Why So Many Do Not Put Enough in their 401(k) Plans
Three researchers from Boston College have just released a paper discussing shortcomings of the 401(k) retirement plan. The problems run even deeper than this.
The Boston College Center for Retirement Research has a new paper out that examines some of the shortcomings of the 401(k) plan and how that is contributing to the shortfall in retirement savings that so many Americans are faced with.
While the paper does discuss some issues that pose some challenges for people overall, the real reason why people don’t save enough for retirement extends well beyond the structure of our retirement plans and really comes down to a voluntary lack of participation. While some of the problems are structural, for instance with the fact that many do not have access to a 401(k) plan at work, even those who do don’t contribute anywhere near enough typically.
They point out that while the 401(k) has been around for 40 years now, it is still somewhat immature. It is true that there are some people who are approaching retirement that have not had the benefit of the 401(k) being in existence throughout their entire working life, but this only concerns a small proportion of current workers, as the great majority have not been working full-time for more than 40 years.
It is not that there wasn’t any sort of government-sponsored retirement programs prior to the 401(k) coming into being, as traditional IRAs have been around for 45 years now, and there even fewer people who have been working for longer than that. While the 401(k) is generally more lucrative, it’s not that people could not save up for retirement in the 1970s, they just had to wait until the 401(k) became available to get employers to match their contributions.
It’s not that employers didn’t kick in extra money for people’s retirement prior to all this, as we have traditionally relied on company sponsored pension plans to do this. In the 1970s, this was fully in fashion, and it wasn’t until the 401(k) became popular that companies realized that they could provide these benefits more cheaply if they matched retirement contributions.
This isn’t even a matter of their casting off the burden of a pension plan, as they most certainly knew that 401(k) plans would require significantly less contributions from them than with a pension plan. This is because this puts the ball in the employee’s court, and the company’s contributions now became proportional to those of the employees, who given the chance would prefer living it up now and contribute little to their retirement.
This is exactly what has happened, and even though a company may earmark a certain percentage of an employee’s compensation for this, the great majority of this remains left on the table year after year. The employees are happy enough just to have the means to take advantage of this, and will prefer companies that have a generous plan, even though they may not have the will to take good advantage.
This also transfers the blame to the employee if they do not achieve their retirement objectives, rather than people blaming the pension plan as was previously the case. There are still some workers that have pensions at work but for the most part, the 401(k) has replaced this, to the delight of the companies who offer it.
401(k) Plans Offer Some Very Big Advantages, Provided We Take Advantage
401(k) plans are here to stay, and it doesn’t even make sense for people to compare them to pension plans that are long dead and are no longer in the conversation. We can compare 401(k)s to other types of saving for retirement though, and it does beat everything else pretty handily if they provide a match, which is what sets it apart from IRAs or non-registered accounts.
An IRA has the advantage of providing potential tax benefits over a regular account, but a 401(k) not only provides this but it also has the employer kicking in a lot of the money as well. The two together make it considerably more preferable than any other way to save for this.
To say that the problem with so many people’s retirement nest egg being way too small or projected to be has very little to do with how long 401(k) accounts have been around, and this one is of a magnitude that looks like it was just added on to the other reasons just so they could get to four.
Their second reason does have a bigger impact though, which they put as the lack of universal coverage. We will never get universal coverage though, at least if the market is left to decide, as it does, because 401(k) plans cannot be accommodated with lower-paying jobs.
There is only one reason why companies offer 401(k)s, and that’s because they have to in order to stay competitive in the labor market. If they could attract and retain the same people, there would be no reason for them to do this. Corporations just don’t do things out of the goodness of their heart, and doing so would be contrary to their objective of maximizing profits.
They don’t just give this extra money away either, as they instead structure compensation in a way that includes these contributions to the retirement of employees. All benefits comprise a part of what a company is willing to pay someone, and the salary that people get comprise a lot smaller portion of this than we usually think.
People in low paying jobs aren’t going to get much in terms of benefits because there just isn’t enough room. If you are making minimum wage, your rate of pay is likely already elevated beyond what the market would price it in, and also often beyond what a company would pay in a freer market.
Regardless, there just isn’t any room left between what a company wants to pay in overall compensation to these workers and what they actually pay. The gap is often zero, and it has to be a lot higher than that to fit in major benefits which are expensive.
We could try to claim that the lack of availability of 401(k)s as a reason why lower-income workers who do not have a plan at work are struggling to save for retirement, but the real reason is because they just don’t make enough money to not only qualify for this benefit but to save very much at all.
