I don't like 401(k) either

Felix Salmon hates the 401(k), and he explains his reasoning here. His strongest argument is the data, which shows that the first generation of retirees who grew up with these individual retirement savings accounts find themselves with meager retirement savings (average: $120,000, excluding those with zero).

I have always disliked 401(k), and here are some reasons:

I hate the myth of individual control. These accounts (just like health savings accounts and other similar things) are sold to us as an expression of individual freedom and choice. But it is a mirage.

First, it is never a good idea to chop up money into little pockets. The same banks who every day praise the benefit of diversifying our portfolios also lobby the government to establish these individual accounts. If you earn $60,000 a year, and get paid bi-weekly, then your paycheck is $2,500 less tax withholding. If you put 5% of your earnings into the 401(k), then every two weeks, you put away an extra $125. Imagine you then split the $125 into five or ten investments. It just doesn't make much sense.

And this doesn't even consider the per-trade fees that Charles Schwab, or E*Trade, or any of those firms charge us, as a percentage of the expected gains from your trade. Transaction costs are where individuals will always lose to funds.

Second, how many of us can truly beat investment professionals at the investment game? Most of us don't have the time or inclination to be monitoring our portfolio 24/7. The professionals have access to better information. They are able to react faster when something unexpected happens. In fact, our too-big-to-fail banks routinely have zero days of trading losses in a given quarter when they trade on their own accounts. (This does not mean these banks will perform the same when it comes to our money.) I'm aware that most professional fund managers are shown to do no better than some simulated simple-minded strategy. Is there a study that takes the investment performance of the average Joe and compare them to the average fund manager?

Third, moving from a defined benefit plan to a 401(k) is to shift risk from institutions to individuals. When we were sold the myth of individual control, we were also gifted the Trojan Horse of financial risk. Now, we are responsible for our own individual bad decisions. This is an important point. More people in the pool lowers the average risk.

Fourth, the 401(k) is regressive. The lower your salary, the smaller your biweekly contribution. The risk borne by the individual is higher when the principal is smaller.

If those are not enough, individual control is simply a lie, and becoming more so each year. Most of us find that the banks that run the 401(k) only allow us to put our money in one of the funds they administer. They charge a fee to put the money elsewhere. In one case, I was told if I really want to invest in funds not in the approved list, I must first buy one of the designated funds, and then transfer the money to the fund I really want. Needless to say, the in-and-out is not free. There is another company who matches my contribution but in company stock, which is the opposite of diversification; and if I want to transfer the money to a different asset, I have to pay fees.

It's a steep price to pay to enjoy that "individual control."

 

Comments

[Ken]

Under the Australian system we choose the type of investment. In the fund I am in, these range from capital stable to high growth, which are defined as a mix of cash, bonds, Australian shares, international shares, investment property. Dependent on the mix I can choose what level of growth and risk I want. I think I can even choose my own mix. The organisation that runs the fund decides on what shares etc. One suggestion is to have investments that are linked to share market indices plus dividends, for which the management costs would be lower. It all works fairly nicely, except that I don't have enough yet to retire. Our university system is becoming a bad place to work.

[zbicyclist]

Some comments:

1. "Little pockets". Little pockets are fine so long as your expenses don't go up as a percentage. It's the expenses that are a mess with 401k's, depending on how much your employer looks out for your interests.

Fees are deadly: http://wallstreetonparade.com/2013/04/pbs-drops-another-bombshell-wall-street-is-gobbling-up-two-thirds-of-your-401k/ shows with a 2% fee structure two thirds of the money ends up with the management firm, not you. This is simple math, and anyone with Excel can verify Bogle's calculation. There's also no reason for 401k fees to be high, since there's no investment advise being given and the funds used are typically large ones. There are several core Vanguard funds with expense ratios in the .05% to .15% range.

2."Average Joe". The average Joe typically gets into trouble by buying on history (i.e. buy after the market has gone up, sell when it goes down). Other than that, there's not a lot of evidence that professionals do better for the average investor (because of the fees you pay). Take a look at the "Morningstar" experience in Bogle's famous "buy the haystack" article: http://www.vanguard.com/bogle_site/bogle_speechesequity.html

3. "Risk shift". No argument there.

4. "Regressive". Not sure regressive is the right term, but it's definitely true that for high income individuals the 401k is likely to be a smaller piece of their total savings, and so they bear less risk. If they bear less risk, lower income individuals bear more.

It certainly is true that loan utilization rates vary, and tend to be used more "for participants in their 40s, those with 10 to 20 years of tenure, those earning $40,000 to $60,000 per year, and those with plan balances between $20,000 and $30,000. For those who have a loan, the loan-balance-to-401(k)-balance ratio declines with age, tenure, compensation, and 401(k) plan balance." http://www.nber.org/papers/w17118

BUT: is this situation better than having a defined benefit plan (such as the Illinois public employee pensions, which are even guaranteed in the Illinois constitution) which the employer (the state) does not fund and now wants to partially renege on?

[David J. Littleboy]

You asked:
"Second, how many of us can truly beat investment professionals at the investment game?"

The answer is: every single one of us. Just buy an index fund and you just beat the pants off the vast majority of investment professionals. Of course, on one does that. Not even me (I refuse to own stocks).