After 35 Years, the 401(k) Dominates Retirement Savings

The people who helped start the 401(k) revolution in 1981 lament what has become of it. At the time, the hope was just to help supplement a traditional pension program. The reality is that 401(k)s have replaced pension plans as the main retirement savings vehicle.

Herbert Whitehouse, a Human Resources executive for Johnson & Johnson, was one of the first to recommend his executives use a 401(k) as a tax-free way to defer compensation. “We weren’t social visionaries,” he says. They were looking for ways to cut expenses and retain top workers. However, because many companies have jumped on the bandwagon, pensions are becoming a thing of the past.

Traditional pension plans do have their weaknesses: bankruptcies could weaken or wipe out the plan, and it is difficult for employees to transfer the plan to a new company.

Enter the 401(k) with the promise that an employee could have enough savings for retirement. Teresa Ghilarducci, who directed the Schwartz Center for Economic Policy Analysis offered assurances to Union Boards and even to Congress that 3 percent savings would be enough. She now admits the first calculations were a little “too rosy.”

There were other issues policy makers didn’t take into account, such as workers yanking the money out of the 401(k) or choosing investments unsuitable for their ages.

Only 61 percent of eligible workers are currently saving. A whopping 52 percent of households are at risk of running low on money during retirement.4 These are scary numbers. It is no wonder people fear running out of money more than they fear death.5

The nation’s policy makers and some states have made proposals or started initiatives to help change the behaviors of savers and companies. One proposal would mandate retirement savings and the system would be run by the Social Security Administration. However, we are a ways off from having a solution to a societal problem that could be compounded by the Social Security trust fund running dry by 2034.6

The onus is on each one of us to save for retirement and implore our parents, children, friends, and even neighbors to help patch the holes in a sinking ship by saving for retirement.

The bright spots are the people that have benefited from the 401(k). For example, Robert Reynolds could retire comfortably at age 64 after saving for 3 decades. He says the formula is very simple, “If you save at 10 percent plus a year and participate in your plan, you will have more than 100 percent of your annual income for retirement.”7

Like it or not, we live in a world where 401(k) accounts have nearly eliminated pensions. Your financial future is your responsibility. So, make a personal commitment to save for your future.

 

1. The Champions of the 401(k) Lament the Revolution They Started, Wall Street Journal, Jan 2, 2017
2. The Champions of the 401(k) Lament the Revolution They Started, Wall Street Journal, Jan 2, 2017
3. The Champions of the 401(k) Lament the Revolution They Started, Wall Street Journal, Jan 2, 2017
4. The Champions of the 401(k) Lament the Revolution They Started, Wall Street Journal, Jan 2, 2017
5. http://www.marketwatch.com/story/older-people-fear-this-more-than-death-2016-07-18
6. http://money.cnn.com/2016/06/22/pf/social-security-medicare/
7. The Champions of the 401(k) Lament the Revolution They Started, Wall Street Journal, Jan 2, 2017

Women Should Save 2 Percent More Than Men

In an age where women have an increased influence in the workforce, it doesn’t seem right that women have to save more than men for retirement. However, that is what the research from Hewitt Associates suggests.

There are several contributing factors to this need, some inherent and some that can be corrected. An inherent factor for women is a longer lifespan—living an average of three years longer than men after retirement. The extra 2 percent is needed for the additional insurance cost for a longer life. The lower average yearly salary for women ($57,000) compared to a man’s ($84,000) indicates that a woman should save a higher percentage to match the dollar amount men save. Some correctable factors include: waiting longer to start saving for retirement, investing more conservatively, and not taking advantage of the company match in a 401(k).

Women are able to close the retirement gap by taking a few simple steps.

• Invest early and increase contribution rates. One goal should be to contribute 10-20 percent of gross income into a retirement account. This doesn’t have to be done at once; contributions can be marginally increased each year.

• Ask for advice. Many women feel insecure about managing finances. A wealth management professional can help determine personal risk tolerance and how aggressively to invest money.

• Leave a 401(k) invested. If suspending work due to family reasons, don’t cash out a 401(k)—this avoids taxes and hefty penalties. A 401(k) can be rolled-over into an IRA or professionally managed account.

• Put off retirement for a few years. This may be painful but could mean a great deal down the road. Don’t sacrifice the future for the present.

Women have several challenges that make retirement preparation more difficult. Recognizing these issues and making small changes in their saving and investing habits can have a significant impact.

