The Real Problem With 401(k)s


As the aging baby boom generation faces the challenge of saving for retirement despite inadequate preparation, 401(k) plans have earned the scorn of countless critics. Yet few people really focus on the primary problem with 401(k) plans: that they allow workers to cheat themselves out of a decent retirement.

Making financial survival optional
For decades, the traditional pension system took care of workers by ensuring them a fixed monthly payment for the rest of their lives after they retired. By providing pensions to their workers, companies assumed the responsibility for setting enough money aside and investing it well enough to be able to meet their obligations to their workers years or even decades into the future. Put another way, companies had to do the same sort of retirement planning as individuals, except on a much more massive scale that aggregated thousands of workers who expected to retire at vastly different times.

By contrast, 401(k) plans were designed to avoid any guarantee of a certain monthly payment for workers after they retired. Instead, they allowed for fixed contributions to retirement plan accounts, leaving the eventual future value of the plan assets in doubt.

From a corporate perspective, there was certainly value in making the shift away from traditional pensions. In the mid-2000s, Verizon (NYS: VZ) froze pensions for more than 50,000 of its managers, while IBM (NYS: IBM) froze pensions for more than 100,000 workers back in 2008. More recently, General Motors (NYS: GM) and Bank of America made plans earlier this year to implement their own pension freezes. In each case, companies enjoyed more predictability in pension costs.

If that had been the only motivation behind the changes, then companies could have taken steps to make workers equally well off under 401(k) plans. Specifically, they could have taken the money they otherwise would have put toward pension-plan contributions and directed all of it toward employer contributions to 401(k) accounts. By doing so, they would have left workers with a benefit of roughly equal value, at least on a theoretical basis.

A hidden pay cut
Instead, most companies minimized employer contributions after eliminating pension plans. Bank of America's plan, for instance, involved making an additional annual contribution of 2% to 3% to 401(k) accounts. Yet when you consider the numbers, the roughly $1,000 to $1,500 in annual expenses that B of A will take on for a salaried worker making $50,000 won't come close in all likelihood to earning enough to replace the lost monthly pension that worker would have received under a traditional pension. Moreover, during tough times, many employers didn't hesitate to eliminate contributions like employer matches, with American Express (NYS: AXP) and JPMorgan Chase (NYS: JPM) among dozens of companies that temporarily suspended matches before bringing them back when conditions improved.

Employers would argue that 401(k) plans give workers the ability to decide for themselves how much to save for retirement. Yet according to a recent Towers Watson survey (link opens PDF file), fewer than one in six employers believes that most of their employees use retirement and investment planning resources well, while only a quarter think their employees have realistic expectations about their eventual retirement prospects.

If employers really cared about making sure their workers saved enough for retirement, as nearly three-quarters of them say is their primary purpose in offering a 401(k) plan, then they have an option at their disposal to ensure that: Cut salaries and direct every penny to making adequate employer contributions to workers' retirement plans. By essentially taking the savings decision out of the hands of workers, employers could allow 401(k)s to achieve their original purpose of helping ensure an adequate amount of retirement savings.

Not gonna happen
But rather than bringing the implicit pay cut involved in shifting from pensions to 401(k)s out into the open, employers are much more likely to simply let prevailing trends take their course. That leaves workers in the position to discover for themselves just how much they lost when their pensions were replaced, and they'll have to negotiate hard if they want to come up with the money to replace those valuable benefits. Those who don't will be in for a rude awakening when retirement approaches.

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Fool contributor Dan Caplinger owns warrants on JPMorgan Chase. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of JPMorgan Chase, IBM, and Bank of America. Motley Fool newsletter services have recommended buying shares of General Motors, writing a covered strangle on American Express, and creating a synthetic long position in IBM. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy isn't a problem for anyone.

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