Why 401(k)s Have Failed

John WasikContributor 

4/24/2013

Last night’s “Frontline” show on PBS did Americans a great service. It showed the folly of the 401(k) structure, which has been a problem for decades.

Unfortunately, while Frontlne’s Martin Smith and his many great guests focused on costs (too high), poor guidance and employer neglect, the larger point is that employers don’t have to provide 401(k)s at all — and probably shouldn't.

The 401(k) plan was never meant to be a mainstream pension plan and is a poor substitute for one. It’s a voluntary program that was intended to supplement retirement savings –  one of those quirky little options in the byzantine tax code that employers seized upon as a way to save money while pretending that they were doing the right thing by their employees.

As Prof. Teresa Ghilarducci has been saying for years, the 401(k) was an experiment — and it’s failed. They cost too much because employers can pass along most of the costs to employees, which eat away returns. Some absorb plan expenses, but they are the rare exceptions. Unlike big medical insurance plans, employers don’t work hard enough to get the best price on mutual funds within the plan, although they are compelled by law to do so.

Even though a St. Louis-based law firm has taken the lead in suing big employers over excessive 401(k)  fees, employers can still pat themselves on the back because they offer plenty of retirement funds.  And that’s despite new Department of Labor guidelines requiring disclosure of costs;  most employees don’t know how to compare fund returns to benchmarks nor do they know what they should be paying for 401(k) funds. Ignorance is bliss if you’re an employer.

What You Should be Paying

For the sake of simplicity, employers can offer funds that charge less than 0.10 percent annually. These are available in off-the-shelf mutual or exchange-traded funds. But far too many plans charge employees “retail” rates of 1 percent or more annually. Why such a disparity? Because employers can pass along the costs and there are no minimum standards for a 401(k) other than it be “prudently” managed. Even more criminal are small-company plans set up by insurance companies, which charge more than 2 percent annually.

Several attempts at legislation have been floated to offer universal, low-cost options similar to the program offered to federal employees, but it always gets shot down by employer and financial service lobbies.

Taking issue with the Frontline program, employer-linked groups noted that the presentation focused too much on fees. The American Society of Pension Professionals and Actuaries (ASPPA), a benefit professional’s group, issued this statement today:

Nothing in the history of this country has promoted more savings by average Americans than the 401(k) plan, with total assets in excess of $4 trillion (plus over $5 trillion in IRAs, much of which is from 401(k) rollovers). Three-quarters of American families became investors first through their workplace retirement plan. It is hard to imagine where we would be without our nation’s private retirement system. The system is not perfect. We need to expand coverage to those without a plan at work. We need to make it seamless for workers to save through greater utilization of auto-enrollment. And we need to make sure we focus on outcomes so the system produces the retirement results reasonably expected by both plan sponsors and participants.”

True, 401(k)s have encouraged workers to save. But what if they all had low-cost index funds in their plans instead of actively managed funds, as suggested by Vanguard Group founder Jack Bogle? What if employees had professional financial planners guide them into allocations that were right for their age and risk tolerance? What if they knew how to diversify properly to avoid the stock debacle of a 2008 or 2000?

There’s no way of measuring how much further they’d be ahead, but I’d suspect that we’d see fewer daily industry surveys of how little people have saved for retirement.

Authors like Helaine Olen have been right on the mark in saying that the financial services industry and employers are all too eager to tell us how little we’re saving, yet don’t serve as honest brokers in maximizing our retirement savings. That would require cutting fees, 

eliminating middlemen, increasing employer contributions and getting rid of the fee structure that is based on assets under management. And above all, the most dangerous part of this equation: Educating employees on how to invest cost- and risk effectively.

The more money in our kitties, the more money financial mavens make, even though they do little to deserve the extra compensation.  But only a handful of companies like iShares, Fidelity, Schwab and Vanguard seem to be interested in providing basic funds at rock-bottom prices.

Did you know a price war in exchange-traded funds has been going on over the past two years? Many basic index funds are offered at no commission and are among the lowest-cost funds on the planet. Have you seen these funds turn up in your 401(k)? It’s highly unlikely since few employers regularly audit their plans to lower costs.

Brokers and financial service providers that set up 401(k)s are hard-pressed to acknowledge this in-bred conflict of interest.

They can set up a suite of mutual funds, but the more money they charge, the worse off future retirees are.  Until this conflict is resolved by making retirement-plan managers fiduciaries — legally responsible to put employees first — little will change. Such a rule has been pending before the SEC and Labor Dept., but the coalition of Wall Street and employers have been fighting to dilute or kill it.

