by Jane White
Unfortunately, like just about everything else in life, the truth is somewhere in the middle. Over the long haul, everyone needs to own stocks because you are a part owner of companies whose shares will be worth many multiples of what they were when you first bought them once you retire. Over the short haul, as you get closer to retirement you need to convert to cash equivalents, such as money market accounts, because stock values run the risk of short-term slumps. On the other hand, nobody should own government bonds because they are a long-term investment whose premiums are generally less than the rate of inflation, so you’re actually losing money. The proof is in the pudding: Examining 20-year-holding investment periods from 1926 to 2001, large-company stocks yielded better than 5% returns in all but 19 of the 56 holding periods. In contrast, long-term government bonds lost money in all but eight of the holding periods.
If logic had trumped partisan ideology during the debate over privatizing Social Security when former President George W. Bush tried to overhaul it in 2005, its shortfall would have been addressed by a combination of tax increases and a shift of much of its assets into stock index funds rather than stuck in poorly performing short-term and long-term government bonds, as is currently the case. Rather than privatizing Social Security and allowing investors to shoot themselves in the foot by attempting to time the market with brokerage accounts as Bush proposed (some say at the behest of the brokerage industry), the assets would be managed by a government-sponsored enterprise that would invest in a mix of stock and money market index funds, as is the case with the Thrift Savings Plan, which covers many government employees. Unfortunately, since the Social Security Administration is scheduled to take in fewer taxes than the benefits it pays out starting in 2016, a combination of a lack of a bipartisan dialogue and ignorance about finance has produced another retirement disaster.
So it’s no surprise that this lack of financial literacy on the part of Congress and some who purport to be financial experts surfaced during the stock market slump in October 2008. There was a brief media flurry over whether 401(k) plans were working, but the attention was directed not at the paltry employer match but at the misguided notion that stocks they hold are risky and shouldn’t be in the plans, despite the fact that they dominate the assets in pension plans.
Testifying before the House Committee on Education and Labor on October 7, 2008, Teresa Ghilarducci, an economics professor, proposed replacing 401(k) employer matching contributions with an annual government deposit of $600 that would be invested both in “safe and risky” investments whose investment returns would be subsidized by the taxpayers, along with requiring that employees contribute 5% of their pay into these investments.
However, replacing an employer contribution with a one-size-fits-all $600 government contribution would devastate nest eggs for 95% of Americans—and the other 5% are probably poor enough that Social Security replaces most of their income at retirement.
Another academic who is frequently quoted in the media on pension matters also appears to use faulty math to address the empty nest egg dilemma. Alicia Munnell, who heads up the Center for Retirement Research, appears to have come to the conclusion that all Americans need to do is work two to four years longer. She says that “in theory workers could accumulate substantial wealth” simply by contributing 6% of pay at age 30 and ending up with a nest egg of $380,000. Why she thinks this one-size-fits-all number would equal retirement adequacy is not clear since it works only if the person’s income near retirement is $38,000 ($380,000 equals ten times pay at an income level of $38,000). Since the median income for that age group is around $65,000, these calculations don’t add up.
Auto-Enrollment: Better Than No Reform, but Not a Cure for Pension Poverty
The only reform to 401(k) plans has been to automatically enroll employees in an inadequate plan rather than requiring employers to contribute more to these workers’ accounts. The Pension Protection Act (PPA) of 2006 makes it easier for plan sponsors to automatically enroll their employees at a starting contribution rate of 3%, which can be raised by at least 1% of salary per year until it reaches 6%. However, although auto-enrollment will give people nest eggs that are better than nothing, it won’t fill them.
The problem with the preceding formula is twofold: First, a 3% starting contribution rate is too low for everybody. It’s less than one-third of the rate required at a starting age of 25 and less than one-seventh for a starting age of 40—and these scenarios assume an employer match! Second, auto-enrollment keeps the default rate artificially low for job changers, at least for those enrolled in a plan that would have raised their contribution rate each year. For example, workers who changed jobs every seven years would accumulate only 40% of what they’d need—and that’s assuming an employer match at each job. Job changers working for companies without a matching contribution would accumulate less than one-third of what they need.
To make matters worse, employers aren’t required to adopt auto-enrollment, and the ones that have adopted it typically don’t enroll current employees who aren’t participants, only new hires. Nearly two-thirds of employers use automatic enrollment only with new hires, according to a survey of almost 5,500 plans by Plansponsor.com, a retirement research firm in Stamford, Connecticut. In addition, they enroll employees at a “default” contribution rate that is lower than what they would have saved on their own. A Vanguard Group study shows that employees tend to save at an average rate of 2.9% when they are auto-enrolled, versus a 5% rate under voluntary enrollment.
