This post responds to Knight Kiplinger’s piece titled “401(k)s for Everyone” found in the February 2011 issue of Kiplinger’s Personal Finance Magazine and online here.

Knight Kiplinger discusses making the 401(k) mandatory in order to give a firm nudge to employees into saving something for retirement.  The ends are noble… it is clear that financial education in the United States is awful and mistrust of the financial industry runs high.  Too often people are skeptical of bankers and other financial institutions, and skepticism leads to delaying important actions one should take as soon as they enter the workforce.

His piece outlines his arguments for making 401(k) availability mandatory, and additionally argues that employee participation should be mandatory.  But some of these proposals are not consistent with good financial planning practices.

  1. Make all employers provide a 401(k) plan - he gets no argument from me here.  401(k) plans allow a worker to contribute much more to retirement than IRA options, up to $16,500 per year as of 2011 for those under 50 as opposed to $5,000 per year (tack on an extra $1,000 catch-up contribution for older savers for IRAs, $5,500 more for 401(k) contributors).  There is no question that those with access to 401(k) options should be using them.  And depending on your income level you can do both.
  2. Require workers to contribute 3% of earnings, automatically rising with age to 6% or more – This suggestion surprised me.  Why?  Isn’t saving more as you earn more a good thing?  Yes, but it runs contrary to what you should be doing.  At any age, you should be saving as much up to the limit as you can possibly afford if you have not yet met your retirement savings goals.  But the best time to do that is when you enter the workforce.  At a 7% market return rate (slightly lowballing for the history of the markets, even including the late 2000’s) you double your money every ten years.  Every dollar invested at age 22 has the potential to be close to sixteen dollars when the money can be withdrawn without penalty at 59 1/2 years.  Did you know that someone investing $5,000 per year at 7% return from age 22 until they turn 31 and stopping will have more money saved when they turn 64 than someone starting to invest $5,000 per year at age 32 until age 64?  Early is the key, not later.  Those investing early should not be required to invest more as they get older, they can start to spend a little then or establish an early-retirement portfolio. Forcing an older saver into higher pre-tax retirement contributions may not be in their best financial interest.
  3. Default investment choice would be a “life cycle” asset allocation – This is another problem.  Life cycle funds, commonly called “target date funds,” allocate your money in percentages of stocks, bonds and cash based on the year you plan to retire.  These plans may sound good because they take a lot of decision-making away from the saver.  They are better than nothing, but they are doing a disservice.  At this moment in 2011 interest rates are beginning to come off of years-long lows, generational lows.  The absolute WRONG time to buy into bond mutual funds is when rates are rising.  The fund will generate a bond interest yield but the underlying bonds in the fund decrease in face value as interest rates rise.  You may get 5% yield on a bond fund portfolio but lose that much or more in the per-share value of the fund.  If you are close to retirement age, better to establish a CD ladder or a ladder of short-term bonds so the declining-prices bonds get recycled quicker.  But the target date funds ignore that, robotically moving you into a higher bond position than may be smart.  They also ignore how much money in other assets you may have, or worse keep your portfolio too conservative if you haven’t saved anything, taking you from nothing to a little more than nothing instead of taking on some risk to catch up on time lost.
  4. All Company-matched funds would be fully vested immediately – This is a good idea, but I fear companies will game that requirement, dropping wages to compensate.  In many 401(k) plans your company will kick in an amount, say dollar-for-dollar up to three percent.  This is great for the investor and is free money… you can contribute 6% of your salary for a 9% overall contribution which offsets a lot of risk in a portfolio when you are already 50% ahead!  But most companies employ a vesting schedule. For example if you leave the company in two years but your company’s policy says you are not fully vested until three years, the company may claw back their kick-in amount when you leave.  I don’t think two or three-year 100% vesting schedules are unreasonable as they provide incentive for workers to stay with a company and decrease turnover, which in turn decreases corporate costs and maybe they can match more money.  But requiring immediate vesting will be made up somewhere, probably in compensation.
  5. Early withdrawals not allowed except for cases of permanent disability – no argument there.  This money is for the future you, not the “now” you.
  6. 401(k) payouts would be annuity-style, not allowing lump-sum – The saver has spent her entire life for this, why limit the money she can take out?  If the saver has been smart enough to save for forty years, she isn’t going to suddenly withdraw it all and go to Vegas with it.  Personally I’d like the choice to take a portion of that and buy a nicer house far away from where I am now, living off the rest.  I didn’t save all that money just to have it metered out at some arbitrary percentage someone else came up with.  Knight suggests the remainder go to one’s estate, but that money is for me and me alone if I want it that way.

If I had a magic wand I’d have the country focus more on making financial education a core part of our nation’s curriculum, to the degree that planning for one’s retirement in the 20’s is as obvious as needing to put on a seat belt. And like it or not, we all contribute to a retirement plan already called Social Security through payroll taxes. It was never meant to be a retirement plan and it is entirely insufficient as one one its own, but it exists and we all pay into it. Let that continue to be the fallback for those who refuse to save for retirement. It is better in my view to go for the gold instead of the bronze, educating our people on good financial practices instead of forcing some not-so-sensible requirements on them.

 

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