Most Young People Should Not Save For Retirement in Their 401k

No joke, a recent study by exceptional economists confirmed[1], in part, that “… most young people should not save for retirement …” and that automatic features are financially injurious for younger workers because “… the welfare costs of automatically enrolling younger workers in defined contribution plans—if they are passive savers who do not opt-out immediately—can be substantial, even with employer matching ….”

I am proud to say I agree—even though I am a proponent of hyper-aggressive, perennially-applied, automatic features for all 401k eligible workers who are not saving or saving less than the plan’s target amount—regardless of age, wage, service, or sex. How’s that?

Don’t save for retirement in your 401k

While the math will always be way over my head, I agree with the study’s takeaways and findings:

• “…Low-income workers, who receive high Social Security replacement rates, should not save much for retirement at any age.”[2]

• A standard life cycle model also implies that low real interest rates make a front-loaded spending profile optimal, which reduces the benefit of saving at younger ages. …”
• “… With time and mortality discounting pushing consumption earlier, and interest rates doing little to favor late-life consumption, the life-cycle model implies a declining path for consumption. …
• Even if time and mortality discounting are offset by asset returns, … individuals with an increasing wage profile of earnings should not save when they are young because their income at younger ages is below their lifetime average. …”
• “… In the life cycle model, it is suboptimal for young people – regardless of whether they face the typical flat wage profile of low-income workers or the typical steep wage profile of high-income workers – to save for retirement even with tax preferences and standard employer matching. …” [3]

So, how can I reconcile support for automatic features with the above? Simple, don’t limit your 401k solely to retirement preparation.

Over 25 years ago, we changed the marketing of our 401k plan and removed every mention of “retirement” from the marketing materials. Younger workers were not interested—even those who had heard of Franco Modigliani.[4] Older workers knew the plan’s purpose. Instead, we changed the marketing to “Drive to your Dreams, Whatever You May Be Dreaming About”![5]

Soon thereafter, I changed the focus of my 401k presentation to new hires so that, on their very first day on the job, regardless of age or wage, I asked them, “Will You Be A 401k Middle-Class Millionaire … Someday?” We stopped talking about retirement.

The study authors confirmed that: “Without the ability to borrow against future earnings to fund consumption, these younger workers are constrained to spend no more than their earnings. Thus, sacrificing consumption during these early years causes a large decline in utility.”[6]

Before adding automatic features in 2007, to facilitate borrowing (and, just as importantly, repayment), we updated the plan’s loan processing to provide “liquidity without leakage, along the way to and throughout retirement.” We confirmed that plan loans are not “leakage” unless they are not repaid. And our plan’s experience and other studies show that most plan loans are repaid.[7]

In that way, we ensured that 401k participants could address their current financial priorities while preparing for retirement and building household wealth.  

Public policy ‘mistakes’

The study authors also asserted that from a public policy perspective:

“… For a typical low-wage worker with a flat wage profile, the welfare cost of being auto-enrolled in a state auto-IRA plan with no employer match can be as high as 27 percent of wages. …”

“… policies that successfully boost 401(k) participation rates and discourage leakages uniformly at all ages may make young and middle-aged people worse off. …”

For comparison, given the opt-out rates and leakage from state-mandated IRAs, it appears Oregon, California, Illinois (and others, especially Maryland [8]) have decided in favor of the Roth IRA for “non-retirement” saving.

‘Done Right,’ a 401k can be consistent with Modigliani’s Life Cycle Model

401k plans can be very effective tools for smoothing consumption over a lifetime – increasing total rewards from employment and enabling spending in excess of that otherwise possible from wages alone. For example, a plan loan allows a participant to borrow deferred federal and state income tax withholding.

The study authors also assert:

“… In the presence of a 50 percent or better match and a 10 percent withdrawal penalty, using a 401(k) as a rainy-day fund or for another savings goal may be optimal.” and

“… Viewed from (the) perspective (of) … the life cycle model … leakages from 401(k) balances for young workers might be interpreted as correcting a mistake rather than a major problem in need of further government policy. …[9]

They argue that there are better, more direct ways to encourage “non-retirement” savings among young people to meet immediate financial needs. I doubt there is anything better. I agree that a 401k with a match is one part of an optimal solution. However, pre-retirement withdrawals that are subject to income and penalty taxes are not – they are a suboptimal form of liquidity.   

