In Uncategorized on March 26, 2009 at 16:45

So Much for the 401(k). Now What? By THE EDITORS (Photo: Spencer Platt/Getty Images) Tens of millions of Americans are enrolled in private employer-sponsored retirement plans — the great majority of them in 401(k) plans, which long ago replaced traditional pension benefits. These plans are easy to participate in with payroll deduction, and most people — once signed up — don’t spend much time thinking about the investments they’ve chosen. All that has changed in recent months. The huge loss of value in those accounts, caused by the stock market decline, has imperiled retirements for older workers and caused younger workers to wonder whether they should have participated at all. Given the wipe-out of years of savings, are there ways to make retirement nest eggs safer? What might replace the 401(k) as the dominant savings vehicle? Alicia H. Munnell, Center for Retirement Research Jacob F. Kirkegaard, research fellow, Peterson Institute Thomas R. Saving, economist, Texas A & M Teresa Ghilarducci, economist, The New School David C. John, senior fellow, Heritage Foundation Thomas C. Scott, money manager They Can’t Do the Whole Job Alicia H. Munnell is the Peter F. Drucker professor of management sciences at Boston College’s Carroll School of Management and director of the college’s Center for Retirement Research. Even before the financial crisis, I was concerned about the ability of 401(k) plans to provide secure retirement income. They were not designed for that role. When 401(k) plans came on the scene in the early 1980s, they were viewed mainly as supplements to employer-funded pension and profit-sharing plans. Since 401(k) participants were presumed to have their basic retirement income security needs covered by an employer-funded plan and Social Security, they were given substantial discretion over 401(k) choices. We need a new tier of retirement income that would allow 401(k)s to return to their original role as a supplementary savings plan. Today most workers with pension coverage have a 401(k) as their primary or only plan. Yet 401(k)s still operate under the old rules and the balances in these plans will likely be insufficient as the sole supplement to Social Security. Therefore, we need to consider a new tier of retirement income that would allow 401(k)s to return to their original role as a supplementary savings plan. The goal of this additional tier would be to replace about 20 percent of pre-retirement income. To accomplish the goal, participation should be mandatory, participants should have no access to money before retirement, and benefits should be paid as annuities. The system should be funded and reside as much as possible in the private sector. Moving beyond principles is difficult. The challenge hinges on the trade-off between lifetime returns and the required contribution. Equities offer a higher return, but they also bring greater risk. The natural response is to think about trying to protect people by offering guarantees. The problem is that low rates of guarantee –- 2 percent or 3 percent inflation-adjusted –- would have done nothing to protect workers over the last 84 years. The reason is that no retiring cohort would have earned less than 3.8 percent on a portfolio of equities, so low guarantees would never have kicked in. Only high guarantees – like 6 percent – would have had any impact, but standard finance theory says such guarantees are not possible, as long as the guarantor shares the market’s aversion to risk. Perhaps the best we can do is a tier modeled on the Federal Thrift Savings Plan for federal employees with sensible target date funds. Such an approach would avoid unnecessary risks, such as investing in a single stock or holding too large a share in equities just prior to retirement. But it would be nice to think a little more about guarantees and risk sharing. Stop Rewarding the Wealthy Jacob F. Kirkegaard, a research fellow at the Peterson Institute for International Economics, is the co-author of “U.S. Pension Reform: Lessons From Other Countries.” The tax-code is a powerful redistributive tool, and the term “401 (k)” comes from the section of the tax code that describes the tax breaks given to employee retirement savings plans. Approximately 60 million Americans today have a 401 (k) plan, or just over 40 percent of the non-farm work force. In other words, more than half the United States work force does not have a 401(k) plan and thus derive no benefits from the associated tax break. It is bad government policy to subsidize relatively well-off American’s 401(k) retirement savings, especially when these are increasingly held in risky assets. Yet tax-breaks cost our government a lot of money. The latest data shows that 401(k) plans in 2007 alone resulted in lost federal tax revenue of $46 billion. Because the 40 percent of American workers with a 401(k) plan are overwhelmingly found among the higher income groups, this makes the plan a very regressive government policy that in effect transfers billions of dollars from poor to rich Americans. It is bad government policy to continue to subsidize relatively well-off American’s 401(k) retirement savings, especially when these are increasingly held in risky assets. At the end of 2007, two-thirds of 401(k) assets were held in equities, up from about 40 percent in the early 1990s. This increase is irrational, considering how the American population aged over this period. If Americans want to gamble with their nest eggs in the stock market, they should go ahead, but they shouldn’t get a government subsidy through a tax-break to do so. Instead, 401(k) tax-breaks should focus on middle- and low-income workers, and favor only low-cost portfolios with an explicit portfolio-weight link to age and equities held only in index tracking funds. This will lower investment risk and cost, and ultimately help make 401 (k) plans both safer and available to more Americans. Don’t Judge 401(k)s in a Crisis Thomas R. Saving is the director of the Private Enterprise Research Center and professor of economics at Texas A&M University. So your 401(k) has tanked, what do you do now? There is little doubt that the majority of us had a significant portion of our 401(k) invested in equity markets and most of us have experienced a loss of nearly 50 percent in the value of that investment over the past year. While this inverse financial tsunami is a rare event, rare events happen. The essential question is, would you have been better off if your 401(k) was invested entirely in U.S. Treasuries? Your future is still more secure if you own it rather than someone else. For example, consider the last bad drop in the stock market in 2000 to 2002. The inflation-adjusted yield on a 35-year portfolio invested in the S&P 500 if sold at the market peak in January 2000 was 9.74 percent, but at the market trough in July 2002 it was still a robust 7.35 percent. Both these yields are far greater than the inflation-adjusted yield on Treasuries. There is no doubt that the world is risky and rare events happen. But what is the alternative? Assuming that the current value of equities represents the future earnings of the underlying corporations, then unless you believe that something fundamental