Americans Are Taking Control of Their Money

Do you remember what America was like in 2006? If we could give the year a financial theme, I would label it, “Borrow and Spend!” Buying a home was easy; no verification of employment and no down payment were necessary. An interest-only loan could be obtained without any reasonable expectation of one’s ability to repay the loan.

As a matter of fact, you could borrow up to one-hundred percent of a home’s value, skip a month’s payment, and even cash out any value that had come from the rising price of the home. Leverage was the hot financial fad! Many Americans borrowed as much as they could and bought whatever they wanted!

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What a difference ten years can make. Contrast 2006 with 2016; today people are taking control of their financial situations, putting themselves in the driver’s seat, and keeping their own hands on the steering wheel. Financial responsibility is much more prevalent.

Disposable income —the money we have left to spend after taxes have been paid—has increased at an average rate of just less than one percent per year over the past ten years. So income is up a little. This makes the fact that personal saving is up very impressive. We have seen the personal savings rate increase from 3 percent at the end of 2005 to 5.5 percent at the end of 2015.

This significant improvement demonstrates a shift for Americans towards greater financial strength. Here are some of the positive outcomes.Americans saving

Reduction in personal debt
Still smarting from the financial pinch of the last recession, cash flow is now king. For many of us the perception of acceptable levels of debt has changed significantly. Debt is financial fragility, which is why Americans again recognize the value of getting out of debt as quickly as possible. Many have taken advantage of low-interest rates and refinanced to shorter-term loans. Paying off short-term loans such as car loans and signature loans is now a priority, and the use of credit card debt has reduced significantly.

Spending less
Knowing what we should do and putting it into practice can be challenging. This is especially true when it comes to living within your means. However, it is possible and it is powerful. No other financial habit is more important!

We have had the opportunity to meet with many people that have adopted the philosophy of a simpler lifestyle. This allows them to enjoy what they have without the pressure to get more “stuff” and then live with the financial burden. Managing spending also impacts our future lifestyle. If we spend everything today…what will we live on in retirement?

Increased accessible savings
After experiencing financial instability, many people have gained a witness of the need for liquidity. Access to emergency money to cover needs for 3 to 6 months has been widely recommended for decades, but it has gained new favor in the last 10 years. The wisdom of this applies beyond those still working. Retirees are also paying attention to liquid savings to make sure they can cover the unexpected emergencies that will surely come.

Focus on planning for the future
A shift has taken place in young people as well. They are saving for their futures at the beginning of their careers. Company-sponsored retirement plans such as 401(k) or 403(b), as well as individual IRA or Roth IRA, are now common to this young generation and they are off to a strong start.

Financial Health

Those who see retirement on the horizon have a new goal. They want to maintain a comfortable lifestyle throughout their retirement years. With fewer pension plans providing retirement income, the burden to provide income during retirement has been shifted to them. Many have hit the ceiling on contributing to their retirement plans and are using additional savings to help them reach their goals.

It is clear that over time all things can change; the market, our spending and savings habits, even our perception of what’s important financially. We have learned many valuable lessons and have made significant strides to improve our financial situations. The next ten years will undoubtedly bring more changes; some will be good and some will be bad. Remember to prepare when times are good and don’t fall prey to the next financial fad. Keep in mind that you are in the driver’s seat.

Open Enrollment

For most employees fall is the season to enroll in many of the benefits offered by their company. It is a good time to review your options and make sure you are taking advantage of the benefits available to you. Here are the most common open enrollment benefits:

• Participation in 401(k), 403(b), or other company-sponsored retirement plans

• Health insurance plan selection

• Planned spending account contributions (Cafeteria plan)

• Beginning or increasing group life and disability income benefits

Don’t let this opportunity pass you by. If you miss the open enrollment period, you may not be eligible to enroll or make changes for another year.

IRA Rollover versus 401(k)

Money BrainIf you have ever left a 401(k) at a previous job, you are probably wondering what you should do with your money. If you have over a certain amount, many 401(k)s will allow you to leave the money there or you could roll the money over to an IRA. Below is a list of seven questions you should ask yourself to determine where your money should be.

