Response to an Article Criticizing 401(k) Plans

Anyone familiar with my blog and my practice should be well aware that although I make a living providing financial advice with respect to employer-provided retirement plans, I am no fan of them to say the least.  So one would think that I would agree with any article that similarly espouses my disdain for 401(k) plans.  In this particular case, however, one would be wrong.  In fact, this article has made me now do something I never thought I would do:  Defend 401(k) plans – or at least separate legitimate criticisms from criticisms that are either false, incomplete, or just don’t make any sense.  Does this mean I no longer believe the industry is a corrupt racket that needs to be put out of its misery and that 401(k) plans should be abolished?  Does this mean I’m pushing 401(k) plans because I make more money if people contribute more? (I don’t make more money because I charge flat fees based on the work I do that are not asset-based)  Of course not.  it’s just that when I saw an article like this, I felt compelled to write a response for people who formed an opinion on 401(k) plans based on this article without doing any further research.  Here is a breakdown of each point:

1. You can be wiped out overnight.

A report on CBS’s 60 Minutes TV show asked of 401(k)s, “What kind of retirement plan allows millions of people to lose 30-50 percent of their life savings just as they near retirement?” Good question. Unlike other investments that are protected from losses, your 401(k) rises and falls with the stock market where you have absolutely no control. Retirement planners will tell you the market averages 8-11 percent returns per year. That may have been true last century, but this century has seen that turned into a fiction. From 2000 to 2015, the market was up just 8.4 percent total when adjusted for inflation, or 0.56 percent per year, and that was after a substantial market rally. Do you want to live your ideal life only if the market cooperates?

The idea that one can lose money in the stock market is no secret.  Of course the market is subject to risk, but the author is only referring to market risk, yet there are many other types of risks to consider such as inflation risk, interest rate risk, credit risk, taxability risk, call risk, liquidity risk, reinvestment risk, social/political/legislative risk, currency/exchange rate risk, and business risk.  Does anyone really believe that they have control over any of these types of risks either?  Is “having control” necessarily better? Yes, the market has not fared well over this recent 15 year period, but cherry-picking one particularly bad time period is hardly evidence to change your entire investment philosophy.  If so, Warren Buffett wouldn’t have said this in one of his annual letters to Berkshire shareholders, dated February 28, 2014: “If “investors” frenetically bought and sold farmland to each other, neither the yields or prices of their crops would be increased.  The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties. Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions.  The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit.  So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm. My advice to the trustee couldn’t be more simple:  Put 10% of the cash in short-term government bonds and 90% in a very low-cost S & P 500 index fund (I suggest Vanguard’s).  I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions, or individuals – who employ high-fee managers.”

2. Administrative Fees and the Tyranny of Compounding Costs

The toll taken by 401(k) and associated mutual fund fees is staggering, and can eat up more than half your gains. With 401(k)s, there are usually more than a dozen undisclosed fees: legal fees, trustee fees, transaction fees, stewardship fees, bookkeeping fees, finder fees and more. But that’s just the beginning. The mutual funds inside 401(k)s often take a 2 percent fee off the top. If a fund is up 7 percent for the year, they take 2 percent and you get 5 percent. It sounds like you’re getting more, right? At first, yes, but in the end the mutual fund wins. As Jack Bogle, the founder of Vanguard explains it, “What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compound costs.” If you contribute $5,000 per year, from 25 years old to 65, and the fund goes up 7 percent every year, your money would turn into around $1,143,000. Yet, you’d only get to keep $669,400, or less than 60 percent. That’s because 7 percent compounding returns hundreds of thousands more than a 5 percent compounding return, and none of it goes to you. The 2 percent fee cuts the return exponentially. In the example above, by the time you turn 75 the mutual fund may have taken two-thirds of your gains. Bogle puts it like this, “Do you really want to invest in a system where you put up 100 percent of the capital, you take 100 percent of the risk, and you get 30 percent of the return?”

