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Rethinking the 401(k)
J. Mark Iwry, head of the Retirement Security Project at the Brookings Institution.
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TEXT OF INTERVIEW
Tess Vigeland: Around, oh... September, 401(k) account balances became a national obsession. Millions of us have watched the money we invested for retirement evaporate as the markets went over a cliff. The S&P 500 is at its lowest level since 1997. The Dow has lost almost half its value in just over a year. These private accounts were never meant to be the backbone of our retirement system; they were designed as an add-on for wealthy executives. But over the past 20 years or so they've become the default with very little government regulation. And now 401(k)s are getting a tough -- and some say overdue -- second look.
Mark Iwry is a principal of the Retirement Security Project at the Brookings Institution. Thanks for joining us.
Mark Iwry: Pleasure to be with you.
Vigeland: Why is this the time to reform the 401(k) system -- if it is?
Iwry: This is the time to reform the 401(k) system, but I would emphasize not to replace it. We need to step back and recognize that the 401(k) is a saving vehicle, not an investment strategy; it can accommodate aggressive or conservative investments. When the market was rewarding, naturally the emphasis has been on people not missing out -- not excluding the average American from the potential growth that would provide a more adequate retirement. Now, with the events of the last few months, naturally the concern has shifted more to protecting the average American from the risk of catastrophic losses in their retirement savings.
Vigeland: Is there really any retirement system that would be safe when it's pegged to the stock market?
Iwry: Well, in the tradition pension system, as in the 401(k), if one wants to invest in a conservative way, there can be a guarantee of a particular return with a minimum risk of loss. The key is not really what type of plan -- the key is what type of investment.
Vigeland: But with the old pension system you were guaranteed -- you knew exactly what you were going to have.
Iwry: When you look beneath the surface it's not really that one of them guarantees an adequate retirement and the other one doesn't. Ultimately both of them are investing in the market. The traditional defined benefit plans now, for example, that have lost asset values in this current market, are in need of immediate help from Congress so that employers will be willing to continue them. But without any particular help, we would see employees in those plans being exposed to the risk that the employer will simply stop the plan -- will freeze it.
Vigeland: So what ideas do you see gaining traction in Congress and also in the incoming administration?
Iwry: Let me mention two in particular. Number one, the tax system is not structured in a way that benefits the majority of Americans. The higher our tax bracket, the greater the benefit, the greater the incentive to save. The lower the tax bracket, the less our financial incentive. That's obviously a very backward structure and the answer is a credit; if you add a credit, let's say at the rate of 50 percent the amount they save up to some modest amount, you're really giving people a meaningful financial incentive to save for the first time. A second key initiative that I think will get traction is the automatic IRA. We are in a position to be able to reform the 401(k) in a way that effectively extends the essentials of the 401(k) to 78 million working Americans, employers that are not ready to sponsor a 401(k) or a defined benefit plan would simply let employees save the employees own money by payroll deposit into an IRA. The employee would automatically be enrolled. They could opt out if they wanted to. The employer would not incur any out of pocket cost, but would be a go-between forwarding the employee's money to the IRA.
Vigeland: Mark Iwry is with the Retirement Security Project and a senior fellow at the Brookings Institution. Thanks so much.
Iwry: Good to be with you.
The 401K is a lie. It was never meant to be America's retirement vehicle, just a nice tax hedge for wealthy execs. It became American's retirement vehicle because it enabled employers to transfer retirement risk to employees: your 401K comes up snake eyes, that's down to you, not us.
Studies have found it is impossible for the average person to save enough in a 401K to fund retirement -- and that was before the market went to hell. Sure, 401Ks work for wealthy people. But so would shoving their money under the mattress, providing they can shove enough of it.
David, What investment returns are you guaranteeing for 2009? What will be the guaranteed performance of the S&P 500 in 2009, 2010 and going forward? Can you also guarantee that the Big 3 automakers will never face bankruptcy? Can you guarantee that AIG, Merrill-Lynch, Fannie Mae, Freddie Mac, etc., are blue-chip companies that will survive well into the future? I listen and watch the major financial media, and I have been hearing that we are at a bottom in the market and it has finally turned around for the last twelve months. Please take a few minutes and research the performance of the stock market in the decade of the 1970s and then decide if you can guarantee 20% performance of your basket of stocks in 2009.
Please remember that retirement income will come from employees' paychecks no matter what. If the government funds retirement, it comes out of taxes. If you want DB/Pension plans, the employer has to make larger contributions in an unflexible system (do you think they'll change anything else, such as pay/benefits?), and if the employee funds it they have to defer to the 401k.
