The Real Reason 401k Plans Have Come Under Fire

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The Real Reason 401k Plans Have Come Under Fire

Recently, there have been a number of media stories about the ineffectiveness of company 401k plans. The “Retirement Crisis” is upon us and we’re all doomed because the traditional pension plan has been destroyed in favor of 401k plans. Even long time advocates of that position are now questioning the validity of the argument. Yet pension or 401k, the same problem still exists.

What is that problem? Savings rates.

Most financial firms recommend somewhere around 10-15% of earnings should be saved for retirement. That number can be achieved with a combination of employee savings and employer match, assuming someone works at a place that A) offers a 401k plan and B) gets an employer match.

That 10-15% savings rate number is ON TOP of Social Security (SS). And if you’re foggy on how SS works, here’s how: Each person pays 5.3% of her salary to SS and has a 5.3% match from her employer. That’s 10.6%. Where does 5.3% come from? Remember, FICA taxes are 7.65% of your salary. And FICA consists of Medicare/Medicaid, Social Security Disability and Social Security benefits. Of that 7.65%, 1.45% goes to Medicare and 0.9% goes to Social Security Disability. That leaves 5.3% for traditional SS benefits or what some people might call a retirement paycheck.

The Social Security Administration (SSA) has done a variety of analyses on retirement income over the years. The most recent indicates that, for a majority of people, about half of their retirement income is derived from Social Security benefits.

The Congressional Benefit Office conducted a similar analysis to the SSA. Their conclusion was roughly the same. Excluding the highest quintile of wage earners, as they are less reliant on SS benefits, the study concluded that SS accounts for about 40-60% of a wage replacement ratio – the amount of money needed to replace wages from working years.

Either way, there’s a shortfall of retirement income. How do we overcome that shortfall? Answer: save more.

The simple math is this: if 10.6% of your wages, via FICA taxes (5.3% from you and 5.3% from your employer), can account for somewhere between 40-60% of your income replacement ratio, doesn’t it make intuitive sense that saving an additional 10% would get the average person to 80-120% of their retirement income needs? Yet, the average savings rate, excluding SS, is about 5.7%. And that number is a bit misleading as it looks at the savings rate after taxes. As a % of gross income (before taxes), the average person saves far less than 5.7%. Likely closer to 4%. That’s a far cry from the 10% upon which most financial experts agree.

So, how can companies offering 401k plans help their employees get to that “magic number” of 10%?  First, automatic enrollment and automatic escalation of savings (an automatic increase of the savings amount every year by, say, 1% per year) are two good ways to hit that savings threshold. As well, employers should consider not only offering a list of funds from which employees can choose, but also offering pre-made models or target-risk (or date) funds that do the investing automatically for employees. This can remove the barrier for employees to figure out how to invest. Lastly, design the company match to entice people to save us much as possible. For example: instead of offering a match dollar for dollar on the first 3%, perhaps do 0.75 cents on the dollar for the first 3% and 0.25 cents on the dollar for the next 3%. Under the first match structure, the employee is saving 3% and getting 3% for a total savings rate of 6%. Under the second scenario, the employee is now getting the same contribution from the employer (a total of 3%), but the employee is saving 6% of her own to get the full company match. That’s a total of 9%.

The problem is real: not enough saving. But the solution isn’t to bash 401k plans. It’s simply making them more employee-friendly and finding ways to more adequately incentivize people to save.

By | 2019-01-22T20:11:24-05:00 October 5th, 2016|401(k)), Asset Allocation, Blog|0 Comments