The Brutal Truth About The Almighty 401(k)
While the 401(K) Can Be Better Than Nothing, It’s Not a Financial Panacea
“Today, people have to be self-reliant if they want a secure retirement income.” -Scott Cook
The 401(k) has been with us now for 40 years. We’ve had some time to look at the results of this bellwether retirement vehicle and the results are in: it doesn’t seem to work very well.
As an unlikely successor to the pension plan, the 401(k) has grown in popularity over the last 40 years. It has become the standard for employee retirement plans but it’s now clear that there’s something rotten in Denmark.
The Good Ol’ Pension
“I’m retired — goodbye tension, hello pension!” — Unknown
In the old days, we had pensions. Pensions would almost guarantee you a retirement income- paid for by future revenues and investments from the company you worked for.
You would work your whole life for a company and they would take care of you in retirement.
Nowadays, people don’t work for a single company their whole life and companies don’t take care of anyone until they’re dead. Even in Japan, the poster child for this type of symbiotic relationship, things are changing.
Now pensions are disappearing and for good reason: they are too expensive. Pensions have added massive legacy costs to company balance sheets.
Government pensions are showing signs of trouble as well. Many are underfunded- even during good economic times. During recessions they can experience severe funding problems and require taxpayer bailouts.
Use Only as Directed
”I believe that the root cause of every financial crisis, the root cause, is flawed government policies.” -Henry Paulson
40 years ago, we got the 401(k). It was intended to be used as a supplement to pensions by allowing employees to put their bonuses into something similar to a pension plan. In this way, they could delay paying taxes on their bonus money until they withdrew it later.
Then the unthinkable happened: pensions started disappearing.
Now there are hardly any pensions, but nobody really touched the 401(k). It’s still there. The problem is, it’s not being used as intended.
Instead of being a supplement to a pension, it is now the de facto standard in retirement planning for most employees.
Many employees have been force-fed information by the financial industry’s sales and marketing machine. For many people, the 401(k) is all they know and all they have ever known, about saving for retirement.
Companies won by killing their pensions and shifting the responsibility and costs of retirement onto their employees by using the 401(k) instead.
They benefit even more if there is a company match and employees don’t enroll in the plan. The company gets to pocket the money they would have paid the employee.
The financial industry won by railroading people into these plans.
Using highly effective sales pitches, they turned the 401(k) into the end all be all of retirement, in the minds of employees.
These employees (who more often than not, know very little about money) aren't aware of, and are not presented with many options outside of that.
The financial industry then crafted a fee structure that ensured a lucrative, decades-long wealth transfer, from the pockets of employees into the bank accounts of Wall Street’s biggest firms.
In fact, 401(k)’s have much higher fees than pensions ever did.
The shift away from pensions coincided with the cuts in Social Security that saw the retirement age rise and wages fall behind real productivity.
It was a perfect storm. Employees lost.
The 401(K) Doesn’t Appear to Work Very Well
”You can be young without money but you can’t be old without it.” -Tennessee Williams
1 in 3 Americans won’t have enough to retire.
Many people don’t even have a 401(k) and not because they are using some other retirement plan, they just actually have…nothing.
If you’re in a low-income bracket, you probably don’t have enough to put into a 401(k) even if you wanted to. You need that money to live on.
In fact, half of all working age families have no money in retirement accounts at all. The average is around $5,000.
For people between the ages of 56–61, the average is a whopping $17,000. Even at the top 10% of income earners, there is only an average of $274,000 in a retirement account, which won’t get you very far, for very long.
A large swath of the working class in America has been completely left out of a retirement plan. It is a retirement system that has magnified inequality, but at the same time, is not even doing a very good job for those in the upper 50%.
Let’s see why.
Some of the Ways a 401(K) Can Rob You of Your Hard Earned Retirement
”When you steal from somebody, you are saying to them, ‘I don’t respect how hard you worked for your money.’ When somebody steals from you, that’s what they’re saying.” -Charles Barkley
Your 401k Is Invested in the Markets, and Markets Are Volatile
The stock market goes up and down. We know that. In fact when it’s down it often creates some nice buying opportunities.
However, what if it’s down when you need to withdraw your money for retirement? You may not have hit your retirement goals yet!
With the age of the Internet and the rise of trading algorithms, markets have become more volatile than ever.
Computers now perform 75%+ of all trading on Wall Street. Stocks and indexes can crash at speeds we’ve never seen before, due to rapid selling and heavy shorting of stock, by computer algorithms.
Exchanges even have “circuit breakers” now, which halt trading when a stock goes down “too fast”. The financial shocks have become faster and more painful than ever before.
Financial advisors will tell you the markets have “averaged” 7–8% a year. But in recent years, due to massive draw downs and lackluster returns, it is becoming clear that this may not always be the case.
