Reinventing Retirement Income in America
Table of Contents
- Executive Summary
- The Importance of Retirement Income
- Determinants of Retirement Income
- The Change in Retirement Pension Plans
- The Performance of 401(k) Plans
- Explaining the Poor Investment Returns
- Other Causes of Low Returns
- The Threat of Future Liability
- Goals for an Effective Retirement System
- Building a Better Retirement System
- About the Authors
Other Causes of Low Returns
The low returns also reflect a number of inherent failings in 401(k) plans as currently structured, involving participants, plan sponsors and the law.
Problem: Lack of Knowledge. Several studies find that many participants in defined contribution plans have an appalling lack of understanding of basic principles of investing. For example, a recent national survey of participants found:22
- Respondents generally considered company stock less risky than a diversified domestic equity portfolio.
- 44 percent thought money market funds included stocks and 43 percent thought they also included bonds.
- Nearly 20 percent didn't know they could lose money in equities.
- 65 percent didn't know they could lose money in a bond fund and
- 60 percent didn't know they could lose money in a government bond fund.
"Many participants have an appalling lack of understanding of basic principles of investing."
Small wonder that so many participants in 401(k) plans have little or no grasp of the principles of prudent investing! They may have a limited or extensive list of funds from which to choose, but they base their selection on individual funds rather than investment strategy. The fund offerings may not stress the value of index funds, which invest in the stocks or bonds used to compute a particular index and have low management fees because they are not actively managed. Participants take too little risk, as in the case of those letting most of their assets stay in money market funds or cash, or too much risk, as in the case of those putting the great majority of their assets into high-tech stocks or funds.
Problem: High - and Hidden - Administrative Costs and Management Fees. Administering a 401(k) plan and managing its investments costs money. Many plans have selected low-cost funds, with fees fully disclosed to plan participants and often paid by the employers. However, many other plans have higher fees mostly paid by the participants. Some of the latter contain mutual funds with high retail price structures.23 Participants often are unaware that they are paying administrative fees for these funds from their accounts. In some cases, especially with smaller employers, plan sponsors choose these funds because in return the mutual funds handle administrative chores such as keeping track of account balances, sending out statements and answering questions.
The New York Times recently reported that some fund companies rebate part of the administrative fees to employers or outside plan administrators.24 The administrative fees, which the Times said usually amount to about 0.25 percent of the assets in an account for large plans, add up. For example:25
- An investment of $5,000 a year for 30 years with a 10 percent annual return amounts to $863,594.
- Annual fees of 0.25 percent will reduce that amount by $40,883.
- If fees are 1 percent, as they often are in smaller plans, the benefit reduction is $151,387 (or 21 percent) - and some plans have costs exceeding 2 percent.
Even if there are no rebates or cost-shifting, companies sponsoring 401(k) plans have little incentive to monitor the fees closely or to negotiate lower fees for plan participants when the costs are paid from the participants' and not the company's funds.
"Thirty-nine percent of those age 18 to 34 cash out their 401(k) accounts when they change jobs."
Problem: Cashing Out. Even modest contributions to one's 401(k) at an early age can grow to a significant sum by the time of retirement. However, almost a third of people with accounts - and 39 percent of those ages 18 to 34 - cash them out when they change jobs. Plan sponsors can (but are not required to) cash out an account balance valued at under $5,000 when the participant terminates employment.26 The employee can roll over the money into an individual retirement account (IRA), move it to a new employer's plan, or take a lump sum payment minus income tax and a penalty for early withdrawal.27 The ERISA Advisory Council reported that only 20 percent of individuals who received lump sum distributions rolled the entire sum into another tax-deferred account.28 A report to the advisory council recommended that all defined contribution plans be required to accept rollovers of cash from other qualified plans. Putnam Investments, a money management firm, estimates:29
- Withdrawals amount to between $33 billion and $39 billion per year.
- Those withdrawing the money pay $7.1 billion to $8.3 billion in unnecessary federal taxes and penalties each year.
Problem: Hardship Distributions and Consumer Loans. Many plans allow an employee to make a hardship withdrawal, usually to purchase a primary residence, pay college tuition, pay unreimbursed medical expenses or prevent eviction from or foreclosure on a principal residence. These withdrawals are subject to income tax and a 10 percent early withdrawal penalty.30 Further, the participant cannot contribute to the account for one year after a hardship withdrawal, thus losing any matching contribution from the employer.31
Most 401(k) plans also allow a participant to borrow from his or her account for non-hardship purposes, such as buying a boat or a big-screen television, and to repay the loan to the account with interest. This can be tempting because the interest rate is lower than credit card interest and the interest goes into the participant's own account. However, the interest is paid with aftertax money, which will be taxed again when it is withdrawn in retirement. In addition, the participant loses the return while the funds are out of the 401(k).