A recent argument claims the popular and effective 401k retirement savings vehicle is a scam, a view championed by author and “financial investigator” Pamela Yellen. I disagree (respectfully).
In 2009, Yellen wrote Bank on Yourself. The back cover informs readers that it “reveals secrets to taking back control of your financial future that Wall Street, banks, and credit card companies don’t want you to know.”
Her solution is dividend-paying whole life Insurance. It’s not a new concept, first covered and popularized by Nelson Nash, another financial writer.
This isn’t a criticism of dividend paying whole life insurance because it has benefits, but those benefits do not mean 401k plans are somehow ill-equipped to serve the investing public.
According to data from The American Retirement Association, 80 percent of the 401k balances in are comprised of individuals who earn less than $100,000, and 43 percent of workers with a retirement plan earn between $35,000 and $50,000.
Here’s Yellen’s argument, with my rebuttal for each:
She argues future tax rates are an unknown, and if rates increase participants will pay higher taxes on larger amounts.
The point of a tax deferral is to receive the deduction while working and earning since participants are in higher brackets now than when they retire. Retirement plans typically offer (or include the ability to offer) two tax deferral methods.
One is traditional, with a deduction on the money invested in the plan, which then grows tax-deferred and is taxed upon withdrawal.
The second is a Roth contribution, in which taxes are paid initially and earnings are considered tax-free thereafter. It’s the same as the dividend-paying whole life insurance strategy Yellen recommends as a solution to future tax-rate concerns.
Match in Lieu of Salary
Yellen argues that an employer match is also a “scam” because it affords the employer the opportunity to contribute in lieu of paying additional compensation in salary.
She assumes an employer would give the money to the employee if no match existed. She fails to realize that an employer and employee pay social security and Medicare taxes on each dollar of salary. A 401k match or profit sharing contribution is an expense deduction for the employer and grows tax-free for the employee.
To net $1 of salary, it costs roughly $1.16; approximately 8 percent for social security and Medicare for the employer and approximately 8 percent for the employee (6.2 percent Social Security and 1.45 percent Medicare per the IRS website).
The employer contribution can assist employees with their retirement savings efforts, thus helping to prepare for retirement. If an employee were to receive that money in the form of salary, chances are they might not save it for their retirement. It’s part of the gross compensation and teaches discipline, serving as an important recruiting and retention tool for companies to create additional incentives for employees.
She argues that fees detract from savings and prevent participants from retirement.
It’s misleading and underestimates the value employees receive from a workplace retirement plan. Yes, there are fees in retirement plans: Recordkeeper/third party administrator (TPA), custodian, advisory fees, and investment costs.
Many employers will absorb the recordkeeper/TPA and custodial fees to receive a deduction. It leaves the employees to pay the advisory and investment fees. With regards to the latter, there are more low-cost options now available in retirement plans, and returns are always net of expenses.
According to an American Funds study spanning 10 years through 2012, investment funds posted an annualized return of 7.05 percent. However, the average investor realized a 6.1 percent return. There’s more than the 1 percent difference in value provided by a financial advisor that she somehow claims participants are “losing.”
Lastly, no product or service is free—dividend paying whole life insurance also comes at a cost.
Yellen argues limitations and restrictions on participant access to their money is the equivalent of putting it in “prison.”
It’s both irrational and inaccurate. Many plan documents (per IRS guidelines) allow for early withdrawal for several reasons; if an employee dies, becomes disables, is terminated from service, or if the company’s retirement plan itself terminates.
Additionally, 401k plans, like dividend-paying whole life insurance, provide individuals with the ability to access loans, as long as their plan document permit.
Finally, 401k plans are not savings accounts. They’re meant to be retirement income vehicles, which is the reason for the tax deferred growth and deductions. It focuses on better investment habits and teaches the importance of sacrificing for the future.
Yellen asserts that employees, on average, barely outpace inflation.
However, Dalbar Inc. analyzed the 20-year period ending 12/31/2015, and indicated the S&P 500 Index averaged 9.85 per year, whereas the average equity fund investor earned 5.19 percent annually.
According to www.IUSInflation.org, the latest annual inflation rate (through June of 2017) was 1.6 percent. It means the average equity fund investor outpaced inflation by 3.59 percent. To further combat her claims, the inflation rate at the end of December 2015 was the second lowest in 50 years.
Not Enough Saved
She argues that the 401(k) doesn’t work because most pre-retirees still don’t have enough saved. This conclusion does not consider the success 401k have realized in helping employees save for retirement.
Again, according to The American Retirement Association, the most important factor that determines an individual’s retirement savings behavior is if they have access to a workplace retirement solution. In fact, over 70 percent of workers earning between $35,000 and $50,000 per year decide to participate in their workplace retirement solution.
Conversely, when a workplace solution is not offered to employees, less than 5 percent of Americans will invest in an IRA.
According to a recent Pew study, just over half of the small and midsize businesses surveyed (between five and 250 employees) offered a retirement plan benefit to their employees. The issue, as I see it and as the data suggests, is a lack of access. The 401k plan is not broken and when offered, utilization is extremely high.
In summary, the 401k plan is the retirement savings vehicle for American workers. Dividend-paying whole life insurance is one financial strategy, and I would argue a 401k plan is another. Each option has merit.
Derek Fiorenza is COO and CCO with Summit Group Retirement Planners, Inc. Summit Group Retirement Planners, Inc. specializes on collaborating with employers on the design, installation, and ongoing servicing needs of their retirement programs. For further information, please contact a Summit Group Retirement Planners representative at 267-433-1050 or [email protected].