1. Do you want to be the financial advisor on your account?
Do you feel comfortable answering these questions: Am I saving enough? Am I taking the appropriate amount of risk for my age and time horizon? Which investments should I hold? How do I make my money last for all of my retirement? If you already know the answers to those questions and are competent at deciding the asset allocation of your 401(k), then your current 401(k) may be sufficient. If you don’t know the answers to those questions, then you may want to roll out your 401(k) into an IRA at Smedley Financial where we can help answer these important questions.

2. How much do I value regular feedback and personalized advice?
Most 401(k) plans are limited in the advice they can render because of fiduciary liability. If you have ever asked a 401(k) advisor where you should invest your money, you may have received a response like: “Where you feel comfortable.” 401(k)s also can’t handle non-retirement investments, real estate, or life insurance. In addition, 401(k) advisors are typically servicing too many participants to provide personalized advice. Seek out a private wealth manager, like those here at SFS, that can advise you on your whole financial situation and align your investments with your goals and values.

3. Is the investment choice important?
Many 401(k)s offer a limited number of investment choices, typically 10 to 20. They may be lacking the ability to diversify into many other investment options that could boost return or diversify risk. IRAs tend to offer a much broader choice of investment selections. For example, our brokerage account has access to over 3,000 different investments. Review the investment options available and determine if they allow for appropriate diversification and if they have had good investment performance in relation to their benchmarks.

4. Do I understand how to compare fees and expenses?
Thanks to recent laws, 401(k)s are now required to disclose their annual fees, which makes this comparison easier. Compare the fees for the 401(k) and the IRA by looking at the total fee and what services are provided for that fee.

5. Am I between ages 55 and 59½?
For employees that separate service between the ages of 55 and 59½, some 401(k)s allow penalty-free withdrawals. IRAs on the other hand only allow penalty-free withdrawals after the age of 59½. Determine when you may need your 401(k)/IRA money and whether you have other sources that can bridge the gap between retirement at an earlier age and age 59½.

6. Am I concerned about creditor protection?
Both 401(k)s and IRAs generally offer substantial credit protection. 401(k)s are typically excluded entirely from bankruptcy proceedings while IRAs are typically excluded up to a maximum of $1 million. Check with your state to verify any state specific rules.

7. Do I own employer stock in my 401(k) plan?
Before cashing out your company stock in your 401(k), consult with a tax advisor to determine if a tax strategy called Net Unrealized Appreciation could benefit you. Depending on your individual circumstance, the company stock may be taxed at a lower rate. Once company stock is transferred to an IRA, it is treated like the rest of the IRA money and is taxed as ordinary income when it is withdrawn.

Before making these or any important financial decisions, talk to the Wealth Management Consultants at Smedley Financial so they can help you reach your goals.

Need Help Allocating Your 401(k)?

One of the most common questions we get at SFS is “How should I invest my 401(k)?” This is a critical question, especially considering that 18% of retirement assets are tied up in these accounts (source: Investment Company Institute). Managing your 401(k) may be the most important place to place your financial focus after managing your spending.

First things first—start saving now. Starting early is the best way to get compounding rates of return to work in your favor. Remember, Albert Einstein called compounding rates of return the “8th wonder of the world.”

Next, take advantage of free money by getting the full match your employer offers. Not all 401(k) plans include a match, but if yours does, then make sure you get the full benefit. The rate at which you save is far more important than the rate of return you get. So, keep saving for the future.

Now let’s get into the investing nitty-gritty. Every person must decide how much risk to take in his or her savings. Your risk tolerance should be based on your ability, willingness, and possibly your need to take risk. It will be different than that of your friends and coworkers. It may even be different than that of your spouse.

Your ability to take risk includes factors like your overall financial situation and your time horizon. The more savings you have, the more risk you can take. The longer you plan to invest, the more risk you can take. Why? Your chances of positive returns in stocks go up the longer you invest.

Willingness to take risk is more difficult to determine. The essential question is how well will you be able to handle a drop in the value of your investments? If you view a fall in the stock market as an opportunity to buy more then you may have a high tolerance for risk.

When it comes to picking investments, the easiest route is to find an investment that approximates your retirement date. These all-in-one solutions provide some diversification. While diversification is far from a guarantee, it is still a good way to help manage risk. The pitfall of the retirement date choices is that these don’t take into account your personal situation (health, income, assets, debt, etc.) and they may not even disclose exactly how they are invested.

If you choose to select your own mix, be careful. Selecting the hottest performer last year can get you in a lot of trouble. Distributing your account balance evenly into each option is certainly not the way to go either.

