A 401(k) isn’t Enough

In the United States, the 401(k) wasn’t intended to be the only account for people to draw on in retirement. As the first wave of workers in the “401(k) generation” begin to retire, only time will tell what unforeseen consequences may come from its rise to the forefront of retirement savings accounts.

Let’s start at the beginning. Back in the late 1970s, a provision in the tax code — subsection 401(k) — was approved as part of a larger law (the Revenue Act of 1978). This provision allowed employers to create an employer-sponsored retirement account that their employees could contribute to. Ted Benna, a benefits consultant commonly known as the “father of the 401(k)”, was among the first people to use this provision to help his clients with a desired redesign of their retirement options. The key provisions clients initially liked were that employees could make pretax contributions, and employers in turn could provide matching funds to encourage people to save.

Over the past few decades, the 401(k) plan has evolved in ways that could spark issues for retirees.

Although Benna likes the 401(k)’s options overall (pointing out how pensioned employees have gotten their benefits cut as former employers have gone bankrupt), increasing plan complexity and the transfer of plan fees to the employees have contributed to his belief that the 401(k) system has gone awry. More broadly, many 401(k) plans have been “opt-in” and don’t require people to select investments, causing people to put off saving for retirement and/or accidentally hold onto cash (losing value to annual account fees and inflation) instead of investing for the future. Even those who have a 401(k) open and are investing may be under-saving relative to their needs in retirement. A common rule of thumb is to save 10-15% of your gross (pre-tax) income, but many people only put enough to get their employer match, if that (maximum employer match is typically 3%-7% of salary, depending on an employer’s structure).

At the same time, the rise of the 401(k) has mirrored the demise of the private pension. In 1979, 4 in 10 private-sector workers in the United States had a pension. That number has fallen to only 13% nowadays, a remarkable 75% falloff. While there’s more debate to be had on the relative value of both, pensions at least had clear expectations on payouts, and all pensions are protected by the US Pension Benefit Guaranty; even if your former employer goes bankrupt, you won’t lose your entire pension.

If the 401(k) by itself isn’t enough, what can be done to at least enhance it?

The first step is to consider additional avenues of personal financial security. Notably, the Roth IRA is a great post-tax investment vehicle to allow funds to grow over time (contribute post-tax, but if you withdraw after age 59.5, all investment gains can be withdrawn tax-free). Because the Roth IRA helps safeguard against future tax increases, it may be worth contributing money up to the limit here after putting in enough money into a 401(k) to get employer match. Of course, once you do both, increasing your % contribution into a 401(k) is still important (only matching your employer’s max match offer isn’t likely enough).

The next step is to consider ways to nudge people towards building their financial security within current systems. More 401(k) plans are switching to “opt-out”, in part thanks to work by behavioral economist Richard Thaler: most people go with the status quo, so if you want to help them make better financial decisions, remove barriers by auto-enrolling employees into a 401(k) plan with a small % of salary auto-deducted pre-tax, and increase that percentage every year (most people won’t notice any significant change to their lifestyle if 1% more going into the 401(k) instead of their take-home paycheck). There’s more work to be done here (a lot of opt-in plans only start at 3% and stop increasing percentages once it hits 7%, which is lower than the 10%-15% heuristic), but it’s a good start. Adding accessible education about 401(k) plans, other investment vehicles, and getting people to thinking through how they want to balance saving and spending choices across their lifespan can further help people make more-optimal choices tailored to their lives.

Finally, there are broader questions about system-level changes. Continued strain on Social Security (which was also not intended to be enough to retire on, let alone cover today’s average life expectancy and declining birth rate) means that generations who are counting on expected payouts may be in for a rude awakening. There are also questions about rising prices across goods that reduce purchasing power: fresh food, college, healthcare and health insurance, housing, etc. Pragmatically, there are government-level changes that can be made to meet these needs, but they must be balanced with available resources (long-term changes necessitate increased taxation or reduced spending in other areas).

The young workers in the early 1980s who were among the first to find themselves with 401(k) plans instead of pensions are now in their 60s, with the classic “retire around age 65” heuristic just around the horizon. If they contributed a substantial-enough amount, held onto their investments instead of selling in market downturns, and rode through the bull markets of the 2010s, then their 401(k)s might be enough to live on. If, on the other hand, they have under-contributed, withdrawn funds (and taken associated tax penalties) throughout the decades for various wants or needs, and planned on bigger Social Security checks than they are realistically going to get, retirement at age 65, or even 75, may not be a viable option.

Again, only time will tell.


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