Over the course of her 40-year career, Sarah’s 401(k) plan contributions reduced her pay by $84,000. But she’ll retire at age 65 with almost $1 million in her 401(k), nearly 12 times what she put in. That’s enough to generate $39,372 in annual income at a four percent return when Sarah retires without even touching the principle. Incidentally, that’s a conservative figure, given the Watson Wyatt study cited above. And if Sarah is wise, she might choose to save even more of her salary to compensate for loss from inflation. The biggest mistake people make with their 401(k)s is not contributing to them regularly – say, if the market seems down. Federal Reserve Chairman Alan Greenspan has often complained aloud that Americans are saving less than ever and plunging further into personal debit. Even an unsophisticated 401(k) plan is better than no savings plan at all - and certainly better than a pension that a company can’t pay. There is no question that many Americans urgently need a straightforward, reliable way to begin preparing for retirement. If your company offers a 401(k), don’t write it off just yet. And tell your friends and coworkers. They may thank you for it.
The Lane Report is a trademark of Lane Communications Group. All other trademarks are the property of their respective owners.
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There’s a terrible rumor floating around in some investor circles: The 401(k) is uncouth. Some talk as if the savings plan were an overly conservative way to build a nest egg. And the statistics seem to show that fewer employees are choosing them over traditional pension plans these days. But we shouldn’t be so quick to abandon the 401(k).