Here’s my simplistic illustration of the impact of 21st Century plan loan processing on liquidity (changing to electronic banking, a line-of-credit structure, and adding behavioral economics tools, concepts, and processes). This example is focused on emergencies,[10] confirming that they can enable the elimination of pre-retirement hardship withdrawals. But, of course, plan loans should not be limited to emergencies.[11]

We might call a 401k plan that utilizes 21st Century loan functionality the “Bank of Modigliani”:

• Contribute, save
• Get match
• Invest
• Accumulate
• Borrow to meet current need
• Resume target investment allocation[12]
• Repay loan while continuing to contribute
• Rebuild the account to a larger balance
• Repeat as necessary up to and throughout retirement

I have not found any practical or policy alternative that is better than the 401k, “done right,” for building “non-retirement” savings to enable increased pre-retirement consumption while concurrently improving household wealth and preparation for retirement.

If you know of one, please let me know – jacktowarnicky@gmail.com

Author’s note: What is 401k, “done right”?

To accomplish all three goals, (1) Building “non-retirement” savings for increased pre-retirement consumption, (2) Improving household wealth, AND (3) Preparing for retirement, a 401k plan design must anticipate the diversity of the participant population. For building “non-retirement” savings, note that many live paycheck to paycheck,[13] many are in debt[14], and many are not creditworthy. Plan liquidity must provide a lifeline to both avoid and reduce high-cost debt – payday loans, credit card cash advances, etc.[15] To build household wealth, plan designs must also minimize leakage – removing hardship withdrawals, minimizing leakage at/after separation by embracing asset retention and accommodating rollovers (at hire, while employed and post-separation) including defaulted plan loans. To prepare for retirement, the plan should define eligibility soon after hire, prompt participation when first eligible,[16] prompt contribution rates that qualify for the maximum employer financial support (too many fail to contribute enough).[17] and anticipate a lack of financial and investment literacy. I also favor a graded vesting schedule with some immediate vesting coupled with annual or more frequent confirmation of yet-to-be-vested assets because workers continue to change jobs frequently.[18]

And while every employer doesn’t offer a 401k, there exists a more than adequate (except for the highest paid), tax-favored retirement savings plan that has been available to all wage-earning Americans since 1982, for the past 41 years – the Individual Retirement Account (IRA).[19] In 2001, over 20 years ago, new legislation added Deemed IRAs and liberalized IRA rollover rules, which, once added to your 401k plan, can allow workers of all ages and all wages, to continue contributing even after they have separated – directly, or via a contribution to an IRA followed by a rollover.[20] And, with the Pension Protection Act of 2006[21], over 15 years ago is now clear that automatic features have had a substantial impact on asset accumulations among low wage, short service, younger workers – regardless of sex.[22]

So, if your 401k plan is solely focused on retirement, perhaps those younger, lower-paid workers who do not enroll or who opt out would also agree with the study’s findings. 

Superior outcomes are possible for younger, lower wage workers through plans that perennially apply automatic features and incorporate liquidity without leakage – effectively redesigning a 401k into a Lifetime Financial Wellness Instrument.[23]

Disclaimer No. 1: My comments are my own based on my past experiences in plan sponsor roles and do not necessarily reflect those of any employer or association I have been employed by or affiliated with, past, present, or future.

Disclaimer No. 2:  Information was provided by individuals with knowledge and experience in the industry and not as legal or tax advice. The issues presented here may have legal implications and you should discuss this matter with legal counsel prior to choosing a course of action. This article is intended to be informational only. It is not (and you/others should not use it as a substitute for legal, accounting, actuarial, or other professional advice. Any advice contained in this article was not intended or written to be used and cannot be used by anyone for the purpose of avoiding any Internal Revenue Code penalties that may be imposed on such person [or to promote, market or recommend any transaction or subject addressed herein]. You (others) should seek advice based on your (their) particular circumstances from an independent tax advisor.

