The winner from last week’s book The Subprime Solution is Angie.  Please email me at livingalmost at gmail dot com! Remember this is the last week to email me about the TurboTax Giveaway. You must subscribe to my RSS or Email Feed and send me an email with the secret word!

This week I’m reviewing the book Coming Up Short – The challenge of the 401k plans by Alician Munnell and Annika Sunden.  It’s a book talking about the challenges facing 401ks and what has happened since their inception in 1981.

Chapter 1: Introduction

The book is organized to talk about the sequence of events people face when deciding whether to invest in a 401k or not, what to invest in, and how to manage withdrawing funds.  Thus each chapter examines a different aspect of the 401k retirement plan and it’s role in our society today.

The book talks about a 401k being a pension plan.  But in truth it’s not a pension plan. It’s basically a saving vehicle for retirement.  When we talk about pensions, most people think of a monthly stipend paid out for the rest of their lives from a company.  They will get a fixed amount, regardless of what they contributed during their working years.  This type of defined benefit pension plan is what most define as a “pension” plan.  The book however calls 401ks and defined contribution plans pension plans.  I think this is a misnomer and can make the book rather confusing personally.  But onto the book.

Chapter 2: 401k Plans and Retirement Income

The authors start by showing us graphs of the changing landscape of retirement pension plans from just 20 years ago.  In 20 years we’ve gone from a defined benefit plan, where a person has a lifetime annuity (monthly payment), to a defined contribution plan or 401k.  20 years ago people would get say 1% of their salary for each year worked for the rest of their lives.  However today, defined contribution plans or 401k are saving accounts.  The defining characteristic the authors mention is that 401k plans are voluntary.  Thus the employee and employer choose to make contributions.   The authors also mention a hybrid plan.  A plan that is a mix between a defined benefit and a defined contribution plan.  Typically these hybrid plans pay out the employee a fixed sum upon retirement rather than a lifetime annuity.  But these are rare and were really only popular as companies moved from a traditional annuity retirement plan to a 401k retirement plan.

One study quoted in the book suggest that traditional pension/annuity plans allow companies to attract the best workers.  Those workers who are looking long term for the high payout instead of wanting the money now.  In other words people willing to delay gratification.

However, since it’s inception 401k plans have skyrocketed in popularity yet defined pension plans have fallen by the wayside.  Why?  Is it really that people want their money now?  Not necessarily.  Rather companies prefer not to take the risk of giving pensions because there is no way of determining what they will pay out.  With the 401k and defined contribution plans, companies know exactly how much they will be contributing to their employees, thus costs were predictable.  While in a traditional annuity, it depended on how long the employee lived and how long they worked.

But are people better off with a 401k versus a traditional pension?  A 401k allows people mobility job wise and allows them to save as they see fit.  They are not forced into savings and they do not lose anything by changing jobs, and have direct control of their money.

Unfortunately it’s not easy to measure if people are better off with a defined benefit or defined contribution plan.  It appears than people utilizing a 401k can come out far ahead in savings, however, they must be saving from an early age and continuously to outperform a traditional pension.  And since people do not typically begin saving for retirement until later in life, it appears that a 401k /defined contribution plan actually hurts people more than helps them.

However, the argument that people start saving later is countered by the argument that Americans today are a highly mobile society.  That we do not stick with our jobs long term, thus negating the benefit of a traditional pension annuity.  That in general people are not with one job for 30 years in order to reap the benefits of pension plan, which might replace 70% of their income.

Finally there is a major difference between a defined benefit and defined contribution plan – RISK.  If the market tanks like it’s currently doing, then the employer must still cover the benefits guaranteed for a defined benefit pension annuity.  However with a defined contribution plan, there are no guarantees of any income or replacement of lost funds.

The conclusion of the chapter is that most people will be worse off from the switch from a defined benefit to a defined contribution plan.  They will not save enough to make up the guaranteed savings that comes from having a defined benefit plan.

Chapter 3: Participation and Contribution in 401k Plans

This chapter focuses on whether people participate in 401k Plan or not.  This is a major factor in the previous chapter in determining whether people are better or worse off under a 401k plan versus a traditional defined benefit annuity.  The chapter found that people in the lower income brackets were less likely to contribute to a 401k plan.  However, these low income workers began to contribute at levels similar to high wage earners when they were close to 50.  Thus when broken down in age brackets those under 35 barely participated no matter what their income bracket.  While the majority of people over 50 contributed no matter what their age bracket.  Thus contributions were predictably tied to age and income.

In 1999 when the IRS began to allow automatic enrollment into 401k plans, they found that almost no one opted out of the enrollment. Thus the same inertia that caused people to not enroll, could be used to help them start saving.  The biggest benefit was to the low income group, who previously had been unable to save for retirement.  Not seeing the deductions they did not change them once in place.

So perhaps we should cover everyone under a mandatory enrollment retirement 401k, that is separate from our jobs?  This way everyone can have a 401k and contribute.  Also no one would have the excuse not to save for retirement?

Chapter 1: IntroductionChapter 4: Investment Decisions in 401k Plans

This chapter examines whether we should offer more or less investment options in 401k.  It starts out by mentioning in 1995, the average number of options was 8 investment options per plan.  Now the number has jumped up to an average of 38 investment options per plan.  But does this help or hinder people?

From three different surveys, the book presents that having extra investment choices actually is less desirable to people.  Turns out that people often feel intimidated by their own selections.  However, they are quite amendable to being able to pick a preset portfolio out of say 4 that they feel is appropriate to their level of risk.