It would be more correct to describe this shortcoming as the fact that many do not earn enough to either warrant matching contributions in a 401(k) or to even save very much period, even if they had one. Those who do have them earn more, including the amount allocated to their 401(k) matching, as this is part of their income as well.
Not earning enough is certainly a very significant obstacle in itself, and a far bigger one than not having a 401(k) at work. This is not one of the issues that is subject to remediation and is just another manifestation of not having the capacity or opportunity to earn enough.
It’s challenging enough for higher-paid workers to put very much in their 401(k) each year, and a great many do not participate at all. If participation is as low as it is among those who do have access to this, and these workers tend to make a lot more money than those who do not have the plan, it is doubtful that even having universal access would make much of a difference for those who currently do not have access.
The third reason that the authors cite is fees. You can’t run a program like this, or invest at all in anything, without fees. Similar fees apply whether you buy your stocks and bonds in a regular account or in a 401(k). 401(k) plans do require more administration, and therefore a little extra in fees, but without these extra fees, the plan could not exist, as this extra work does cost money and someone has to pay for it.
The matching and the tax advantages that 401(k) provide completely overwhelm what little extra people pay for the administration of their plan.
This Really Is All About Leakage, But the Most Leakage Occurs Right After We Get Paid
The final reason that they give for our paltry retirement savings is what they call leakage. This one does deserve to be on the list, unlike the other 3. People do indeed spend their retirement funds prior to retirement and leakage is an appropriate way to describe this, and we could even say that leakage is the whole problem once we realize what this leakage really consists of.
We should not just measure leakage by looking at what leaks out of our retirement accounts once invested, as this is just one way that people are discounting the future too much and putting too much weight on the present.
The number that we instead need to use is what a person would end up with in the end if they did the right thing and gave what we could call proper regard to their retirement. Some of what they call leakage may actually be a result of putting too much toward retirement savings, where they aren’t keeping anything behind to handle their future needs, and have no choice but to withdraw from their 401(k) or IRA or other savings vehicle when they need money.
This ends up being a terrible idea, as it involves paying penalties on the amounts withdrawn. There are situations where this cannot be avoided, but we need to make sure that we don’t put so much in these accounts that we will likely need to pay penalties to access our money if we need it, which only allows what we can contribute with a fairly high degree of confidence that we will not need until retirement.
There are lots of cases where people just spend their money on things that they may not have really needed and things that should be a lesser priority than retirement when we look at the overall utility that we get from the money. If we blow quite a bit of this on things like trips or expensive items we cannot afford and still afford to save for retirement, now that’s leakage.
This sort of thing happens all the time with the money that they should save for retirement but instead choose a less valuable option overall. There are countless examples, but this involves things like trading in your Toyota for a Lexus and then having to take the bus in your retirement years because that’s all you can afford. The extra utility that the Lexus provides probably doesn’t compensate you for having no car at all in retirement or to even need to scrimp on food and shelter.
One thing that the 401(k) has done is multiply future value and have us in a position where we should be discounting the present instead. It used to be that we would compare $10,000 now or $20,000 down the road, inflation adjusted.
People will always discount the future, meaning the money today is worth less the further out you go. It makes sense to do a little of this, as we don’t know if we will even be around then, but we tend to do a lot more discounting than we should.
However, with matching, this now becomes $40,000 instead of $20,000, as money held back not only gives up the return over inflation, but also misses out on the matching, and we don’t even need to use discounting to compare now.
The return on matching is actually immediate, as if you have a one to one match, your $10,000 becomes doubled on the spot and gets put into your account. All of your disposable income becomes subject to this test, and if people thought about this one thing more, this should at least tilt the scales more and have them wanting to take better advantage of their 401(k).
In a real sense, everything that you do not contribute to your 401(k) but could do so if you chose to is leakage. While there are reasonable limits on this, such as people unduly downgrading their lifestyle to max contributions, our understanding of what is really undue is what is in need of examination.
We really should be looking at our budget and multiplying the value of what we could do without by the matching rate of our 401(k) to get a better idea of what the true opportunity cost of this is. If we want to slow down the leak, we need to actually look at its size and how slowing it down will help us.
Otherwise, we’re just plodding along in our lives without the degree of understanding that is required to do anything but a poor job of being the guardian of our lives and especially our retirement. The time to understand is not when it is already too late.
Editor, MarketReview.com
Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.
Contact Robert: robert@marketreview.com
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