Our topic this week is the 401(k). (Not $401k...) The 401(k)
is a retirement savings account which gets it's name from a section of the tax
code: Section 401. I'll let Nancy explain the plan in her 2005 column. Enjoy!
It's a scary world out there for someone approaching
retirement. Lay-offs and forced early retirement, corporate scandals and
disappearing stock value, shrinking pension benefits, and, now, a Social
Security system heading for hard times. What's a body to do?
The most valuable asset anyone can have is their ability to
work and earn a living. For those who are already retired, the scariest thing
is knowing there are no more paychecks to be had. Whatever you generate must
come from assets you have built up through a lifetime of saving and investing.
What if you didn't save enough? What if you picked the wrong investments? What
if rising healthcare costs eat into your stash? What if inflation skyrockets
and leaves your earnings in the dust? It's a scary world out there.
In 1950, General Motors started the first pension plan for
its employees. The idea was simple. GM would set aside a certain amount for
each employee, investing it, and adding to it until the employee retired. Upon
retirement, the employee would receive a monthly check from GM until his death.
Company loyalty was rewarded with guaranteed payouts in your old age.
Taking the risk
Sometime in the 1970s, companies started offering 401(k)s
and profit-sharing plans. As an employee, you would set aside money from your
paycheck, choose investments, and add to it until retirement. Upon retirement,
whatever had accumulated in your account is what you had to live on in your old
age. This change marked a shift in risk. In the old plans, the employer took
all the risks. In the new plans, the employee took all the risks.
When the employer was shouldering the risk, there was a need
for some sort of protection. So, the Pension Benefit Guaranty Corporation
(PBGC) came into being. This is a government agency, which acts as an insurance
company on pension plans. Should a company go bankrupt, PBGC would step in to
cover those guaranteed payments to employees. This seemed like a no lose proposition.
Then, times changed. The steel industry went through hard
times, and, time and again, the Pension Benefit Guaranty Corporation was called
on to fill the gap. Tough economic times combined with tough times in
investment markets leave many pension plans in a pickle. The latest company to
fall back on PBGC is United Airlines. PBGC has $39 billion in assets, but now
owes over $62 billion in benefits to 1.1 million people. Although United States
retirees will continue to receive a check thanks to PBGC, many are finding that
check reduced considerably.
Getting the
opportunity
Many old line companies offer both types of plans, but newer
companies only offer 401(k)s or profit-sharing plans. There are no guaranteed
payouts, only an opportunity to save and invest at will. As scary as the
situation is with the old pension plans, academics are concerned about employee
behavior with the new plans. When those employees retire who only have a 401(k)
and Social Security to depend on, will it be enough? Will those employees cry
foul, saying the didn't know enough to handle the risk thrust upon them?
In studying employee behavior in these plans, research has
found most people to be lacking in knowledge. The average contribution rate is
only about 4%, a rate which will leave many in poverty at retirement. Also,
most adopt a fund selection strategy called conditional naive diversification.
No matter how many funds are offered within a plan, employees, on average,
select three or four funds. That may not be so bad. Any more than that can be
difficult to track, but most employees simply divide their contribution evenly
among all chosen funds. If you select four funds, you tend to allocate 25% to
each fund. Here's something interesting researchers have found... if you select
only three funds, the math is not so easy (100% divided by three), so, instead
employees put more in one fund, then divide the rest equally between the other
two. So much for a reasonable allocation among cash, stocks and bonds based on
time horizon and risks. Just split it up evenly and run with it.
We also know that few people change their original
allocation. They rarely adjust to accommodate changing markets or their own
aging. They're just not paying attention. Also, if company stock is offered
within the plan, employees consider that separately. They don't even think of
that in light of the allocation to other funds. It's just something extra.
Enron and WorldCom employees know the danger of depending on
company stock too heavily. Should the company disappear, your retirement goes
down the tube. That may not be so horrible if you're 30 when it happens, but
what do you do when it happens at age 50? Throw in the solvency problem with
Social Security, and we're back to a scary world. What should you do?
Words of wisdom
The best thing is to follow the old adage, "Don't pull
all your eggs in one basket." Don't give up on those pension plans, but
invest outside of them, as well. Invest in your company 401(k), but do it
wisely. If you need help, find an advisor. Give your plan an annual check-up to
make sure it's doing what you want it to do. Don't load up on company stock.
Invest outside of retirement plans, too. Add to regular savings on a
disciplined basis. Save and invest like you'll never draw another paycheck. One
day, that will be the case.
And last, but not least... don't factor in Social Security.
Think of it as icing on the cake. If it doesn't come through, you won't go
hungry.
--Nancy Lottridge Anderson, Mississippi Business Journal, May 30 - June 5, 2005