Future retirees are offered little or no protection under current laws. Observes the National Association of Personal Financial Advisors (NAPFA), which represents fee-only certified financial planners (who are also fiduciaries):

“While broker-dealers largely want to maintain the status quo, Americans are struggling to make ends meet and save for their futures — they deserve the protection of a fiduciary standard from every professional who touches their financial lives. This is a wake-up call for legislators and regulators to finally do something to protect American investors.”

The fiduciary standard is a good place to start. Then we need to commoditize 401(k) funds and de-link them from employers. There should be a national program open to anyone (regardless of whether you’re employed or not) that offers a complete suite of diversified index funds at the lowest-possible prices. Such a program already exists in the Thrift Savings Plan for federal employees. Let’s make it available to everyone.

Then, Congress should require that every 18-year-old know the basics of compound interest, investment risk, diversification, debt management and fund expenses. We require that people know the rules of the road and pass a driving test before they get a driver’s license in every state and license everyone from hairdressers to plumbers. Why not require that everyone possesses some essential financial knowledge? Why not consolidate all of the 401(k), 403(b), 457, IRAs, SEP-IRAs, SIMPLEs and Keoghs into one vehicle?

As my contribution to Money Smart Week, which is sponsored by banks and credit card companies, I propose a mandatory standard for financial education. This basic education might do more to end the retirement savings crisis than any number of exposes on 401(k)s.

Somethings to think about when you consider your financial well being and insurance

Insurance product needs evolve in life when circumstances change, simply by age or through events i.e. marriage, buying a home, or having children. The list is endless. Here is a sampling of products and who they likely will help. Please remember this is a general list and every person should consult a professional for specifics for their situation.

The beauty of what I’m doing is I am not confined to a single provider. Once a product is determined to meet your needs we can align the best provider whether it is lowest cost, best riders, or specific terms provided by a specific provider.

Annuities (ages 40 plus) Anyone that has a 401K from a previous employer is also a great candidate

For someone that wants to take market volatility out of the equation. This product has a guaranteed interest rate (higher than a bank CD). It can be used as a single payment premium and annuitized over a particular time period; the remaining unused money is transferred to a beneficiary.   The other option is guaranteed payment for the rest of one’s life (lower monthly annuity payments and upon death payments discontinue) which may be used for someone without a beneficiary.

If applied properly a younger person could use this through ongoing payments into the annuity but illuminate the opportunity for higher growth through equities or funds.

Life Insurance (ages 0-45)

Payout likelihood and cost difference

Both term insurance and permanent insurance use the same mortality tables for calculating the cost of insurance. A death benefit which is income tax free; however, the premium costs for term insurance are substantially lower than those for permanent insurance.

The reason the costs are substantially lower is that term programs may expire without paying out, while permanent programs must always pay out eventually. To address this, some permanent programs have built in cash accumulation vehicles (whole and Universal Life) to force the insured to "self-insure", making the programs many times more expensive.

Other permanent life insurance policies do not have built in cash values (whole and Universal Life). The policy owner may have the option of paying additional premium in the early years of the policy to create a tax deferred cash value. If the insured dies and the policy has a cash value, the cash value is often paid out tax free in addition to the policy face amount.

Insurance industry studies indicate that the probability of filing a death benefit claim under a term insurance policy is low.[citation needed] One study placed the percentage as low as 1% of policies paying a benefit. The low payout likelihood allows term insurance to be relatively inexpensive. Because of the low likelihood of an insurer having to pay a death benefit, term insurance may offer more coverage per premium dollar - by a factor of up to 10.

Life Insurance (50 - 80)

Final Expense

These policies are designed for lower income people who would like to ensure they don’t leave the burden of funeral expense to their survivors. The premiums are usually less than $100 per month but the benefit is capped at $50,000 for most providers.

Whole Life (ages 50-80)

Whole life insurance is a life insurance policy that remains in force for the insured's entire life and requires (in most cases) premiums to be paid every year into the policy. As opposed to Term Insurance in which premiums rise as the client gets older Whole life stabilizes the premiums (usually until age 120) and payments discontinue at 120 years of age and premiums are considered paid in full. There is cash value component to this policy but the cash value portion can be used to reduce premiums. 