Unfortunately, unless there is a public uproar—instructions for participating in it are included in the next chapter—the best the Obama Administration may do is require auto-enrollment rather than mandating higher employer contributions. The director of the Office of Management and Budget, Peter Orszag, is a proponent of auto-enrollment, having co-authored a book, Aging Gracefully, that promotes it. President Obama has also called for requiring employers that don’t offer a retirement plan to enroll employees in a “direct deposit” IRA account, covering the 75 million people who don’t have plans. Again, President Obama’s intentions are good, but as is the case with auto-enrollment, simply enrolling employees in a plan that requires them to foot the bill for their retirement is unheard of in other advanced countries. All companies except those run by the self-employed in Australia are required to contribute an equivalent of 9% of pay into their employees’ accounts.
Automatic Annuitization: Ripping Off People Who Can’t Afford to Retire
Not only has the mutual fund industry avoided the responsibility for telling their 401(k) clients how much to save in their accounts to achieve their goals, but many of the fund companies and their counterparts in the insurance industry have no compunction about selling annuities or other investment products such as managed payout funds to Baby Boomers who have reached retirement age without sufficient retirement assets. An incorrectly headlined front-page article in The Wall Street Journal, “Golden Years: As Boomers Retire, Insurers Aim to Cash In,” described the insurance industry’s push to sell annuities to retiring Baby Boomers despite a “checkered past” because of high fees, churning, and other issues. According to the Journal, sales of variable annuity products have increased more than 50% from 2002 to 2007.
Along with conveying the false impression that most people can afford to retire from a 401(k) plan, the article never addresses the most problematic potential feature of annuities: They can’t make empty nest eggs full. The function of an annuity is to make your adequate retirement savings last a lifetime even if you live to age 100 or more. If you haven’t accumulated enough, you need to keep working—a fact that sellers are not required to disclose to their customers.
Unfortunately, some pension advocates are favoring “automatic annuitization,” which means that workers with inadequate nest eggs will be sold a costly product that won’t enable them to retire—what’s more it’s likely that an unscrupulous insurance broker will try to earn commissions by selling annuity
owners a new one shortly thereafter.
The so-called Retirement Security for Life Act of 2007, most likely dreamed up by the annuity industry and introduced in 2007 by Representatives Stephanie Tubbs Jones (D-OH) and Phil English (R-PA) and the ultimately defeated Sen. Gordon Smith (R-OR), would amend the Internal Revenue Code so that 50% of the income generated by the annuity would be excluded from tax; for the typical retiree the tax break would be up to $5,000.
The tax deduction, however, could be totally offset by the fees and frequently deceptive sales practices of the industry; the misdoings by some annuity salespeople include misleading investors about investment returns and how soon investors can access the money, along with generating commissions by convincing the customer to buy a new annuity. What’s more, the product isn’t even necessary, because the mutual fund industry offers an investment product called a managed payout fund that accomplishes the same goal at a lower cost.
In 2006, the National Association of Securities Dealers (now Financial Industry Regulatory Authority) issued an investor alert regarding annuity salespeople who conducted workplace seminars in which they convinced employees to retire early, cash out of their 401(k) accounts—and very likely causing them to pay “penalty taxes” if they were under age —and open an IRA that consists of a variable annuity. In one disciplinary case that NASD prosecuted, the broker told the employees, “You can make as much in retirement as you can at work,” saying that he could generate annual investment returns of 18% and assumed annual returns of 11% to 14%—which no investment can guarantee.
What follows are just a few of the numerous examples of actions taken against annuity sellers in various states.
• In 2008, Florida Governor Charlie Crist signed a law increasing penalties on annuity salespeople who pressure clients to buy annuities they don’t need or want. The law increases fines from $100,000 to as much as $150,000 for certain “unfair or deceptive annuity sales activities,” including “twisting,” in which a salesman lies about the benefits of his annuity to get clients to sell their current annuity from a different company, or “churning,” which involves replacing the annuity they have with a new product from the same company.
• In 2006, New York Attorney General Eliot Spitzer announced an agreement in which the Hartford Financial Services Group would pay $20 million in restitution and fines and implement reforms designed to bring fair play and transparency to the marketing of retirement products.
