The 401k plan is every worker’s path to a worry-free retirement. It is far better than pension plans. It is infinitely better than Social Security. In fact, if people used their 401k plans effectively, there would be no need for Social Security or Medicare. The issue is the way many people use, or should I say misuse, their 401k plan that has resulted in them getting a bad rap.
The biggest flaw in the humble 401k plan, and the reason they get a bad reputation, is that they allow people to withdraw from the plan before retirement. Now they try to discourage this behavior by charging you a 10% penalty if you take the money out early, yet people continue to take the money out anyway. It seems like every story about someone starting a business in Money magazine talks about the entrepreneur using their 401k plan to fund the business. Sure, she make one-quarter of what they used to and they are now age 45 with no retirement savings, but she’s much happier baking cookies in the shape of farm animals than she was at that big corporate job. Guess we’ll get to bail her out at 65.
Of retirement plans, only a 401k even has the option to take money out. You can’t call up your pension manager at 35 and say you’d like to take out your portion of the plan to start a bakery. Likewise, you can’t call Uncle Sam and ask if you can get a loan against your Social Security account to start-up a chain of muffler shops. Even if you are finding yourself being thrown out onto the street, these accounts are untouchable. So why is it that people just changing jobs can somehow withdraw their 401k funds and push a reset on their retirement?
So why do I say that a 401k plan is so wonderful when compared to the options? The reason is that the rate of return you can get from a 401k plan is so much better than the other options because you can tailor your investments to you and your stage of life. How so?
Well, let’s look at a pension plan. In a pension plan your employer (and maybe you) contribute to a big portfolio that is invested by a professional money manager. The main concern of your company and the pension plan manager is making enough of a return to allow him to pay out current obligations and grow the value of the portfolio enough to pay future obligations as promised without your employer needing to make a lot of catch-up contributions. This drives conservative investing and conservative promises. Getting a 6% rate of return is just fine since they only need to make 5%, say, to pay their obligations. Even if they get a higher rate of return, you’ll still only get paid out the 5% rate-of-return, so you are pretty much doomed to have limited returns. Of course, figuring out your plan’s rate of return is extremely difficult since there are all sorts of gimmicks – just know that it will be less than an all-stock portfolio since they need to invest for steady returns.
In your 401k, you can invest for your stage of life. When you’re in your twenties, since you have 40 years before you’ll need to start pulling out money, you can invest entirely in growth stocks. This strategy will have unpredictable returns over the next year, or even the next five years, but it will have a much greater return than will an investment in income securities over the next twenty to forty years. How much better will you do?
Well, let’s plug an investment of $5,000 per year into an investing calculator. I’ll use the one on the sidebar, which uses a calculator provided by the Dave Ramsey website. Let’s assume both a 6% return in a pension plan and a 12% return in a 401k plan invested entirely in stocks.
After 40 years at 6%, according to the calculator, my pension plan will have a value of $891,359.20. This will allow me to withdraw maybe $32,000 per year in income during retirement. The 401k with a return of 12% would be worth $4,864,097.97 at retirement, resulting in a yearly income of about $160,000 through retirement. That is about five times as much.
But what if you pull all of your money out of your 401k at age 45 to pay off your credit cards? Well, then you would be getting about $461,000 at age 45, which you would then blow on things, resetting your retirement savings to zero. Let’s say that you try to rebuild your savings, making $5,000 contributions from age 45 to age 65. At retirement, you would only have another $461,000 – not enough for a comfortable retirement since that would require a couple of million dollars. You would also need to be more conservative on your investments since you would be starting later in life, so you only might make 6% on your investments. This would leave you with only $215,679.97 at age 65.
Besides making early withdrawals, what other mistakes do people make with 401ks that they can’t with other plans?
- They don’t contribute enough. With a pension, you’re probably contributing at least 8% of your salary, between your contributions and those of your boss. With Social Security you’re contributing almost 13%. Before you start complaining about your 401k returns, try contributing at least 10%.
- They don’t start soon enough. With a pension, you’re probably enrolled from the time that you start. With Social Security, even a job in high school has payroll taxes withdrawn. Many people go blissfully through their twenties and even their thirties without enrolling in their 401k plan. This results in having a couple of hundred thousand dollars at retirement instead of millions.
- They invest too conservatively. Equities (stocks) will do far better over a period of twenty years or more than will bonds. Both will do infinitely better than cash assets like money market funds or CDs. It is true that stocks and bonds may decline in value over short periods of time, sometimes dramatically, but the greater returns offered will results in millions of dollars more at retirement. At a minimum, an individual who is age 20 should be 80% in stock mutual funds and 20% in income mutual funds. Over time there should be a gradually shift to more income assets, like maybe being 60% in stocks and 40% in bonds at age 50, then finally a build-up of some cash once an individual is within a few years of retirement. Unfortunately many individuals put all of their 401k assets in the income fund, thinking that they are protecting their savings. Unfortunately, inflation will wipe out at least half of the money they save by the time they reach retirement.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
