How the 401K Relies on a Dangerous Assumption
that the average individual can act in their own long-term interest, alone...
1978 Congress passed Public Law 95-600 or The H.R. 13511 (95th): Revenue Act. If you have insomnia, read these revenue acts for rapid symptom relief. The 1978 Revenue Act was the act that quietly opened up tax-deferred investments for “highly compensated individuals” - either owners or those earning in the top 1/3 of a company’s salary range. This was the inception of 401K tax-deferred investment plans.
As corporate salaries began a long process of acceleration in the 1970s (faster than inflation in most cases),1 executives wanted a way to stash excess earnings without paying taxes on that income. 2
Then, 401K plans took off unexpectedly as American companies abandoned the pension plan as a volatile risk to profits. Later, Congressional amendments expanded the 401K plan universe to include ALL employees. If you set up a 401K for yourself, a company owner in most cases, you now had to offer any full-time employee access, even the janitor and your lowest-paid employees.
And that’s where the flawed assumption snuck in the side door.
Is the janitor set up to be a savvy long-term investor? Who is helping him? Anyone? Bueller? Does the janitor even have the luxury of thinking long-term about anything?
Today, 63% of retirement plan participants have defined-contribution plans, not defined-benefit plans (i.e., pensions).3 A pension is a genuine lifetime cash income guarantee. It is a direct promise, a benefit you could sue for if not received. Pensions are contractually limited salaries for the rest of your life. You could plan very easily against these numbers. My grandfather had one as an R&D chemist at a paper plant. Defined benefits are a polite, responsible way to generate company loyalty.
But let’s be honest. By turning the average American private sector employee into an amateur stock trader, what did we do?
Well, you’ve replaced a corporate income guarantee with a forced gambling exercise that relies on specialized knowledge, self-discipline, and something far more subtle: a burning concern with risk management (something that high IQ, anxious people excel at!)
Yet there’s another issue under the surface. The declining purchase power of social security benefits makes your 401K strategy much more important. One recent estimate indicates that even recent, large COLA adjustments to social security checks are not keeping up with senior citizen expenses, primarily due to rising medicare insurance premiums (including optional Part C and D coverage).4
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Relying On Individual Investor Education is Communal Naivete of a Very American Kind
A lot is now riding on the average middle-class worker having a brilliant 401K strategy. The difference between astute and average investors in terms of financial outcomes is enormous when you model it out (more below).
If we are all the CEOs of our personalized social networks, then we definitely are the CEOs of our retirement investing. No one else is assuming responsibility for your retirement financial outcomes. This may be fine for high IQ, well-educated adults with access to financial acumen in their social networks and the education with which to make sense of online advice.
But this is NOT the majority of the 63% of working Americans in retirement plans.
The modern defined-contribution approach to saving for retirement makes huge assumptions about the individual that simply do not bear out with modern social science:
the average individual is a rational investor (hah!)
the average individual will save for the future vs. cash for today’s bills
the average individual has access to good retirement planning advice
the average individual will spend the time to understand how fund fees or corporate plan fees erode income generation (a lot) over 40 years.
young individuals will voluntarily save vs. spending income on partying and lifestyle expenses
it’s easy for any individual to know how much to save (it’s not)
people don’t like math (even when it’s in their best interest)
The explosion of the private, fee-based wealth advisor industry is just one data point that shows how many people would much rather outsource the murky topic of investing their life savings to someone else, anyone really so that they don’t have to think about it or confront the horror that they are not saving nearly enough for a 40-year retirement.
If the rich are outsourcing the actual investing, then what confidence should the average middle-class 401K participant have in a DIY approach? Hmmmm. Gives you you pause, doesn’t it.
You and I shouldn’t have too much confidence in ourselves.
The litany of amateur mistakes is well-known to professional financial advisors:
Not contributing to the maximum extent of a corporate match (argh!)
Taking out 401K loans for discretionary lifestyle fun (vacations, home renovations) and sabotaging long-term, compounding returns (ARGH!)
Still not understanding compounding returns (sigh)
Not checking fund fees before pushing piles of cash into them (2% vs. 0.2% matters…a lot over thirty years)
Not balancing risk appropriately per your phase of life, distance to retirement, or distance to your most likely years of demise (probably in your 90s given current cancer survival rates)
Not planning for the real-world inflation-adjusted cost of your future lifestyle!! (a lot of math involved here…boring, detailed math)
That list of major errors can create huge variations in your balance outcome at retirement and during your retirement.
How big are these potential variations?
The Great Recession Teaches Us the Power of Compounding
The sudden market shitshow of 2008/9 is the perfect, real-world history lab in which to learn the impact of common investing mistakes made by otherwise smart people. it teaches us the limits of relying on individualistic investing.
