Let's say you are 65 years old. Which sounds like more money?
- $455,140 now, or
- $3,000 per month for life.
It wasn't too long ago (if one generation counts as "not too long ago") when pensions were considered the default retirement plan for most Americans. Work for a good company, get your gold pen at retirement (if you're retired, what do you need a fancy pen for?), and sit back while the pension money rolls in. This is where the phrase "seniors on a fixed income" originated. Between Social Security and pension income, their income was not expected to increase much over time. Conversely, inflation during the 70s and early 80s far outpaced any increase that they could expect in retirement income. Sadly, standards of living were ravaged.
In the 1980s, an obscure piece of tax code, section 401(k), ushered in the largest and most popular retirement plan for an entire generation of Americans, and perhaps more to come.
Of course, the companies loved it. It is cheaper to administer than pensions, with all the pension rules and filings. Employer contribution to the plan is much lower, and in some cases, zero. The burden of investment management, and providing a reasonable retirement has been shifted from the employer to the employee.
Sounds like a great deal for the employer and a lousy one for the employee. Yet, employees, by and large, love 401(k) plans. It is one of the first things, after health insurance, that most employers mention as one of their benefits. Especially if there is a matching component. Employees like the control of the investment dollars. Of course, they generally don't enjoy having to make the investment decisions. They like the portability, especially after the employer contributions have vested.
But here is what I believe to be the biggest reason employees love their 401(k). They FEEL wealthier. Which sounds bigger, a guaranteed income stream or the lump sum necessary to generate that income stream? Here, let me give you some numbers.
These are not specifically pension numbers. They are estimates taken from immediate annuity quotes found online. For a 65 year old male to receive an income of $3,000 for life, a lump sum of $455,140 is required. This is for a single life, no survivor or period certain guarantees.
So, back to the original question. Which sounds like more money for a 65 year old?
- $455,140 now or
- $3,000 per month for life.
We already know that they are essentially the same.
If handled properly, the control can be a tremendous benefit. Employees have an opportunity to balance their portfolio across their entire net worth, rather than their employer retirement money being carved out in its own silo. The ability to name beneficiaries can serve as a key estate planning tool. The tax deferral is probably the biggest benefit, although not unique to 401(k)s.
The downside of course is the potential for employees to mismanage their investments. This is especially the case when too much of the account is allocated to their employer stock. And frankly, any amount is too much. The worst plans are the ones that only match in employer stock, or provide higher matching if it is in employer stock than other investment options. Can anyone say Enron?
The next worst plans are the ones that restrict investment options to a limited basket of high cost mutual funds or, even worse, variable annuity options. Most commonly, the plans that come at a high cost are a result of a cheap employer using a commission based investment house who will do the 401(k) without any administrative costs to the employer. Of course, the reason they can do that is that all of the admin costs are passed on to the employees in the form of high cost investment options.
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