Also the chapter talks about how the income bracket and gender affects people’s investment strategy. It was found that lower wage earners typically invested in ‘”safe” interest earning investments.  As did women as a gender.  However, it was found that all people did not change their investment strategy as they aged.  Why?  Inertia.  It appeared that all people were not conscious about changing their strategy as they aged or their portfolios changed.  Everyone stuck with the same strategy.

Thus the chapter suggested making few investment choices available and perhaps focusing on lifecycle funds.  Funds where the asset allocation mix changed over time to match the age of the participant.

Chapter 5: The special case of company stock

This chapter focuses on a problem common with many 401k plan.  The excessive holding of company stock within the 401k.  Typically this comes about because the company will match the contributions of the employee in the form of company stock.

Unlike laws regulating taxable accounts, there is no law preventing people from holding more than 10% of their assets in company stock. Thus employees can often hold up to 50% of their portfolio in company stock.  Thus there has been a push to prevent people from holding in a 401k, Employee stock purchase plan no more than 10% of their total holding in the company stock.

But why do employees continue to hold company stock?  Irrational exuberance would be one answer.  People believe in the company and it’s potential.  Also pressure by the company to keep invested in the company.  Often times companies will place restrictions on the sale of company stock.  While the most famous company stock bust was Enron, other companies such as Rite Aid, Lucent Technologies, and Ikon technologies also burned their employees with company stock.

Thus the chapter concludes it’s time to set strict regulations on company stock being part of a 401k plan.  Perhaps limiting the amount an employee can hold.  Thus people will no longer be overexposed to risk due to investment in one stock.

Chapter 6: Leakages from 401k Plans

This chapter talks about people losing money from 401k plans.  Losing money?  Not really.  More like people taking money out pre-retirement for non-retirement needs.  First up is borrowing against your 401k.  Many plans offer employees to take out loans against their 401ks because it makes people more likely to contribute.  Also people like to borrow from their 401k because they are paying “interest” to themselves.  But the implications of people borrowing against their 401k were huge when the projections of their portfolio balances were extrapolated.  It appears that borrowing against the 401k potentially could devestate the compounding effect.  Honestly, it’s pretty simple to understand that borrowing against retirement money is DUMB.

Second, the authors looked at lump sum distributions. Or distributions people typically take when they leave their jobs and have to “rollover” or take a distribution from their old 401k.  Ideally people would roll old 401k into new 401k or IRA.  In truth, majority of people don’t, thus decreasing their retirement nest egg substantially.

The conclusion is that the government should not allow lump sum distributions and force all 401ks to be rolled over into IRAs.  Thus preventing people from tapping their retirement savings.  Also the authors claim people should be allowed to continue paying off their 401k loans after they leave their jobs instead of demanding immediate repayment.

I think this a most awful idea.  There should be a ban on borrowing against 401ks because it just allows people to spend money they should be saving period.  And 401ks should not have a lump sum distribution, instead laws should be in place to force rollovers into other retirement vehicles.  I fear that we will soon have nothing saved for retirement because everyone will be using it up to live on NOW.

Chapter 7: Withdrawing 401k Funds at Retirement

Previously employees never had to make decisions regarding their retirement nest eggs.  They were paid a monthly pension from a lifetime annuity.  Thus they never had to worry about outliving their resources.  However, with defined contribution plans, there is no such guarantee.

Thus the risk of outliving your savings is a real one.  One suggestion by the book is to buy an annuity.  Upon retirement take your 401k money and invest in an annuity, therefore gaining a guaranteed monthly payment like a traditional defined benefit pension.  However annuities are not cheap, and often come with high fees.  Another problem is that annuities tie up large sums of money, thus in cases of emergency a person would be unable to withdraw say $50k to pay for major home repairs.  Instead they might have to borrow $50k and pay it back using their monthly stipend.

The book really pushes investment in annuities. As a way to guarantee income. I think it’s a terrible idea and the whole chapter overstates the guarantee of an annuity.  The costs of purchasing an annuity and tying up a large lump sum can be riskier than the authors state.

I believe that withdrawing a set amount say 4% annually and sticking to a budget and saving whatever isn’t spent is a better idea.  This gives people flexibility to withdraw less or more depending on their own personal circumstances and the market environment.

Chapter 8: Making Pension Plans do their job

Finally the book wraps up with suggesting the ideal “pension” or retirement plan.  The authors suggest that traditional pensions had it’s flaws mainly that the monthly benefit was not tied to inflation.  Thus the longer you lived the less purchasing power you had.  However, now people are more at risk because they are forced to save on their own.  They no longer have the traditional defined benefit safety net.

Thus the authors suggest that we should merge both plans.  We should allow everyone to have a 401k, since currently about half of the workers in the US are covered by a 401k plan. Then we should automatically enroll everyone.  And we should automatically default everyone into life cycle mutual funds which changes the investments as people age.  Finally we should try to allow people to buy annuities in 401ks so they can mimic traditional pensions.  Basically the book is suggesting a larger social security plan but privatized.

I have to wonder, could it really work?  And what would be the point of social security?

This was an interesting book about 401k plans and their fallacies.  The truth is that 401k plans are here to stay.  There is no way any company in the future will be able to truly cover their share of a defined benefit annuity plan.  They will be unable to predict what they really need to set aside to cover their employees pensions.  Thus, in time defined benefit pension plans will be a thing of the past.  Everyone will be covered by a 401k or retirement savings plan of some sort.

We will all be forced to be more concerned with retirement savings and planning.  We will no longer have the safety net of  a guaranteed monthly annuity after we retire.  In fact, in many scenarios, those of us who are high wage earners will likely not even be able to count on Social Security.  Social Security will be a means based pension for those who haven’t saved or made enough to survive.

So leave a comment for a chance to win!  I’ll draw the winner next Wednesday night as I review another book next Thursday!