During the Great Recession, 401K balances went down 40-60% and took a decade to recover. The Great Recession, therefore, wiped out ten years of compounding on everyone’s principal balances as of Sept.1, 2008. Me too. Thank God my balance was small, and my wife’s was basically zero. (This was a perversely advantageous market timing some Gen Xers and Millennials had).
As I will now show with a forced math lesson, the Great Recession revealed how powerful just a few newbie mistakes can be.
If you had a $100,000 401K balance in 2008 before the crash and it declined 50% in about six months (by March 2009), you lost about $95,000 in net earnings over the next 10 years. This assumes you were a Growth investor tracking the rhythm of the S&P 500 (which yielded 15% average annual returns from That’so 2019).
That’s a lot of lost earnings and it led to many people re-adjusting their expectations of retirement. The lifestyle damage was worst for the currently retired and Baby Boomers approaching retirement. The smartest people in the investing world dumped as much cash in the market as they could muster in 2009 without suffering cardiac arrest. At the nadir of nadirs. Very few people actually did this, except the already wealthy. My excuse was sleep deprivation due to a one-year-old mildly autistic child.
But there’s a much more common mistake whose damage is hard to see in ten years but which becomes massive over 30-40 years - picking funds with excessive expense ratios.
The difference between paying 2% in fees vs. 0.2% in well-chosen funds matters. On a $100,000 starting balance, it matters to the tune of $16,000 in lost principal over ten years - to the fee gremlins.
Now, that’s not a lot of money in retirement. It’s one nice vacation for two in 2024. But here’s the thing. Most of us struggle to understand that we really will live for 30-40 years in retirement. 401K investing is about ultra-long-term thinking that the late Daniel Kahneman and others will assure you is not common to humans. You have to train yourself to do this.
You really have to model thirty years’ return on $16,000 of gremlin-swallowed principal to understand how damaging fund fees can get. Over thirty subsequent years, newbie investors would lose $160,000 in gains (!) when they pay just $16,000 in fees in the prior ten years. Sigh.
This math is shocking and puts a horrifying spotlight on how ‘wise’ a young corporate worker needs to be. The problem of compounding inside the murky world of 401K investing strategy is that it puts the burden of wisdom at the front end of the investing timeline, precisely when young Americans are in their Rumspringa phase of life. They are anything but focused on the long-term.
Does this cultural context for 401K investing sound fair to the average person? Does it sound extremely biased to Aspie people who work in the investing industry and are super well-informed?
No. And yes. Those are my answers.
What about you, dear readers? Do you think having the average person totally responsible for their 401K retirement outcomes is good social policy? Why or Why not?
https://www.epi.org/publication/ceo-pay-in-2021/
“The accounts originated in the 1970s as an obscure tax shelter for the well-to-do — a way for corporate executives in high tax brackets to shield some of their earnings from the IRS until retirement” - https://www.wbur.org/npr/104784014/is-the-401-k-a-good-deal-for-americas-workers
Ibid
A study by the Senior Citizens League, which advocates for retired people, claims that "COLAs have increased Social Security benefits by a total of 64%, yet typical senior expenses through March 2022 grew by more than double that rate — 130%." Senior Citizens League. "Social Security Benefits Lose 40% of Buying Power COLA for 202” Could Be 8.6%." cited in Investopedia.com Accessed May 24, 2024 via https://www.investopedia.com/ask/answers/081715/are-social-security-benefits-adjusted-inflation.asp
Interesting questions, James. My retirement was a TIAA account for many years before I rolled it over into an IRA after leaving academe. I don't know enough to tell the difference between the standard recommendations that TIAA advisors were using and the methods my financial advisors apply now. But it seems to be high risk high growth early, then tapering off to more secure investments near the end.
My sense is that the average American is OK with being responsible with their own 401K, or paying a professional to manage it (for a relatively low annual sum). The question of Social Security is a more urgent one. For many years I naively thought that everyone got more or less the same SOC income. How could it be a safety net otherwise? I've more recently learned that homemakers have a laughably low SOC income, suggesting that they are overwhelmingly reliant on a spouse. As someone who quit my job and then got divorced later, this seems pretty messed up. Any spouse who sacrifices for their partner's career thus forfeits financial advantages for a lifetime.
So I would argue that making Social Security actually a safety net and not allowing it to reflect or magnify existing disparities between men and women and the wealthy and working class would be far more urgent than some kind of policy about the 401K.
Love this one. It’s a bit of a trap for sure—but few of us entrepreneurs even had the luxury of a 401K—so I guess a little bit (or a lot) of forced savings isn’t a bad thing. People need to learn new ways to care for themselves. Adapt and grow—or die broke.