IS YOUR 401(k) PLAN A FAILURE?

The decline of the stock market over the last 2 1/2 years, and the devastating bankruptcies of such companies as Enron and WorldCom, have prompted critics to call 401(k) plans a failure. Some have even called the two-decade old concept a scam and say employers need to return to the traditional pension plan to ensure that workers will have enough funds for retirement. 401(k) supporters counter that the problem is not with the plans themselves so much as the way participants use them.

Whatever the pros and cons of the debate, 401(k) plans are here to stay, and plan participants can do more to make their 401(k) an effective way to build a comfortable nest egg. The following are some of the criticisms of 401(k)s and what participants can do to minimize potential drawbacks.

Participation. Critics contend that all eligible workers benefit from a traditional pension plan, whereas 401(k) participation is voluntary. According to the Profit-Sharing/401(k) Council of America, roughly 75 to 80 percent of eligible workers participate in 401(k) plans, with participation rates even lower among younger workers and low-income workers.

Proponents note that more companies are providing automatic enrollments in 401(k) plans, which requires workers to opt out of participation. In these plans, participation rates are around 95 percent, according to the benefits consulting firm of Hewitt Associates.

Proponents also point out that if it weren’t for 401(k) plans, many workers wouldn’t have any type of retirement plan because 90 percent of 401(k) plans are offered by small companies who typically wouldn’t offer a traditional defined-benefit plan.

Failure to contribute as much as possible. The average 401(k) participant contributes less than seven percent of pre-tax salary, according to the Employee Benefit Research Institute. Financial advisors encourage workers to contribute at least ten percent or more of pre-tax salary.

Poor investment decisions. In a traditional pension plan, the company makes the investment decisions. In a 401(k) plan, all workers must be their own investment manager—a task many are not up to. Workers typically don’t diversify well, either loading up on company stock or investing too much in lower-returning fixed-income options. Proponents concede that the average 401(k) plan offers too few investment options for workers, but workers compound the limited choice by choosing only two to three funds, and often similar or overlapping funds at that. Fortunately, workers can seek professional independent investment advice to help them make smart investment choices.

Vulnerability to market fluctuations. A traditional defined-benefit pension plan promises that you will receive your pension payments at retirement, typically based on your highest salary and years of service, regardless of the ups and downs of the market and the economy. If the company’s plan can’t meet its obligations, the federal government will step in, though higher-paid workers may not receive all the benefits they are entitled to. 401(k) plans don’t have any guaranteed payments.

Proponents argue that workers can protect themselves better against market volatility through greater savings and long-term diversification, instead of trying to hit a home run as many workers attempted in the 1990s.

Proponents also point out that pension payouts during retirement typically are not adjusted for inflation—your pension will lose purchasing power over time. A well-invested 401(k) can keep up with inflation so you don’t lose ground.

Cashing out 401(k) plans. Another criticism of 401(k) plans is that when workers change jobs—which they do every four to five years on average—many cash out what they’ve saved and spend it. This is particularly true among younger workers. The money not only can no longer grow tax deferred, but the withdrawal faces income taxes and usually a ten-percent early withdrawal penalty.

Proponents agree that workers need to roll over their accounts into an individual retirement account or another employer’s retirement plan. But they also point out that this portability of 401(k) plans is one of the pluses. The payout from a pension plan can be excellent if you stay at the same company for 30 years, but who does that anymore? If you change jobs every four to five years, you may not even qualify for the pension, or payments will remain small because you don’t have the years of service.

Traditional pension plans and 401(k)s each will continue to have their pros and cons. The important point is that workers must better educate themselves about their plan options so they can make smart choices, whichever type of plan they use.

September 2002— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by McGuire & Co., LLP, a local member in good standing of the FPA.

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