“This investigation shows how payoffs and deception influenced major deals for retirement products,” Spitzer said. The Hartford Financial Services Group also reached an agreement with Connecticut Attorney General Richard Blumenthal.
• In 2005, New Jersey launched its Senior Citizen Investment Protection Act, which limits how long annuity sellers can impose surrender charges in the event the annuity owner wants to sell the product.
How did an industry with such a shameful track record manage to convince some members of Congress to help boost its revenues? Along with the fact that campaign contributions from the insurance industry often influence decisions made by Congress, the industry was probably able to dupe nonprofit organizations representing women and minorities into supporting the legislation, thereby giving it credibility. It probably could do so because the annuitization option does shine a spotlight on one of the more unfortunate features of 401(k) plans, which is that unlike most defined benefit pensions, retirees with 401(k) accounts can and often do take their payments as a lump sum—even before they’ve reached age , causing them to have to pay taxes and penalties. With no good advice, they might spend the money foolishly rather than banking it and taking payments that will last a lifetime—or, more likely, banking it and continuing to work, which most of us need to do.
Unfortunately, neither the advocacy organizations nor Smith and his co-sponsors appear to have researched the track record of the industry before buying into the idea that an annuity is the solution to this problem. For one thing, for the tiny percentage of 401(k) participants who have saved enough, there are other options for providing income streams for life. For example, the mutual fund industry offers “managed payout” or “target distribution” mutual funds that feature lower fees than their annuity counterparts. What’s more, the mutual fund companies offering these products don’t employ salespeople who “twist” or “churn” the funds to generate sales commissions.
Bottom line: Anyone who is turning retirement age and is looking at a 401(k) account that’s significantly less than ten times their salary needs to keep working—that is, stay in the “accumulation phase” of investing until they have reached that goal, in which case they can study their best options in the “distribution phase.” There is no investment product that can turn a “sow’s ear” nest egg into a silk purse.
401(k) Security Act: Mandatory 9% Contribution for Companies with Ten or More Employees, Government Contribution for the Rest
Rather than continuing to “reform” defined benefit plans out of existence by putting too many shackles on them, we should work to improve 401(k) plans because they are the right plan for the 21st-century U.S. worker, who switches jobs an average of every four years—the highest turnover rate in the world. Someone with that job-changing history who worked exclusively for companies with only a traditional pension could end up never being vested in any plan—that is, pensionless.
To make a 401(k) plan walk, talk, and quack like a defined benefit plan but without the counterintuitive DB shackles, we should require that companies that are successful enough to have at least 10 employees contribute the equivalent of 9% of pay as Australian employers do, to an account that is portable when the employee leaves work. We should also propose a program that features a government contribution for those companies with nine or fewer employees, along the lines of the Universal 401(k) Plan proposed by Michael Calabrese of the New America Foundation (Disclosure: Calabrese was on my company’s board of directors when it was a nonprofit). More than 70 million American workers don’t participate in a tax-subsidized, payroll deduction saving plan. Calabrese observes that although 65% of full-time workers at firms with more than 100 employees participate in retirement plans, that rate sinks to 45% at firms with fewer than 100 employees and 25% at firms employing fewer than 25.
Calabrese’s Universal 401(k) plan would give every employee of a small company an Individual Career Account in which the government would match voluntary contributions by workers and their employers with refundable tax credits deposited directly into their accounts.
As is the case with Australia’s version of the 401(k), the country already has an employer-based government-matching program for low-income workers in place called the “co-contribution.” On top of the mandatory 9% of pay that workers at all employers regardless of size receive to their super accounts, Australians who earn less than $28,980 receive a $1.50 match from the government for every $1 the workers contribute, up to a total of $1,500; co-contributions reduce as income increases, phasing out completely at $58,980.
We Are on a “Countdown to 2011”
In a nutshell, we are looking at a retirement nightmare. The first wave of Baby Boomers, those born in 1946, is scheduled to retire in 2011 and can’t afford to—at the same time my daughter’s generation, one of the largest in history, is scheduled to graduate from college. Will a big percentage of the 4 million graduates wind up jobless because my generation’s 3.4 million Boomers can’t afford to retire? We’re witnessing a “perfect storm” of pension-poor Boomers, who will need to stay on the job, resulting in potentially jobless Gen Yers, many of whom also have college loans to pay off.
We need a public groundswell to get President Obama to enact the 401(k) Security Act described in this chapter. The next chapter lays out more details of the Act, what you can do to get the Obama Administration to enact it, and some smart 401(k) investing steps you can take in the meantime.
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