has changed so that the long-term future of the economic system is one of stagnation, you should continue to invest in your 401(k) and maintain an age-adjusted equity share. The one fundamental that has changed, at least in the short run, is the market’s perception of the “rare event” risk. It is common for our perception of the likelihood of a rare event to rise immediately following that event. In the investment world, the consequence of this perception is an increase in the compensation investors require for assuming market risk, the “equity premium.” Thus, even if the market expects firms to return to their former profitability, the current value of these equities will be below pre-rare-event level. As time passes, the “equity premium” required to account for market risk falls, allowing the market value of equities to return to pre-rare-event levels. The real question is whether there exists a superior instrument, in this case meaning an instrument with less risk and an acceptable rate of return? Essentially, what is the alternative to the individually-owned 401(k) system? The solution is not a return to the defined benefit plans of the past that depended on the viability of the firms responsible for paying the benefits. Your future is more secure if you own it, rather than someone else. Would you be safer if we nationalized the 401(k)s and gave national guarantees? Taxpayers already provide substantial insurance to retirees in the form of inflation-adjusted Social Security benefits. The security of these “promised” benefits depend on taxpayer willingness during times of economic distress to pony up the money for your well-being while they suffer. Life has no real guarantees. It is better to have a genuine property right to an uncertain retirement benefit than no enforceable right to a promised benefit. A Supplement to Social Security Teresa Ghilarducci, chairwoman of economic policy analysis at the New School for Social Research, is the author of “When I’m 64: The Plot Against Pensions and the Plan to Save Them.” The 401(k) is a failed experiment of how well individuals can save for their retirement in commercial individual accounts. Instead, we need a supplement to Social Security that competes with the 401(k) — what I like to call a “guaranteed retirement account” plan to which all workers and employers would contribute 2.5 percent. What we need is a guaranteed retirement account to which all workers and employers contribute 2.5 percent. The contributions would be offset by a $600 refundable tax credit provided to all regardless of income. These contributions would create credits toward a lifetime pension based on a guaranteed real 3 percent annual rate of return. Congress would distribute the surplus — above a balancing fund maintained to ride out periods of low returns — to all accounts if actual returns are higher than 3 percent inflation. Under these accounts, retirees do not outlive their savings and inflation does not erode buying power. The plan could provide for a partial lump sum of 10 percent of the account balance or $10,000, whichever is higher. Through Social Security and this guaranteed retirement account, a full-time worker making $40,000 per year who contributes into the plan for 40 years would receive roughly 71 percent of their pre-retirement income. Reform the Accounts David C. John is a senior research fellow at the Heritage Foundation and a principal at the Retirement Security Project. 401(k) plans will probably be replaced by — 401(k) plans. The sad fact is that any form of retirement plan causes risk to someone. Traditional pensions put the risk on the company; government-managed systems put it on the taxpayer, who already must pay for Social Security and Medicare excess costs. What is needed is a way to reduce risk on the individual 401(k) investor. First, we need to make retirement saving easier. Automatic enrollment has made the 401(k) process simple, especially for those most prone to under-saving: younger workers, women, small business employees and minority workers. However, only about half the work force is employed by a company that offers 401(k) plans. Phased annuity investments would reduce the risk that a worker reaches retirement with inadequate savings. The bipartisan, cross-ideological “automatic I.R.A.” (which has support from the Obama administration and was also endorsed by the McCain campaign) would enable workers whose employers do not sponsor a pension or retirement savings plan to put money into I.R.A.s with payroll deduction and automatic enrollment. It is simple and easy for employees to understand, and cheap for the employer. Reforming the tax code’s credit for savers so that it sends tax benefits directly to the accounts will help to build balances even faster. Second, we need to make retirement investments safer for older workers. One way would be to include a phased annuity purchase into that investment. Workers would end up with annuities that provide guaranteed lifetime income as well as a lump sum of savings. This would be greatly reduce the risk that a worker reaches retirement with inadequate savings. Finally, we need to encourage more saving. Even under auto-enrollment, initial amounts are often too low. Automatic escalation gradually increases savings to a better level, and should be standard in every 401(k). No retirement plan is perfect. Improving the savings vehicles that we have will bear faster and more secure results than any alternative that hasn’t been tested. The Risk-Averse Future Thomas C. Scott is the chief executive officer of Scott Wealth Management and the author of “Fasten Your Financial Seatbelt.” The future shape of retirement saving will likely borrow from the past, before people became enamored of the notion that the stock market could help them retire as a “401(k) millionaire.” Indeed, that aspiration is an idea that seems quaint. Older investors now want what their elders had: a pension income they can count on for as long as they live. A Fidelity Investments survey released last week found that 85 percent of investors 55 to 70 years old placed greater importance on a guaranteed monthly retirement income than on above-average investment gains. Expect to see new, more conservative financial products and government initiatives to encourage voluntary savings plans. But few have figured out how to get there. A 2007 consumer finance survey by the Federal Reserve Board found that only 5.5 percent of families owned an annuity, a financial product designed to provide reliable retirement income but rarely chosen by the layman because they tend to be complex and confusing. Now that so many people face running out of money before they run out of time, and are willing to swap the millionaire dream for a Social Security-style guarantee, you can expect to see new, more conservative financial products and government initiatives to encourage voluntary savings plans that provide guaranteed incomes. Our parents and grandparents worked decades for the same companies because their pension plans promised a secure retirement. Those days are over but it seems inevitable that, with some new wrinkles, we’re headed back to basics in our retirement planning.


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