---

[1] J. S. Scott, J. B. Shoven, S. N. Slavov, J. G. Watson, The Life-Cycle Model Implies That Most Young People Should Not Save for Retirement, 8/29/22, Accessed 9/27/22 at: https://www.aei.org/research-products/journal-publication/the-life-cycle-model-implies-that-most-young-people-should-not-save-for-retirement/ See also:  S. N. Slavov, Second Thoughts on Automatic-Enrollment Retirement Plans, 9/1/22, Accessed 9/27/22 at: https://www.aei.org/op-eds/second-thoughts-on-automatic-enrollment-retirement-plans/  See also: R. Powell, Many young people shouldn’t save for retirement, says research based on a Nobel Prize-winning theory, 10/1/22, Accessed 10/2/22 at: https://www.marketwatch.com/story/many-young-people-shouldnt-save-for-retirement-says-research-based-on-a-nobel-prize-winning-theory-11664562570?reflink=mw_share_twitter

[2] A. Biggs, Statement before the Committee on Ways and Means United States House of Representatives The Real Retirement Crisis: It’s Not Where You Think, 2/6/19. “…  For middle-income workers, Social Security replaces between 54 and 60 percent of inflation-adjusted career average earnings. These workers need to save modestly on top of Social Security … For a low-income individual in the bottom fifth of the earnings distribution, Social Security replaces between 83 and 96 percent career-average earnings. Even assuming that low earners require a higher replacement rate, these figures explain that it is rational for many low earners not to save for retirement above what Social Security provides. This does not mean low earners are perfectly provided for by Social Security. Due to quirks in Social Security’s benefit formula, some low earners receive very high replacement rates while others receive lower ones. …” Accessed 10/2/22 at: https://www.congress.gov/116/meeting/house/108921/witnesses/HHRG-116-WM00-Wstate-BiggsA-20190206.pdf

[3] J. S. Scott, J. B. Shoven, S. N. Slavov, J. G. Watson, Note 1, supra.

[4] J. Towarnicky, Another Nobel Laureate in Economics Who Was Focused on 401(k) Plans – Part 2 of 3, 12/4/17. “… A famous twist (famous only for benefit weenies like me) was that almost 25 years ago, Professor Modigliani patented a method for issuing 401(k) credit cards with the aim of increasing liquidity from 401(k) plans (https://www.google.com/patents/US5206803 ). He believed workers should be able to utilize retirement savings without triggering leakage – confirming the dual-purpose nature of 401(k) plans that can be used to meet current consumption needs, and when loans are repaid, can rebuild the account for future needs. Monies would be available up to and throughout retirement.” Accessed 9/28/22 at: https://www.psca.org/news/blog/another-nobel-laureate-economics-who-was-focused-401k-plans-part-2-3

[5] J. Towarnicky, Practical Dreaming: What Are Your 401(k) Participants Dreaming About? Benefits Quarterly, 4th Quarter 2021

[6]  J. S. Scott, J. B. Shoven, S. N. Slavov, J. G. Watson, Note 1, supra.

[7] Lu, Timothy (Jun) and Mitchell, Olivia S. and Utkus, Stephen P. and Young, Jean A., Borrowing from the Future: 401(K) Plan Loans and Loan Defaults (April 2015). NBER Working Paper No. w21102, Accessed 9/28/22 at: https://ssrn.com/abstract=2596431

[8] J. Towarnicky, Maryland’s State-Run IRA Is Different, Better, and Still Less Than Optimal. At this point, ALL Maryland workers would be better served by saving in a superior (IRA) alternative. 401kSpecialist.com, 9/16/22, Accessed 9/28/22 at: https://401kspecialistmag.com/marylands-state-run-ira-is-different-better-and-still-less-than-optimal/

[9] J. S. Scott, J. B. Shoven, S. N. Slavov, J. G. Watson, Note 1, supra.