When your account drops 50+% you need make 100% returns just to get back to breakeven.
Your entire retirement plan could be hinged on the market doing exactly what you want, but markets don’t work that way and nobody has a crystal ball.
Unlike Real Estate, Stocks, and even the car you drive, you can’t buy insurance for your 401(k).
Fees Can Drain Your Portfolio like a Vampire
“Performance comes, performance goes. Fees never falter.” –Warren Buffett
Just like with mutual funds, most 401(k) plans and the mutual funds they are invested in, come with a lot of fees, and those fees- like interest- compound over time.
2% in fees, compounded over the life of your 401(k) plan, can add up to a large sum of money (which is why the financial industry loves the 401(k)).
In some cases, the fees might eat up ⅔’s of your gains! 401(k)’s can be extremely expensive and that’s adding to the inefficiency of the entire retirement system.
The question Jack Bogle (the founder of Vanguard) asks is:
“Do you really want to invest in a system where you put up 100 percent of the capital, you take 100 percent of the risk, and you get 30 percent of the return?”
In what world would anyone consider that to be a “good investment”? Yet we do it all the time.
The 401(K) Doesn’t Cash Flow
”I’m a cash flow guy. If it doesn’t make me money today, forget about it.” -Robert Kiyosaki
401(k)’s don’t generate cash flow you can use today and cash flow is king.
A 401(k) doesn’t cash flow while you’re putting money in it, so it’s not helping you increase your income today. And it doesn’t really cash flow when you retire, so you have to drain it over time by slowly (or in some cases, quickly) killing the asset.
Sure you can try and follow the 4% rule for yearly withdrawals, but life often doesn’t play by those rules. Plus, as we have seen, most people don’t have enough in their 401(k) accounts to stick to the 4% rule anyway.
401(k)’s aren’t really “investment” accounts; they are more like glorified savings accounts.
There are many other cash flow investments that will pay a monthly income today and into the future, will adjust for inflation, and that income stream can even be passed on to next of kin.
410(k)’s don’t do any of that that very well.
Opportunity Cost Is an Inconvenient Truth
”Everything has an opportunity cost, and the big things we want in life — like happiness and healthy relationships and wealth — they all have big opportunity costs.” -Mark Manson
You might be tying up money in your 401(k) that you could invest into good (or great) opportunities today.
A 7% average annual return in your 401(k) (if you actually get it) seems great for some people, but to others, this is a very low return and they would be passing up other, more lucrative opportunities.
By putting money into a 401(k), you are paying all those high fees. You’re also being locked into a very limited set of investments. In the process, you could be excluding other, potentially more lucrative investments. This could cost you a lot of money down the road.
401(K)’s Are Not Liquid
”If you don’t have ample liquidity, and it’s not durable, in times of stress, as you’re looking for liquidity, you’re forced to sell assets at declining prices, which then eats into your capital position, so it becomes this very, very negative cycle. There’s no question that liquidity is sacrosanct.” -Ruth Porat
It’s not easy to get your money out of a 401K and if you do, there are either interest payments or taxes and penalties to pay.
It’s your money, but you’re not in control of it.
Taxes Might Be Higher in the Future
”In this world nothing can be said to be certain, except death and taxes.” -Benjamin Franklin
401K’s might be tax deferred, but they get taxed when you take the money out at retirement.
The problem is, taxes might be higher in the future.
With our tax and spend government, which would you bet on? Higher or lower?
Sure you have grown it tax deferred, but you will get whacked with higher taxes, especially if you don’t want to live like a pauper and are in a higher tax bracket.
In this way, 401(k)’s are less like a tax advantaged investment, and more like a tax deferred savings account.
In the end, the government will want its pound of flesh. If you want to enjoy your retirement and spend your hard earned money, they will want a larger piece.
You Don’t Make the Rules
”The economy is not immutable; it’s not about natural laws. It’s about rules, and we make the rules.” -Gavin Newsom
One of the most important rules of investing is maintaining as much “control of the asset” as possible.
Since you don’t control the asset, you don’t have much say in how it works. The government could decide to change the rules on you down the road and there is nothing you can do about it. The fee structure can change; investment options and contribution limits can also change.
For a seasoned investor who understands the importance of control, it’s a nightmare.
You Need to Get Your House in Order First
”Getting your house in order and reducing the confusion gives you more control over your life. Personal organization some how releases or frees you to operate more effectively.” -Larry King
OK, so this technically isn’t a “problem” with the 401(k), but it can be exacerbated by it.
If your financial situation is in shambles you’ll want to get your house in order before contributing to your 401(k). Without enough cash flow you could be building a house of cards.