Long Term Health Insurance (ages 50-80)

This type of policy covers basic daily needs over an extended time. While health care insurance or Medicare helps pay for immediate medical expenses, say, a surgeon's bill, long-term-care insurance helps people cope with the cost of chronic illnesses, such as Alzheimer's disease, or various disabilities. The policies pay for assistance with everything from the basics — bathing and dressing — to skilled care from therapists and nurses for months or even years.

If someone has assets they would like to keep intact for following generations this is a good policy. This would alleviate the necessity to reduce assets to qualify for Medicare / Medicaid while receiving professional assistance.

Prior generations have been very suspect of assisted living arrangements and would prefer spending their final days, months, or years in the confines of their own home. These policies do cover home care or assisted living sites.

Disability Insurance (ages 20 to 60)

Disability income insurance is a form of insurance that insures the beneficiary's earned income against the risk that a disability creates a barrier for a worker to complete the core functions of their work. For example the inability to maintain composure as with psychological disorders or an injury, illness or condition that causes physical impairment or incapacity to work. It encompasses paid sick leave, short-term disability benefits, and long-term disability benefits.[1] Statistics show that in the US a disabling accident occurs on average once every second.[2] In fact, Nearly 18.5% of Americans are currently living with a Disability, and 1 out of every 4 persons in the US workforce will suffer a disabling injury before retirement.

Critical Illness / Dread Disease Insurance with return of premium (ages 20-60)

These policies pay a lump sum payment should someone be stricken with a critical illness or dreaded disease. Terms vary from 10 to 30 years. In the event the policy pays out you still receive your all of your premiums back.   The insurance companies invest the funds over the period you’re covered and the money is returned without interest. The upside is should you require payment it’s there and when the coverage period ends you get the money back

Cancer - Heart - Stroke

Chances of your house burning down: 0.08%

·         Chances of being involved into an auto accident: 4%

·         Chances of developing a critical illness before you are 65: 35%

·         Chances of developing a critical illness before you are 81: 65-70%

Accident insurance with return of premium (ages 20-60)

These policies pay a lump sum payment should someone injure themselves and require medical attention.  Terms vary from 10 to 30 years. In the event the policy pays out you still receive your all of your premiums back.  

The insurance companies invest the funds over the period you’re covered and the money is returned without interest. The upside is should you require payment it’s there and when the coverage period ends you get the money back.

Medicare Supplement Insurance (ages 65 and higher)

A Medicare supplement (Medigap) insurance, sold by private companies, can help pay some of the health care costs that Original Medicare doesn't cover, like copayments, coinsurance, and deductibles.

Some Medigap policies also offer coverage for services that Original Medicare doesn't cover, like medical care when you travel outside the U.S. If you have Original Medicare and you buy a Medigap policy, Medicare will pay its share of the Medicare-approved amount for covered health care costs. Then your Medigap policy pays its share.

Medicare Advantage Plans (ages 65 and higher)

Medicare Advantage Plans, sometimes called "Part C" or "MA Plans," are offered by private companies approved by Medicare. If you join a Medicare Advantage Plan, you still have Medicare. You'll get your Medicare Part A (Hospital Insurance) and Medicare Part B (Medical Insurance) coverage from the Medicare Advantage Plan and not Original Medicare.

Medicare pays a fixed amount for your care each month to the companies offering Medicare Advantage Plans. These companies must follow rules set by Medicare.

However, each Medicare Advantage Plan can charge different out-of-pocket costs and have different rules for how you get services (like whether you need a referral to see a specialist or if you have to go to only doctors, facilities, or suppliers that belong to the plan for non-emergency or non-urgent care). These rules can change each year.

Life Insurance

Term Assurance (annual renewal at potentially higher rates)

Term Assurance provides coverage at a fixed rate of payments for a limited period of time, the relevant term. After that period expires, coverage at the previous rate of premiums is no longer guaranteed and the client must either forgo coverage or potentially obtain further coverage with different payments or conditions. If the life insured dies during the term, the death benefit will be paid to the beneficiary. Term insurance is the least expensive way to purchase a substantial death benefit on a coverage amount per premium dollar basis over a specific period of time.

This product is considered when current income level meets current needs and if one or both (if married and both are working) die the other is left with meeting the ongoing financial needs with less income.

Level term life insurance

Much more common than annual renewable term insurance is guaranteed level premium term life insurance, where the premium is guaranteed to be the same for a given period of years. The most common terms are 10, 15, 20, and 30 years.