If small employers go to 'guaranteed' DB plans, they'll use the same investment providers they've been using: fees and investment lineups will be pretty much the same. The only difference is that you put employers at risk and not employees. Is that better? Who knows?
So maybe the government should be in charge... How's that working out so far? Social Security is their best showing. They've known it's broken for years and done nothing about it. Show me a government entitlement program that's a glowing success, and I'll start imagining a world without 401k.
Finally (this refers to another story on this week's show), the reason that 401k is used by joe-six-pack and not just the executives is that Social Security was never going to do the trick. The common people saw that 1-2K/month was not going to be enough, so they use 401k by choice.
Finally finally: we've already established the Saver's Tax Credit - a way to entice low-income earners to contribute to retirement plans.
Yes, I happen to work in retirement plans, and I sleep very well at night because I help people improve their prospects for a comfortable retirement.
While I understand and appreciate what David Stevens writes in response to J. Mark Iwry, he overlooks that many, perhaps most, American workers have never sought or received an education in the fundamentals of investing or even saving. The average American's debt supports the claim. This is a blind spot in our education system that surely ought to be corrected. Mr. Ivey's remarks in the meantime mean to suggest protections for the unprotected. In the future, hopefully, all workers will understand Mr. Steven's remarks and will be able to act on and reap the rewards his technical terms allude to.
The problem is not with 401-Ks. The problem lies with economic growth and the engines of innovation that spark growth. The economist Joseph Schumpeter described the American economic phenomenon as being one of "Creative Destruction" where new ideas and industries are constantly replacing outdated and obsolete industries. During the 1990s, Information Technology sparked growth and the stock market soared. During the early 2000s, the emphasis has been on preserving industries that are mature and becoming obsolete. Companies and unions in these industries try to preserve the status quo through lobbying and other methods to stop change. Malcomb Gladewell's new book "Outliers" describes people who are outliers. From them come the ideas and innovations that create new growth. For much of the last decade, innovation has been suppressed. Examples of this are stem cell research and alternative energy. It will not get better for 401Ks until new engines of growth emerge.
With all respect Mr Stevens have you ever heard the phrase "historical returns are no guarantee of future performance"?
These companies that in your words have generated "earnings increases' over the last 10 years have done so with the tailwind of the largest debt bubble in the history of the world. The only data you need is the fact that total debt to US GDP is 3.5X right now, much higher than at the beginning of the great depression. I believe we will be at 25%+ unemployment within a year and this is what the market is discounting.
If we are entering another period like the Great Depression, even 35 year olds who have been investing in 401Ks for the last 10 years will be lucky to get their principal back when they retire at 70. No dividend will be 'safe' in our coming depression. That's why smart people of all ages are giving up on investing in equities in their 401Ks
It makes no sense for anyone to invest in the stock market at these valuations. Talk to me when the S&P500 hits 300, a similar decline to what has happened in Japan over the last 20 years.
I've been a listener for over 15 years, but when I heard the Nov 21st show, I thought I had tuned into the "Fixed Income Money" show. The beauty of the 401K is that the average worker can tap into a program that was designed for top executives. Along with the obvious benefits, the average worker accepts market risk if investments are placed in stocks.
Now is not the time to propose more government control and a 7% return guarantee - now is the time to invest at 1997 stock prices. Today, a 401K investor can find stocks of fortune 500 companies that have had an unbroken string of increased earnings since 1997 and essentially buy that decade of performance at a discount. If the investor (note, not saver) chooses stocks paying 4% in dividends that are not likely to be reduced, they only need to achieve 3% growth going forward to achieve Mr. Iwry's 7% government guaranteed proposal.
Solid performers like McDonald's, Emerson Electric, Johnson Controls, Chevron, Exxon, Conoco Phillips, Paychex, Merck, and hundreds of other companies, will likely achieve 20% returns by the end of 2009 from today's levels.
The market returns about 10% over time. A three-month period of -45% returns is a good reminder to Boomers that they should probably start moving more into fixed income investments. For young people, Marketplace should have reminded them in this piece, that now is the time to get into a 401K if they are not in one already. They should max out their contributions and they should have a high proportion of their 401K money in a broad selection of stocks or an index fund. For young workers, investing when the S&P is at 800 points is much more likely to beat Mr. Iwry's increased government intervention proposal when they review their 401K accounts in the year 2020 and beyond.