It’s important to remember that 401(k)’s don’t increase cash flow; they actually reduce it! When you start diverting money into your 401(k), yes you are saving for retirement but your paychecks will actually get smaller.
Also, if you have a lot of debt, a 401(k) can’t beat the interest on the debt. A 7% (if you actually get it) return in a 401(k), won’t beat an 18% interest rate on a credit card bill.
In fact, it will make it harder to pay off your debts, due to you having less total cash flow every month.
Stewardship is Essential
”Finance is not merely about making money. It’s about achieving our deep goals and protecting the fruits of our labor. It’s about stewardship and, therefore, about achieving the good society.” -Robert J. Shiller
To really manage your money properly you need to be 100% responsible for it.
Some people have a mentality of “I will just hand my money over to the experts and everything will be OK.” If things don’t go as planned, they are quick to blame those same “experts”.
Taking complete responsibility and having your “why” guide your decisions, is key for building wealth.
Also, it’s important to note that 90+% of professionally managed Mutual Funds can’t consistently beat the S&P500 index, which is an unmanaged basket of stocks. Makes you wonder where all the “experts” are?
Warren Buffett, arguably one of the best investors of modern times, bet $1 Million dollars that by just stashing his money in an index fund, he could make more money than investing it in a hedge fund.
He won the bet, big time.
“Making money on the stock market “does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals.” –Warren Buffett
Tempting Loans Can Be a Deal with the Devil
”Rather go to bed without dinner than to rise in debt.” -Benjamin Franklin
Many employees find it tempting to borrow out of their 401(k). After all “its my money, and the interest goes right back to me!”
How cool is that?!
But many people saddle themselves with 401(k) loans they have a hard time paying back. The payments can be very high and negatively impact your cash flow in a big way.
Increasing positive monthly cash flow is what makes the biggest impact on your financial situation.
If you can’t pay the loan back, the IRS might consider it “income” and you can end up paying income taxes plus a 10% penalty on the money you couldn’t pay back.
Its usually best to source the funds from somewhere else besides your 401(k) to avoid this situation.
Cutting back on your spending and overhead is probably the best way to free up cash in the near term, instead of borrowing out of your 401(k) and saddling yourself with debt.
The Employer “Match”, Isn’t Really
“There’s no such thing as a free lunch.” -unknown
One of the ways company’s like to sell the 401(k) is with the employer match. If your company offers it, whatever you put in, your employer will match a certain percentage. Sounds like free money, right?
If it weren’t for your 401(k), your employer would be paying you that as salary.
Your paycheck would be fatter.
To get the money, you need to give up a percentage of your paycheck and divert it into a glorified savings account where you have no control over your own money.
So yes, it is your money, but you are not in control of it.
But what if you don’t contribute the maximum of what your employer matches into the 401(k)? or what if you don’t opt into the plan at all? — Then you lose money.
The employer then, doesn’t have to pay you that money as salary, or as a match, so you effectively just lose the money.
If an employee leaves a company before the match is “vested” in the 401(k), the employee again, loses the money.
According to the Center for Retirement Research, employees at companies that offered a 401(k) match had lower salaries than those companies that didn’t offer a match. The dip in salary was equal to the employer’s potential contribution.
So this policy pushes employees into a plan with high fees, no control and often, lower performing investment choices.
For those employees that don’t opt in, or that cant afford to opt into the plan, they basically get a further cut in salary.
Financial Education is Key
”An investment in knowledge pays the best interest.” -Benjamin Franklin
The 401(k) has a lot of problems, but for many people, it’s all they know. In this regard, it’s not entirely a bad thing.
If you lack financial education, then you would be prone to making mistakes, or worse- not taking any action towards improving your financial future.
The 401(k), as flawed as it is, at least allows people to do something towards securing their retirement. In this regard, it’s a lot better than nothing, but it’s important to know what you’re getting into.
While better than nothing, the 401(k) is far from a financial panacea.
If you’re driven to take control of your financial future, put in the time to learn and study, and most of all, take massive action towards making real change in your life, you may be savvy enough to look beyond the 401(k) and see some better opportunities on the horizon.
How do you envision your future? What will get you there the fastest?
Make it Happen
If you’re interested in looking beyond the simple 401(k) and want to accelerate your journey to financial independence, check out my FREE guides including: “The Secrets of Financial Freedom Revealed.”
Disclaimer: This article is for educational purposes only and is not a solicitation to buy or sell securities or an offer of personal financial advice. It is offered with the understanding that the author is not engaged in rendering legal, tax, accounting, investment planning, or other professional services. It is suggested you seek out the help of a financial professional before making any investing or personal financial management decisions. The education contained in this article may not be suitable for everyone — use it at your own risk.