We have been reading a lot of talk lately about how the 401(k) system has failed to address the retirement needs of most Americans. For the most part, we agree that in most situations the 401(k) is not the best place to save for retirement and in every case the 401(k) should not be your only place for retirement savings.
Why has the 401(k) failed?
Most of the 401(k) critics say that most people are just not saving enough for the 401(k) to work. The AARP reports that at the end of 2012, the average 401(k) balance for workers 65 years of age and older was $134,100 and the average balance in this same age group for workers who have contributed to a 401(k) for at least 10 consecutive years was $228,200 years. These were reported as record levels for 401(k) balances.
Let’s think about where this leaves retirees. If you annuitize $228,200 for 20 years with a growth rate of 8%, you get a payment of $21,521/year or $1,896/month before taxes. That is not much to live on even without taking into account inflation. $1,896/month is for the high savers. Most retirees will be left with a little more than half of that amount.
These numbers show that the average worker cannot count on the 401(k) to fund their entire retirement. The 401(k) should only be viewed as part of a complete retirement plan for some workers while other workers should think about not participating in a 401(k) at all.
Why would I not participate in my company’s 401(k) plan?
The 401(k) plan has 1 real benefit:
The Company match
The company match is the money that the employer deposits into a 401(k) plan to equal the contribution of the employee. The American Benefits Council states that in 2013, the average company match was between 5-7%. This can be thought of as somewhat free money, effectively doubling your contribution. If you are contributing 7%, your 401(k) account is actually receiving 14% if your company is matching. This can be a big boost to your retirement savings and is why it is generally recommended that employees contribute up to the company match amount.
The other things that people list as benefits to the 401(k) are either not real benefits or are not unique to the 401(k) plan.
1. Tax deferred growth
Tax deferred growth can be achieved in other types of savings accounts such as Traditional and Roth IRAs, annuities, and whole or universal life insurance cash value. Because tax deferred growth can be achieved in other vehicles, by itself it cannot really be counted as a reason to be in a 401(k) plan.
2. Before tax contributions
Before tax contributions can be achieved through a Traditional IRA (tax deduction). Before tax contribution can either be a benefit or a detriment depending on where future tax rates will be. If future tax rates are higher, the employee may have fared better by paying taxes on the contributions instead of the withdrawals.
3. Higher contributions limits
In 2014 the contribution limit for a 401(k) plan is $17,500 for employees 49 years old and under and $23,000 for employees that are 50 years old and over. The contribution limit for Traditional and Roth IRAs are $5,500 and $6,500 respectively. I do not consider this a big benefit because in most 401(k) plans, employees are not contributing to the IRA limits. If you are contributing to the average company match of 6%, you would have to have an income of over $91,600 to reach an annual contribution of $5,500. I do not believe that the higher contribution limits are a big concern for most workers.
Now let’s compare the one 401(k) benefit to its negatives.
1. Limited investment options
The investment options in a 401(k) plan are usually limited to a handful of mutual funds, bonds, or annuities. The employee must choose from the pre-selected list of investments. This can have many negative consequences. The employee may be forced to invest in underperforming investments and by being invested in the stock market the employee may have to take on unnecessary risk in order to produce a return.
2. Limited access
The funds inside of a 401(k) plan cannot be accessed without penalty before the age of 59.5. A loan of 401(k) funds can be obtained under certain conditions such as hardship, buying a house, or paying for college. This lack of access can prevent the employee from taking advantage of opportunities to grow and secure his or her nest egg throughout their working life.
3. Lack of control
The employee must play by the rules of the account servicer. The servicer tells the employee how and when they can make investments, how they make contributions, and when they can use the funds. This lack of control leads to complacency and lack of ownership of one’s retirement plan. Because there is no control, the employee is forced to wait until 59.5 before he or she can start to turn their nest egg into the retirement income that will sustain them through retirement.
It has been documented that there can be hidden management and servicing fees in a 401(k) as well as higher cost investments.
Based on this assessment it is clear that if there is no company match available, the employee is better off not investing in a 401(k) at all and looking at other retirement vehicles which we will discuss later. If there is a company match the employee should invest in the 401k to take advantage of the match, but then look to the other retirement vehicles to provide diversification and benefits in the places where the 401(k) is lacking. If the company matches, the employee should consider the 401(k) one part of the complete retirement picture. The 401(k) should not be considered the entire retirement plan.
If 401(k) plans do not work, what does work?
