An entire profession, financial planning, is dedicated to telling people they can save enough to pay for 30 years of leisure, and must, pay for their own retirement. A 401(k) is usually a central part of those plans. Even for people who don't have enough money to send their kids to college or buy a home, building their 401(k), they are told, is their first priority.
This topic is so important that Time Magazine dedicated a cover story to it, and this page is dedicated to outlining and highlighting the key themes the article covers.
Congress was trying to close a loophole on executive bonuses when it created the 401(k). Most companies intended 401(k)s--which were originally called salary-reduction plans but then renamed for the portion of the tax code that makes them possible--to be a perk for highly paid executives, not a pension replacement. That's because lower-paid employees probably could not afford to defer a portion of their paychecks. So companies held on to their pension systems even as they added 401(k)s, which by law they had to make available to all employees. When the market took off in the 1980s, the rank and file clamored to get in.
With a 401(k), contributions came out of your pay but were not taxed, and you had control of them. Contributions could be added or suspended. Best of all, when you left your company, your 401(k) traveled with you, removing a penalty for switching jobs that had been built into the pension system. On the corporate end, a change in accounting rules made the growing cost of pensions more apparent to shareholders. Cutting the pension was a guaranteed way to improve the bottom line. The rise of the 401(k) began.
Where 401(k)s Go Wrong
In theory, 401(k)s should provide much more of a retirement cushion than they do. A 2007 study from the National Bureau of Economic Research (NBER) estimated that, on the basis of historical returns, by 2040 the average 401(k) of a near retiree would grow to an inflation-adjusted $451,944. That money, spread over 30 years, could replace at least 50% of the average retiree's income. Add Social Security and even highly paid workers will probably earn more than 80% of their preretirement income. "The only reason these accounts haven't lived up to their potential is that they haven't gotten enough time," says James Poterba, president of the NBER, who co-authored the study.
Why don't these accounts amount to much? A number of reasons. Some people don't contribute as much as they should--essentially ignoring free money from company matches and tax relief. And, as the original engineers of the 401(k) suspected, the less you earn, the less you are likely or able to contribute. For most employees, the maximum contribution to a 401(k) is $16,000 annually. She found that just 5% of people earning $80,000 to $100,000 maxed out, compared with 30% of those making $100,000 or more.
Additionally, to get the hypothetical higher returns over time and avoid investing disasters, you have to hold a diversified portfolio of stocks and bonds. Many of us don't. The report found that 14% of workers held no stocks at all, leading to weaker-than-average returns. On the opposite end, more than a quarter of all 401(k)s were 100% stocks, exposing those accounts to big losses when the market dropped.
The retirement-savings solution: a new type of insurance. Retirement savings, it turns out, are exactly the type of asset we need insurance for. We need insurance to protect against risks we can't predict (when the market collapses) and can't afford to recover from on our own. "People tend to meld savings and insurance in their mind, but they are not substitutes," says Nancy Altman, a former Harvard professor and the author of The Battle for Social Security. "It's fine to have a savings plan as a supplement but not as the main retirement protection for everyone." She says the best way to guarantee a replacement for people's wages in retirement is by pooling risk, and the way to do that is through insurance.
What these plans and others like it are essentially proposing is a form of retirement insurance. Instead of putting 6% of your salary into a 401(k) or some other investment account, each pay period you would send 6% of your check to a retirement-insurance provider. The policy would work similarly to a traditional pension in that it would provide a guaranteed monthly check equal to about a quarter of your final pay, from when you quit working until you die. Some employers might even be willing to pay the annual premium as a perk. If not, employees would pay for it much as they currently fund their own 401(k)s. But the policy would be portable. Contribute for 30 years and you would be guaranteed income in retirement, no matter how many employers you worked for. Combine your retirement-insurance check with the money you get from Social Security, which can equal as much as 50% of final pay, and you have something approaching retirement security.