This is where a little research and help from a professional can help. Give us a call. We can help you navigate the 401(k) maze.

What is the Riskiest Part of Your 401(k)?

You have control over the most important factors that determine successful retirement savings in your 401(k). You control the contributions, investments, and withdrawals. You are the riskiest part of your 401(k)!

Inherent risk does not exist in a 401(k). Why? A 401(k), 403(b), IRA, or Roth IRA is not an actual investment. These are merely vehicles or accounts that allow us to save money for the future in a tax-preferred environment.

The risks come in other areas, most of which we have the ability to control. This article will discuss four of the most misunderstood risks: investment risk, active user risk, savings rate risk, and self-plundering risk.Investment Risk

Within the 401(k) or qualified retirement account, there is generally a wide variety of investment options. These include different sectors of the market and ranges of risk, as measured by volatility. These options can be conservative, aggressive, or anywhere in between.
We cannot control what the world stock and bond markets do, but we do have some control over how our money is invested and how much risk we are going to take.  As participants, we choose which of the investment options we will use. This requires us to know which mix of the options will meet our investment risk tolerance, emotional needs, and time-frame.

Active User Risk

We drive the level of risk. If we choose investment options that are too aggressive, we increase our risk. If we do not diversify among the options, we increase our risk. If we change investment options in response to information we hear or read, we may increase our risk.

The chart to the left shows how volatility in the market changes from year to year. Investors evaluate each year based on the ending market price. Was it positive or negative? Participants tend to forget that even though a year may have ended positive, we could have experienced significant volatility mid-term. Take for instance 2009. The market ended up 23.5 percent by year end. Looking back, it’s easy to forget that during that year the market was down 27.6 percent.

These periods of volatility can cause investors to get sidetracked. They forget their long-term plans. They try to outguess the market by moving in and out. These decisions are often based on emotion, and it is generally to their financial detriment.

On the flip side, some participants remember the volatility and become risk averse. They forget that over time they have experienced more positive years than negative. They forget their long-term objectives and become too conservative.

Savings Rate Risk

We have seen a significant decline in the personal saving rate among Americans. While a 401(k) allows contributions up to $17,500 each year ($23,000 for those 50 and older), many make minimal contributions. Just like investing too conservatively, saving too little will leave many far short of living a desired lifestyle at retirement.

One of the benefits of a 401(k) is that you can make systematic investments directly from your paycheck. You don’t have to sit down and write a check each month. It happens automatically. Not only that, the company may offer a matching contribution. That’s free money! Our clients experience greater success when their savings plan is set on autopilot.

At any time, investors have the ability to increase their investment amount. Unfortunately, as raises and bonuses come, rather than increase their contributions, investors often allow the raise or bonus to be absorbed into their cash flow.

Self-plundering Risk

Participants who view their 401(k) as a savings account or emergency fund fall prey to this particular risk. They access their money by taking loans or withdrawals, diminishing the opportunity for long-term growth. Even if a participant takes a loan and pays it back, they will experience opportunity loss. This is the difference between the interest rate they paid themselves through the loan and the market returns they missed out on. The difference becomes more significant when you compound the missed opportunities over their working years and throughout retirement. Taking early withdrawals is even more damaging. Participants not only miss out on long-term savings and compounding returns, but they will also pay taxes and penalties. The taxes are based on marginal tax rates, but the 10 percent early withdrawal penalty is exact.

For example, say that a participant has a 25 percent federal tax rate and a 5 percent state tax rate. If they were to take a $20,000 withdrawal from their 401(k), they would lose $8,000 (40 percent) to taxes and penalties, netting a meager $12,000. Suddenly that withdrawal doesn’t sound so enticing.

There are many misconceptions regarding risk when it comes to 401(k)s. We want to make sure you are well informed about the benefits and risks in these accounts.

As we see it, a 401(k) is an ideal vehicle that provides us with a tax-preferred way to save for the future. Will a 401(k) be enough to support someone in retirement? Probably not. While most companies offer a company-match to 401(k) participants, many no longer offer pension plans. This makes it paramount that we save more on our own for retirement.

Our investment decisions, savings habits, and our willingness to stick to a plan can prevent us from increasing our risks. Working with one of our wealth consultants can help you make the most of your 401(k) opportunities and avoid some of these risks. Having a plan and making educated choices is just the beginning.