We believe a successful retirement portfolio should do four (4) things:
- Produce income
- Be flexible and accessible
- Should be diversified to protect against market and interest rate fluctuations, tax changes, and economic downturns
- Should be owned and controlled by the saver/retiree
In order to achieve these four objectives an employee must build a portfolio of accounts and assets.
When employers used to offer pension plans, employees knew that they would put in a certain amount of money from each paycheck and when they retired, they would receive a defined amount of income to live on. It was simple: as long as they paid into the plan they would receive income at retirement that was usually adjusted for inflation.
This is not the case with the 401(k), but employees are still thinking about retirement in the same way. The problem with the 401(k) is that employees believe that they are building a future income stream that will support them in their retirement years. In actuality, they are building a lump sum of cash that will have to be turned into income at a later date. This can present a problem, because you never know how much income you will be able to get out of your 401(k) balance until age 59.5. At this point you must pay taxes on your 401(k) balance as well as taxes on any income produced from investing the balance.
A better strategy is to start building income early and often while still taking advantage of tax rules.
A person with a Traditional or Roth IRA can build a well diversified portfolio of dividend stocks and will be able to measure the income long before retirement. The dividend stock portfolio will grow from both appreciation and dividend income tax deferred until retirement.
Investment in a Self-directed IRA will give the investor all of the benefits of the regular IRAs, but it will allow them to also invest in income producing real estate, private businesses, and much more. These investments can build tax deferred income streams while growing in value.
An investment in cash value life insurance gives the investor the ability to build funds on a tax deferred basis and access to the funds at any time to invest in real estate, private businesses, and other income producing assets.
An investment in annuities will grow the investor’s funds on a tax deferred basis and give the investor the option to turn the balance into a stream of income for life. The other option is to take only the income that the sum of money produces as either a fixed or indexed investment.
We outlined 5 different accounts that can be used to build income throughout your working years. This process allows the investor to plan a retirement more effectively. Building multiple streams of income is more important than just accumulating a large amount of cash.
Flexible and accessible:
Flexibility is important because it allows the investor to take advantage of opportunities throughout their careers. Right now is a good time to invest in income real estate because prices are affordable and interest rates are low. There was a point when government bonds were paying upwards of 5% and were very good buys. A once-in-a-lifetime business opportunity may fall into an investors lap. Having flexible and accessible accounts will open many doors for retirement investors.
We have already explained above how flexible some of the other retirement accounts can be when it comes to purchasing investments. In addition, the Roth IRA will let you withdraw contributions tax and penalty free at any time and the cash value life insurance allows you to access the cash value and earnings at any time tax and penalty free.
Diversified for protection:
There is more to diversification than buying multiple mutual funds or stocks. What if the entire market crashes, like we saw in 2008? If your entire retirement was invested in a 401(k) you lost big no matter what you were holding and no matter how close you were to retirement. A well diversified portfolio may have held income producing real estate, cash value life insurance, annuities, precious metals, etc. While the value of the real estate may have gone down, the income should have sustained and continued to produce for the investor. Cash value life insurance, either fixed or indexed, would have lost no value during the market crash. Annuities, either fixed or indexed, would have lost no value during the market crash. Precious metals may have actually increased in value as investors rushed for protection.
What if tax rates increase significantly by the time of retirement? The 401(k) investor will be on the hook for paying the new tax rate when withdrawing money. The same will be true for the Traditional IRA and Annuity investor. The Roth IRA and cash value life insurance investor, however, will have to pay no taxes on withdrawals. By being diversified across these different types of accounts, the investor will be able to plan when to withdraw from each account in order to minimize taxes.
These were two examples of how diversification across accounts can protect the investor in an uncertain climate. True diversification is an important part of a retirement plan and portfolio.
Should be owned and controlled by investor:
What we mean by this is that your entire retirement plan should not be controlled by and tied to your job. Having everything controlled by your job makes it extremely hard to manage the accounts for your best interests. Also, with job movement and entrepreneurship on the rise, it is a better option to have a retirement plan that can function and grow no matter where you are or what you are doing.
This article is not intended to describe all of the details of how each type of investment works, nor is it intended to show exactly how someone should invest for retirement. All situations are unique and change often.
The purpose of this article is to introduce a different way of thinking about retirement planning. By thinking about retirement in terms outside of employer sponsored plans, you create a way to take control of your future and build a retirement that can work for you now and in the future. Once you understand the importance of the 4 objectives of a successful retirement portfolio outlined above and begin to take action, the details specific to your situation can be worked out quickly.