While there have been no more vocal critics about 401(k) plan fees than me, the statement that “The mutual funds inside 401(k)s often take a 2 percent fee off the top” is flat out wrong.  To illustrate, according to The Investment Company Institute: “In 2013, 401(k) plan participants who invested in equity mutual funds paid an average expense ratio of 0.58 percent, down from 0.63 percent in 2012. Similarly, expense ratios that 401(k) plan participants paid for investing in hybrid mutual funds fell from 0.60 percent in 2012 to 0.58 percent in 2013. The average expense ratio 401(k) plan participants incurred for investing in bond mutual funds dropped from 0.50 percent in 2012 to 0.48 percent in 2013. Participants in 401(k) plans tend to pay lower fees than fund investors overall. The 0.58 percent paid by 401(k) investors in equity funds is lower than the expenses paid by all equity fund investors (0.74 percent) and less than half the simple average expense ratio on equity funds offered for sale in the United States (1.37 percent) (see the figure below for more detail). The experience of hybrid and bond fund investors is similar.” Plans with very little assets will likely have “all-in” expenses of 2 percent or more, but this figure also includes record keeping, administration, custodial, and broker/advisory fees.

3. There’s no cash flow for better opportunities.

The theory behind 401(k)s is you keep putting money away, where you can’t easily touch it without penalty for 30 years, and it will compound into enough to retire on. We’ve seen why you should be suspicious of that story.  Compounding charts don’t look the same at 0.56 percent annual returns. But here’s the other problem.  Money left to compound unpredictably for 30 years is stagnant money.  There’s no cash flow ready to direct to today’s best uses.  Instead, it’s sitting still inside one 30-year bet, while newer, better opportunities may be passing you by.

Not having ready access to money set aside for retirement is a legitimate criticism, so there is nothing wrong with supplementing your retirement outside of your company’s 401(k) plan in additional to making contributions to the plan.  However, just because the market is unpredictable doesn’t mean the money is stagnant.  The word “stagnant” means inactive or showing no activity while the word “unpredictable” means uncertain.  So whether or not money will compound unpredictably has nothing to do with whether or not money will be stagnant. It is also not clear if other opportunities are necessarily better since this question can depend on a variety of factors such as what these opportunities are, your cash flow situation, your current income, your age, whether or not your 401(k) plan has a match, and what your 401(k) investment options and expenses are.

4. Lack of liquidity when you need it most.

Money in a 401(k) is tied up with penalties for early withdrawal unless you know how to safely navigate obscure IRS codes. This means you can’t spend or invest your money to enrich your life without great difficulty and/or taking a big financial hit. The only exception allows you to borrow a limited amount of money from your 401(k) if you promise to pay it back. This automatically leads to double taxation and a slew of other negatives, the worst being if you lose your job or your income dries up, the deal changes and you must repay the loan within 60 days. Not even break-your-thumb loan sharks are that cruel.

Lack of liquidity and the double taxation of loans are definitely issues with 401(k) plans, so I won’t argue that point, but the statement “The only exception allows you to borrow a limited amount of money from your 401(k) if you promise to pay it back” is incorrect.  A simple Google search for “401(k) withdrawal exceptions” will provide evidence to refute this claim by showing many other examples of penalty-free withdrawals that you don’t have to promise to pay back.

5. Lack of knowledge encourages unconscious investing.

With 401(k)s, I’ve seen environmentalists who are unknowingly invested in big oil, and anti-smoking advocates invested in big tobacco. Simply put, 401(k)s teach people to be unconscious while investing. Think about it, how much do you really know about your 401(k)? Do you know the funds in which you’re invested? Do you know the details of the companies inside those funds? Do you know the fund manager’s philosophy, history, and performance?  Probably not, How can you expect to gain a return from something that you know so little about? And how can this be called investing? It’s not investing, it’s gambling.

Yes, I’m sure it’s true that many people do not know the 401(k) funds they’re invested in, but why wouldn’t this also be true to any investment outside of their 401(k) as well?  Do people necessarily know any more about the details of insurance and annuities they buy?  If not, would it be better for people to just keep all of their money in cash and never invest in anything? I’m not arguing that it isn’t a good idea to understand the details of your investments.  I just don’t understand why 401(k)s should be singled out any more than any other investment.

6. Fear of taxes leads to underutilization.

401(k)s are tax-deferred, meaning you avoid paying taxes today by committing to paying them later. But taxes are historically low compared to the days of 50, 60, or even 90 percent marginal rates of the past and chances are, with record national debt, that taxes are going up. If you don’t like paying taxes today, why would you want to pay more taxes in the future? The tax deferral aspect of the 401(k), which is touted as a great boon, is actually a primary factor contributing to its underutilization. When the time finally comes to enjoy or live off the money, retirees are incentivized to let the money sit for fear of triggering burdensome tax consequences.