[10] J. Towarnicky, Adding a Sidecar Savings Account for Emergency Savings? Better Solutions May Exist, Benefits Quarterly, 2^nd Quarter 2022

[11] G. Li, P. Smith, Borrowing From Yourself: 401(k) Loans and Household Balance Sheets, Federal Reserve Board, 8/12/08. Accessed 10/4/22 at: https://www.federalreserve.gov/pubs/feds/2008/200842/200842pap.pdf

[12] Author’s note: In almost all 401k plans, plan loan principal never leaves the plan. It becomes a fixed income investment in the participant, because the participant pays interest that is recredited to their own account. So, participants should re-evaluate their asset allocation after taking a loan to account for the fixed income investment of plan loan principal. And, keep in mind, that where the loan interest rate is BOTH less than the rate an individual would pay on a loan from a commercial source (payday loan, credit card advance, etc.) AND more than the rate credited on fixed income investments in the plan, as has been the situation for most of the past 14 years, a plan loan will facilitate current consumption while increasing BOTH retirement preparation AND household wealth.

[13] American Payroll Administration, Getting Paid in America Survey Reveals Employees Want Early Access to Wages, 2022, 9/26/22. “The “Getting Paid In America Survey” also found that 72% of Americans are living paycheck to paycheck.” Accessed 9/28/22 at: https://www.prnewswire.com/news-releases/survey-reveals-employees-want-early-access-to-wages-301633581.html  Author’s Note: These data are consistent with prior surveys that show a super majority (more than two-thirds) of surveyed workers, each year, admit that they would have some or significant difficulty meeting their financial commitments if their next paycheck was delayed one week, … DELAYED, and DELAYED ONLY ONE WEEK. See also: W. De La Rosa, S. Tully, The Impact of Payment Frequency on Consumer Spending and Subjective Wealth Perceptions, Journal of Consumer Research, April 2022. “An analysis of income and expenditure data … demonstrates a naturally occurring relationship between higher payment frequencies and increased spending. … higher (vs. lower) payment frequencies increase spending. The effect of payment frequency on spending is driven by changes in consumers’ subjective wealth perceptions. … The effects of payment frequency on subjective wealth and spending can occur even when objective wealth favors those with lower payment frequencies….” Accessed 9/28/22 at: https://doi.org/10.1093/jcr/ucab052

[14] New York Federal Reserve Bank, Total Household Debt Surpasses $16 trillion in Q2 2022; Mortgage, Auto Loan, and Credit Card Balances Increase. Total non-housing balances see largest nominal increase since 2016. 8/2/22, Accessed 10/3/22 at: https://www.newyorkfed.org/newsevents/news/research/2022/20220802

[15] G. Li, P. Smith, Note xi, supra.

[16] Author’s note: In my last plan sponsor role, I joined that employer on 11/5/85, but I did not become eligible to participate in my employer’s 401k plan until 1/1/89, more than three years later.  See also: J. Towarnicky, Narrowing Retirement Savings Gaps, 5/15/19. , Accessed 2/26/19 at: https://www.gao.gov/assets/690/680568.pdfAccessed 9/27/22 at: https://www.psca.org/news/blog/narrowing-retirement-savings-gaps  A 2016 GAO study “… estimated the impact on eligibility and vesting provisions on workers’ retirement savings. With respect to the minimum age 21 requirement, they estimated the “lost” savings for two example workers (one with medium earnings and average wage growth, the other with lower earnings and less wage growth) as a decline in lifetime retirement savings of 5 percent and 11.5 percent … GAO also estimated the impact of repeatedly applying the one year minimum service requirement for a worker with 11 different employers during a working career – estimating a “lost” savings of $111,454 or 24.0 percent of lifetime retirement savings. … Finally, the GAO study and projections also suggested that vesting policies significantly reduce lifetime retirement savings. They constructed an example where the worker leaves two jobs after two years, at ages 20 and 40, where the plan requires three years for full vesting – estimating that the forfeited employer contributions could be worth $81,743 at retirement (or $22,143 in 2016 dollars)….” GAO, 401(K) PLANS, Effects of Eligibility and Vesting Policies on Workers’ Retirement Savings, GAO 17-69, October 2016, Accessed 2/26/19 at: https://www.gao.gov/assets/690/680568.pdf

