401(k) plans never meant to be a complete retirement plan. Where does that leave future retirees?
Retirement accounts, specifically 401(k) plans, were never intended to be a substitute for a pension. But, the reality is, most people, if they have a retirement account at all, it’s a 401(k). Last year, the Wall Street Journal ran a piece in which the creators of the 401(k) worry about what they started. The 401(k) was designed to supplement income from Social Security and a pension.
Frank Stafford, a professor of economics at the University of Michigan, joined Stateside ?to talk about 401(k) plans and how we use them.
Listen to the full interview above, or read highlights below.
What happened to the promise of the 401(k)?
"I do think people consider a 401(k) or other forms of it a type of pension. And of course there’s a huge advantage in terms of the taxes. Because you can put in the money, pre-tax dollars and then you pay taxes when you draw. But, another interesting feature, is the interim interest that is generated before you draw on it is also subject to no income tax. So it creates this highly favorable thing if you’re willing to participate over a long period of time."
What are some trending behaviors that may jeopardize retirement savings?
"There’s so much tapping into the pensions prior to retirement. Certainly during the Great Recession there was a lot. So they’re drawing down at a great penalty that they have to rebuild it. The other way that leads to a demise of fund buildup is decline in participation. So there’s fairly heavy penalties for taking money out too early before 59 ½. But if you just say 'I’m not participating because I want that money to buy groceries,' there’s no direct obvious penalty. A lot of people, that’s what we’ve been looking at recently, decide 'Well, I’m just not going to participate.'
"The way you build up your pension with what’s called a 'defined contribution' such as a 401(k), you have to put money into something, the stock market. And our work shows that with each of the more recent recessions, middle and mid-range families who might’ve owned stocks are very leery of it. If they keep in their pension, they’re getting away from stocks. So they say, 'Well, I’m getting away from stocks but fixed interest funds are so bad, so low, so why do I do either?' We see a lot of exit from 401(k)s."
What happens if the markets tank just before your planned retirement if all your money is in a 401(k)?
"There are some restrictions on how the funds are invested. Again, I think there are offerings of aggressive stock funds for your pension. That’s not a good idea, as I see it. It’s also the case that there could be drops. I feel like right now, that the stock market, while the prices are very high, the earnings of these companies are also very high.
"It’s not as extreme as the dot-com bubble that prices were totally unrelated to earnings. I do hope that there isn’t some lurking, systemic factor which was for the Great Recession which was all of the junk mortgages. I do worry that things could come in as a systemic risk, which could jeopardize the value of stocks even though it’s not stocks themselves."
What do you recommend if someone is 55 and the retirement account is at $8,000 or less?
"People do come back into the labor force after retiring but I think they should be careful about exiting too early. Protection too should be looking at other wealth they hold. Have they paid down their mortgages? Regrettably this has become far less common than it was 30 years ago. So the instant-refi (refinance) has led for many of these pre-retired folks, compared to the historic data of 30 years ago having no mortgage or a very small balance, having a substantial balance. I think that one thing, however, that’s positive is that if they do pay off their mortgage, this is a substantial protection. Because they can draw on it, they can get home equity loans."
What is the future of Social Security?
"You have to remember that Social Security is called 'contributory social product program.' It’s one of the few lifetime annuities that’s indexed for inflation. It’s very difficult to buy an annuity and say, 'Well, going into the future as long as I live, to rise at the unknown future inflation rate.' So it’s a very attractive program. I think it’s going to be the sum of three things: somewhat higher tax rates, a lot of encouragement so that there’s more incentives to keep working (particularly if you’re healthy), and then people are going to respond if those structures are OK. "