Has the author of this article never heard of a Roth 401(k) which is funded with after-tax dollars meaning the qualified withdrawals are income tax free?  “No, of course this does not mean that a Roth 401(k) serves as a comprehensive financial solution, but if you are going to criticize 401(k) plans, you cannot ignore the fact that this is an option in more plans now than in years past.  Chris Carosa’s thorough and objective article about the debate over the tax advantages of 401(k) plans is far more informative, especially because it is not a completely pro 401(k) article.”  I would highly recommend it to anyone who is genuinely interested in hearing a wide range of informed opinions on the subject.

7. Higher tax brackets upon withdrawal.

It’s ironic that people anticipate that they’ll have healthy returns on their qualified plan while at the same time figuring they’ll be in a lower tax bracket at retirement. If you have achieved any measure of success, you should actually be in a higher tax bracket at retirement. Most advisors, however, assume the opposite. Even worse, those higher tax brackets are likely to be even higher and more daunting in the future.

Again, why not mention the fact that Roth 401(k)s do not burden participants with taxable withdrawals and that more financial professionals and publications are recommending utilizing this option?

8. No exit strategy.

Early withdrawal penalties, over-the-top borrowing rules, daunting taxes, these are all incentives never to touch the money, ever. Getting into a 401(k) seems simple enough. But how are you going to get your money out of it?

See above

9. 401(k)s are easy targets for estate taxes.

Frankly, 401(k)s are sitting ducks for predatory estate taxes. Since there’s no clear exit strategy without major penalties or taxes,  at the end of a person’s lifetime their 401(k)s often end up being a pile of cash that looks very tempting to the government. When it is passed on to the next generation, it’s likely not only hit by the income tax, but the estate tax as well.

This is true, but does not mention the fact that few people will ever pay any estate taxes based on the federal and state estate tax exemptions which have increased significantly.  Yes, we don’t know what estate taxes will be 30 or 40 years from now, but it is nonetheless important to point out that most people have been and are still not subject to estate taxes, especially given that the current average 401(k) balances for people 55 and over is still only about $150,000.

10. The government owns your 401(k) and can change the rules at will.

You may be surprised to learn this, but your 401(k) does not even technically belong to you. Read the fine print and you will find “FBO” (For Benefit Of). The tax code makes it technically owned by the government, but provided for your benefit. Judging from world history, 401(k)s could be in great jeopardy. Other countries have raided private retirement plans to fund the government. Argentina did it in 2008, Hungary did it in 2010 and Ireland in 2011. Similar pension raids occurred in Poland and France. Could it happen in America? Well, during the last recession, Congress invited an expert to give testimony on confiscating 401(k)s and turning them into a public retirement plan like Social Security. It only takes one economic crisis before you retire for possible rule changes or confiscation of your 401(k).

I have read similar articles and would never assume the government is out to protect us.  Governments have committed far worse crimes than stealing people’s retirement money, so I would not be surprised if our government did this or at least forced some of our 401(k) investments to be in U.S. Treasury bonds.  Of course this could happen to IRAs as well. But what the author also doesn’t mention is that there is no reason why our same “benevolent” government won’t also tax life insurance and annuity cash values.

11. Turmoil in retirement.

When it comes time to withdraw money in retirement, maybe you can stomach the taxes, but can you stomach the market swings? Suppose you’ve projected to withdraw 6 percent a year, based on an average annual return of 8 percent. What will you do when the market is volatile? If your fund is down 10 percent one year, any withdrawal is tapping into your principal. At that point, your only choices are start withdrawing principal, or leave the money alone until your account is up again. Try sleeping at night when your income is at the complete mercy of the markets.

There are multiple ways to withdraw money during retirement, and a strategy that works for one person may not work as well for another since the best strategy will depend on the facts and circumstances of the situation.  But to imply that none of your money (or at least very little) should be invested in the market at all (the market is volatile whether it’s in an IRA, brokerage account, or 401(k) plan) simply because the market is volatile is not intended to actually teach anyone anything, but to convince people to just buy life insurance and commission-based annuities.  David Loeper’s article entitled “How Much is that Guarantee in the Window?” does an excellent job analyzing the costs of guaranteed income and exhaustively analyzing if the costs outweigh the benefits.  In other words, it is meant to educate and make people smarter.   Here are some highlights: Out of 1,000 random lifetimes with simulated random returns even more extreme than have been historically observed, in 997 of the outcomes the annuity had a negative relative value to the simple balanced portfolio. There was a 90% chance the annuity guarantee would cost the investor more than $149,000 (about 1.5 times the initial investment) and a 75% chance it would cost more than $243,000. Does this sound “quite valuable” to you? Think about the other factors on top of this. The cash flows we modeled for spendable income were net after taxes and fees versus the annuity that would likely have some portion of the payment being taxed at ordinary income rates. The annuity has zero liquidity where the balanced portfolio offered flexibility to adjust future income withdrawals if there was an unexpected immediate cash need. Of course, we are also assuming the insurance company financially survives a Great Depression environment and can honor its promise to pay.