In this form, the premium paid each year remains the same for the duration of the contract. This cost is based on the summed cost of each year's annual renewable term rates, with a time value of money adjustment made by the insurer. Thus, the longer the term the premium is level for, the higher the premium, because the older, more expensive to insure years are averaged into the premium.

Return Premium Term life insurance

A form of term life insurance coverage that provides a return of some of the premiums paid during the policy term if the insured person outlives the duration of the term life insurance policy.

For example, if you own a 10 year return of premium term life insurance plan and the 10 year term has expired, the premiums paid by the owner of the life insurance policy will be returned less any fees and expenses which the life insurance company retains. Usually, a return premium policy returns a majority of the paid premiums if the insured person outlives the policy term.

The premiums for a return premium term life plan are usually much higher than for a regular level term life insurance policy.

Providers Offered

Gaurenteed Fixed Rate Annuities

Annuities

Despite historically low interest rates, fixed annuity sales are hitting record setting levels as the demand for transfer of risk guarantees continue to grow.

Sales of single-premium immediate annuities and fixed-index Annuities hit historic heights in 2013, according to recent numbers released by the industry data group, LIMRA. Even fixed-rate annuities (multi-year guarantee annuities, or MYGAs), that typically offer a slightly higher yield than CDs, are seeing a growing popularity as well.

The question for most market addicted investors is "How can this be?" With the 10-year Treasury at less than 3%, locking in these historically low-rate levels makes no sense for growth driven CNBC addicted watchers. These increased fixed-annuity sales certainly isn't due to better sales practices within the annuity industry.

Boomer crazy train

It's common knowledge that our population is getting older and is quickly shifting from portfolio growth goals to guaranteed income and lifestyle type goals. People that are already retired along with the rest of us with retirement in our sights are driving this growing fixed-annuity sales movement and "longevity risk free" income demands. Recent U.S. census projections reveal a tidal wave of "guarantees" buyers. One number that jumped off the page was the projection of people that are 65 or older will grow from 43 million to 92 million by 2060. That is the definition of a trend and these demographic realities can't be ignored by anyone, any company, or any politician for that matter.

Both Washington and the annuity industry are what I call "boomer crazy" because they both know that this demographic along with senior citizens are driving the train. That is a fact. Regardless of current interest rates, people will always need guaranteed income streams that they can never outlive. When a person needs more income right now to maintain or enhance their lifestyle, they aren't going to subscribe to interest rate driven newsletter or try to time rates. When a person is thirsty, they drink. This is a simple correlation that applies to ever growing annuity sales that has no end to this trend in sight.

Are we turning Japanese?

As we all know, Japan went decades with low interest rates, and there is a valid argument that our country may be emulating this type of stagnate rate period. The current easing strategy being implemented by the Fed has no past-tick data to indicate what happens when you print and buy back money simultaneously. Anyone who says they know are just throwing prediction darts. The reality is that rates could stay at this range for a while, and I think a lot of annuity buyers are taking this possibility into account.

The search for the interest rate crystal ball

Many so called experts think they actually have a crystal ball, but we all know that all they have is a neat sphere of glass. It's an obvious conclusion that if rates were higher, annuity pricing and payouts would be better. There's no good answer to trying to time rates, and the only prudent thought would be laddering or splitting annuity strategies to hopefully take advantage of any positive rate movement.

As an example of this rate timing challenge, if you waited 3 years to buy an immediate annuity in anticipation for rates to rise, you need to take into account the 3 years of income that you didn't collect against the higher payout you would receive if rates moved north. What's that break even point? The bottom line is that there is no perfect answer and it's a decision based on each person's specific situation.

What do you want your money to do?

Forget about annuities or any other type of investment, What do you want the money to do ? From that truthful answer, I can tell you if an annuity might be able to contractually solve your stated goal. The only catch is that if the answer is “market growth,” then I will emphatically point out that annuities aren't growth products and they need to stay in the non-annuity market. Even though the majority of annuities sold (variable and indexed) are pitched under the misguided dream of market growth, the contractual limitations of those policies are real.

By the way, if your answer is growth and income at the same time, then I politely remind you that annuity common sense should prevail and there is no contractual way to pull that off.

Many people are still looking over their shoulder in fear of another market drop. Those market loss scars are permanent with most American's, and the tradeoff of contractual guarantees in lieu of upside opportunity seems to be winning over investors to the fixed-annuity story. Current interest rates might be flashing on financial television network screens, but the ever growing sales of fixed annuities proves that not many people are actually watching or even care.

Providers Offered