401(k)s, diminished wealth, and FASB
By: Corey Callaway, ANN publisher
Before I step on my soapbox, I wish to make my disclaimer. If you have a 401(k) or a SIMPLE IRA that you can contribute to where you are employed, please, by all means, participate in that plan by contributing to your maximum capability.
With that said, the 401(k) plan is the worst retirement plan ever created.
Wouldn’t you like to know why?
The 401(k) in my opinion has robbed the working middle class of a tremendous portion of its wealth. I will give you a moment to pick your jaw up off of the floor. . . . .
I will begin with some background to back up my statement. The 401(k) is the code section of the tax law that allows an employee to reduce his or her salary by contributing to a Profit Sharing plan. Pretty much all 401(k)s are Profit Sharing plans with the 401(k) code section written into the plan and trust document.
Prior to 25 years ago, many companies had pension plans. These plans generally did not allow the employee to contribute to the plan. Employers funded all dollars to these plans on behalf of employees. Most of your larger public companies sponsored retirement plans such as these. There were just as many Profit Sharing plans that were managed in the same manner with one singular investment portfolio.
In 1973 the conceptual framework was written and created by FASB financial accounting Standards Board, the generally accepted accounting principles (GAAP). A part of these rules caused the publicly traded corporations to account for any pension liability the company owed to the pension plans. This was referred to as the unfunded pension liability.
Basically, the firm owed money to the pension plan based upon the current employees, their salaries, rates of returns on investment, pensioners due benefits, and the like. This new accounting entry reduced the earnings per share (profitability) reported to the public (investors). And the public perception of the pension liability would slow the growth in the stock share price. This occurred only when there was an unfunded pension liability.
In the event, there was a surplus another event began to occur. Some companies were taken over by other companies and the pension plans were shut down and the surplus was distributed back to the sponsoring employer and those funds were used to pay off the cost of the takeover and any excess was distributed as profits. In other cases, the publicly traded companies were allowed to withdraw surplus funds from the pension plans and were used to pad the earnings per share reported to the public.
There was also a slew of new rules written every year that made pension plans more and more expensive to the companies sponsoring them. This, over time, has given the publicly traded companies a cause to terminate their pension plans and, in trade, offer 401(k) plans to their employees.
The publicly traded firms could reduce their expenses dramatically by offering a cheaper retirement plan, the 401k, and sell the employees on the concept of controlling their investments in their retirement plan accounts as an added benefit.
With that said, over the last twenty-five years, I and other associates have found the following problems and social issues have arisen:
1. The investment and administrative costs per employee have gone up compared to traditional pension plans and that cost has been placed upon the backs of the employees. When you had a pension plan all of the investments were placed in one investment portfolio. The trustees of the plan would hire a bank, insurance company or securities firm to manage that portfolio. If the portfolio manager did not perform, they would be fired and another would be hired. This was a very cost-efficient system compared to a 401(k) where you had separate accounts for each employee with different accounts such as salary reduction, employer contribution, rollovers, and more. Then within those accounts, the employee has multiple investment options. The accounting for this is burdensome and the cost of that service is very high. A traditional pension plan is much more efficient by operating one portfolio and the funds were divvied up once a year on paper only, not by physical investment accounts.
When 401(k)s first became popular, the pension administration firms were scrambling to create or purchase the software to accomplish this feat. Today, many systems are available and very cost-efficient, but the costs still remain much higher than a single portfolio pension plan.
2. Contrary to popular opinion most employees do not want to make their own investment decisions nor do they want to learn about investments. This comes from my voice of experience. I have enrolled retirement plans for 30 years and sat across the table from the employees and had the opportunity to ask, “Which funds do you want your money invested in?” 85 to 95 percent of the time my question was met with a blank stare. More often than not, I have chosen their investments for them. Thus all of this grand effort is created to appease the 5 to 15 percent who want to control their investments and this is an expensive escape from the pension plan. Last, many employees are managing their 401k accounts with little or no help and are earning rates of return that are lower than the comparable indexes. There are many studies that prove the employee’s rates of returns are below average.
3. The next problem I have found is that participants have multiple 401k accounts strewn from one employer to the next employer and again to the next employer. More often than not the employee never bothers to roll the old 401k plan assets to the next employer’s 401k plan or roll the 401k over to an IRA. The participant loses track of the 401k accounts and does not manage the investments for themselves, thus causing poor investment performance for lack of attention. I have helped people with as many as five different 401k accounts by combining them into one IRA rollover account. Their neglect is costing them a small fortune.
4. The general lack of attention to these funds detailed in No. 2 and No. 3 above has caused the employees to underperform the market at a dramatic pace. In the last 25 years, in contrast, managed pension plan rates of return have been consistently higher than 401(k)s.
5. Last but not least, participants upon termination have access to the fund in their retirement plans. Most terminated participants spend their retirement funds rather than roll the funds over to an IRA. My solution, and there will be many that will scream in protest, is to not allow the participants to spend the money. This way the funds will be used for retirement and not blown on some shopping spree. If this was to be mandated, most everyone will have something to retire on. As it stands now, I truly believe that a tremendous segment of our population will never be able to retire and will be relegated to live in poverty.
Wrap it all up and the 401(k) plan is entirely too expensive, participant investment choices and lack of investment knowledge and experience set the investment accounts for failure, the portability, and access to the funds prevent the participant from accumulating enough wealth to retire on, and they will always find an excuse or emergency to spend it. Last, the 401k promotes a lack of financial discipline.
In the end, the 401k creates a greater social problem with a large number of retirees and future retirees unable to retire, having failed to amass enough wealth.
My solution is this: do not allow access to the funds until age 65. Do not allow loans. Pool all investment portfolios. And write, or reverse, past legislation to give business the incentive to establish Defined Benefit retirement plans. This is a situation where going back 30 years in history to where we used to be would be an outstanding thing to do.
Corey N. Callaway
Investment Advisor Representative