12. Lost without a comprehensive plan.

I’ve witnessed many people whose finances are in shambles, yet who continue to contribute diligently to their 401(k) plans. It’s like someone with a slit wrist tending to a scraped knee.  You need a macroeconomic, big-picture plan that identifies, prioritizes and manages all pieces of your financial puzzle in harmony with each other. You don’t need a general, one-size-fits-all plan that’s sold to everyone. I don’t understand how having a “big-picture” plan and a 401(k) plan are mutually exclusive. Can’t a “big-picture” 401(k) plan include analyzing the costs and benefits of a 401(k) plan (including the value of the 401(k) match which was never mentioned in this article) to determine how much, if anything, should be invested?

13. Neglect of stewardship and responsibility.

401(k) plans encourage people to give up responsibility for their investment decisions. They believe they can just throw enough money at the “experts” and, somehow, 30 years later, they’ll end up with a lot of money. Then when things don’t turn out that way, they blame others. A true financial plan requires stewardship and responsibility. In short, saving for retirement is wise and prudent. But other investment philosophies, products and strategies can meet your financial objectives much more quickly and safely than a 401(k). Investing for cash flow, or investing directly in a business, or Cash Flow Banking, where you become your own “bank,” could be smarter moves. Even paying off a high interest rate loan can be a smarter move than contributing to your 401(k). Whatever you choose, I urge you to do it as a conscious investor. I suggest that you don’t swallow Wall Street’s promises blindly, and look to those who tell the whole truth about your financial options.

Again, while I don’t mean to imply that investing in a brokerage account or IRA poses the same issue, it is important to note that the same principles of investing still apply.  Also, does this mean that any money invested in the market necessarily ignores stewardship and responsibility? I agree that paying off a high interest rate loan can definitely be a wiser course of action than investing in a 401(k) plan, especially because so many are loaded with such significant and unnecessary expense that erode people’s returns. As for “Cash Flow Banking”, why not just call it what it is?:  Whole Life Insurance.  In fact, if the title of the article were more honest, it should be called:  Why You Should Buy Life Insurance and Commission-based Annuity Products Instead of Investing in your 401(k) Plan.  Now that would at least be an article where I know what the agenda is.

My point here is not that there is necessarily anything wrong with whole life insurance or annuities.  I’m sure there are many ways in which whole life insurance or annuities can fit well into a financial plan in some circumstances.  I don’t believe they are necessarily a worse alternative than 401(k) plans (in case one gets the impression that I am “pro-401(k) plan and anti-life insurance).  And I also want to stress that it’s not always best to always blindly max out your 401(k) for all of the reasons I have written about on my website and blog.  But if you represent yourself as a “financial advisor” to your clients when you cannot legally provide advice without telling your clients they can buy the same annuities without the commissions or surrender charges or that there are blogs like this that are actually meant to help people make more informed decisions because they expose conflicts of interest while 100% of your compensation comes from life insurance and commission-based annuities is dishonest.  Why not just call yourself a life insurance and annuity salesman and tell all of your clients that you can’t provide financial advice, but if they were to use another professional acting in the capacity of a registered investment advisor and fiduciary, then they could receive financial advice?  What’s wrong with laying out all of the alternatives to your clients so they can make informed decisions?  There’s no shame in that.  Isn’t that the whole reason why they seek out financial professionals in the first place?  Butchers don’t call themselves dieticians.  They sell meat while not pretending to sell anything else and people are happy to buy it.  The problem is when people mistake their butcher for a dietician.

Another analogy is the proper labeling of our food.  As consumers, it is best for us to know all of the ingredients in our food, especially if we are allergic to certain foods.  So shouldn’t we demand the same rigorous standards for labeling the services of financial professionals?

I understand there is meaningful debate over what type of advisor compensation model is best for the client, and I agree that when ideas are subjected to the public process of critical exchange, then we all learn something.  But at the very least, clients should understand that when someone makes all of their money from life insurance and commission-based annuities and cannot legally provide advice, they are more like butchers than dieticians.  If clients did understand, I suspect many of these “advisors” would either go out of business or have to change their way of doing business to more honestly and completely reflect how they make money.  Maybe doctors could start doing that too.