[17] Vanguard, How America Saves, 2022. “… In 2021, two-thirds of participants received the full employer matching contribution (Figure 12). Participants in automatic enrollment designs were slightly less likely to receive the full employer match than were participants subjected to voluntary enrollment. However, after three years of automatic annual increases, participants in automatic enrollment designs are more likely to be saving above the full employer match, and more than three-quarters of all participants will be receiving the full employer match, with 6 in 10 contributing at levels above the employer match. …”  Accessed 9/27/22 at: https://institutional.vanguard.com/content/dam/inst/vanguard-has/insights-pdfs/22_TL_HAS_FullReport_2022.pdf

[18] Author’s note: Median tenure of American workers ages 25-64, has consistently been less than five years for the past five decades. Further, measures of median tenure likely understate turnover — because the churn is highest among younger, short-service workers. Data show workers have an average of 12 employers by age 52 – and most of that turnover occurred prior to age 35.  See: Bureau of Labor Statistics, “Employee Tenure in 2022” 9/22/22, Accessed 9/27/22 at: https://www.bls.gov/news.release/pdf/tenure.pdf See also:  See also: J. Clark, J. Young, Automatic enrollment: The power of the default, Vanguard, February 2021, “…  Among new hires, employee turnover was quite high.  Over our sample period (1/1/17 – 12/31/19), 4 in 10 eligible employees left the sample because of job change. …”  In plans with voluntary enrollment, turnover rates were 56% after three years.  In plans with automatic enrollment, turnover rates were 52% after three years.  Accessed 9/27/22 at:   https://institutional.vanguard.com/VGApp/iip/site/institutional/researchcommentary/article/InvComPowerAutoEnrollment  See also: Craig Copeland, “Employee Tenure Trends, 1983–2018,” Employee Benefit Research Institute, Accessed 9/27/22 at: www.ebri.org/docs/default-source/ebri-issue-brief/ebri_ib_474_tenure-28feb19.pdf?sfvrsn=70053f2f_13  See also:  H. Hyatt, J. Spietzer, “The Shifting Job Tenure Distribution,” February 2016, Accessed 9/27/22 at: http://ftp.iza.org/dp9776.pdf See also: Bureau of Labor Statistics, “Number of Jobs, Labor Market Experience and Earnings Growth from a National Longitudinal Survey,”  8/31/21, Accessed 9/27/22 at: www.bls.gov/news.release/pdf/nlsoy.pdf

[19] J. Towarnicky, Retirement Savings Crisis: Access Isn’t the Issue, Prioritization is. 2/26/21, Accessed 9/27/22 at: https://401kspecialistmag.com/retirement-savings-crisis-access-isnt-the-issue-prioritization-is/ See also: J. Towarnicky, Retirement Plan Access is An Issue, Coverage is Not, 12/6/21, Accessed 9/27/22 at: https://401kspecialistmag.com/retirement-plan-access-is-an-issue-coverage-is-not/

[20] The Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. 107-16, Signed by President G. W. Bush, 67/7/01.

[21] Pension Protection Act of 2006, Pub. L. 109–280, Signed by President G. W. Bush, 8/17/06.

[22] Vanguard, note 17, supra: See Figure 30. To summarize, (1) Wage:  Participation for those earning less than $50,000 is 50+% higher in plans with automatic features than in plans with voluntary enrollment, (2) Age:  Participation among workers under age 45 is 50+% higher in plans with automatic features, (3) Sex: Both male and female participation rates increase significantly once automatic features apply (93% versus ~66%), (4) Tenure:  Participation is 50% higher among workers with less than 7 years of service.  Plans with automatic features have a slightly higher average contribution (employer and employee combined) (11.5% versus 10.6%). However, the averages change dramatically if you include eligible, non-participants. Eligible employees hired under an automatic enrollment feature had an average total contribution rate of 10.9% which is nearly 50% higher than the rate of 7.3% for those hired under a voluntary enrollment structure! 

[23] J. Towarnicky, My Financial Wellness Solution, The 401k As a Lifetime Financial Instrument, May 2017, Accessed 9/27/2022 at: https://www.soa.org/globalassets/assets/files/resources/essays-monographs/financial-wellness/2017-financial-wellness-essay-towarnicky.pdf