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Pension choices not what they seem

As 401(k)s replace the traditional pension, politicians have given investors more ways to save. The problem is most people can't afford to take advantage of them.

By Washington Post
May 12, 2002


This is the year American workers go on a retirement-investing binge. At least that's what political leaders hope.

Lawmakers laid the groundwork with last year's tax bill, raising the amount of money employees can stuff into their tax-deferred retirement plans each year. Then, recognizing baby boomers are rounding the corner on retirement, they added a "catch-up" privilege, an extra amount workers 50 and older can set aside each year. And they authorized a limit that gets higher each year over the next six, to heights unimagined when the plans were invented in the late 1970s and early '80s.

A young worker's maximum contribution to a standard company-sponsored 401(k) plan has risen to $11,000 this year. And the allowances keep growing so that, as of 2008, a working couple who exploit every plan and catch-up provision open to them -- including individual retirement accounts -- might be able to stash more than $50,000 in tax-deferred accounts in one year.

So what's wrong? Well, a few things. Some fairly well known, others buried in the fine print.

First, many workers can't afford to save anything close to the new limits. A November study by the Employee Benefit Research Institute showed the average 401(k) balance for workers in their 40s is only about $62,000.

Congress tacitly acknowledged this by including in the 2001 bill a tax credit for lower-paid workers to help them contribute to a retirement plan. The credit can be as much as 50 percent for contributions up to $2,000, but it expires after 2006.

Second, older employees may take advantage of the catch-up provision only if they already were contributing to their plan's limit. Lori Shapiro of Mercer Human Resource Consulting in Philadelphia says her firm's reviews for various clients have found many workers who don't meet that test.

And third, although it's rarely explained this way, the legislation is merely an invitation to employers to consider the new limits. Not all will allow employees to take advantage of the higher maximums.

There are legitimate, complicated reasons for all these stumbling blocks, but ultimately many working Americans are no closer to restoring the balance in the traditional three-legged stool of retirement planning than they were before the 2001 tax bill. The elements of this trusty piece of furniture were supposed to be (1) Social Security, (2) a company pension paid out of money the company set aside for the purpose and (3) a worker's own savings.

The first leg, Social Security, is still standing, though shuddering a bit as its guarantees are pecked away at -- ever-higher taxable income, a raised retirement age, taxation of some benefits, etc. And there are proposals to convert at least a portion of Social Security to individual investment accounts that, like 401(k)s, would depend on investment performance.

All the lettered and numbered savings plans blessed by Congress -- the 401(k)s, 403(b)s, IRAs, SEP-IRAs, Keoghs -- arguably were intended to bolster the second leg, workers' savings, needed for an ever longer and more expensive retirement. But in the short span of 20 years, these company-sponsored plans, made up largely of a worker's own cash, have been nudged over to bolster or even replace the third leg of the stool. Instead of rewarding thrift in employees, they have enabled companies to ditch or severely curtail traditional pension plans.

Look, Ma, a three-legged stool with only two legs!

* * *

The adequacy of retirement saving has received new attention after the collapse of Enron Corp., which wiped out the retirement accounts of thousands of the energy giant's workers and retirees.

The political focus since has been largely on protecting workers from such disaster by allowing them to invest in stocks other than their employers'.

It's become obvious, though, that the more important question is the teetering retirement stool -- not whether workers have too much employer stock but whether they have enough money in their plans at all.

Data on the size of workers' retirement savings -- 401(k)s, IRAs and IRA rollovers -- are scarce, but the information available suggests many people have reason to worry.

Forty-four percent of 401(k) balances in 2000 were less than $10,000, according to EBRI, the benefit research institute. Ranking second, at 14 percent, was the $10,000-to-$20,000 category.

The low balances are important because of Americans' increased reliance on these plans, which appeal to employers because their costs are predictable and the investment risk is shifted to the employee.

Such plans differ greatly from traditional pensions, in which the plan typically promises a lifetime stream of income to retirees based on their wages and years with the company. In these "defined benefit" plans, the employer contributes money to a professionally managed investment fund -- and promises to make up any shortfall resulting from poor investment performance.

If the 401(k) is a worker's primary pension plan, the worker must live in retirement on whatever it contains, plus Social Security and any personal savings. So if a worker fails to contribute to the account, or the investments do poorly, there's a risk of running out of money in retirement.

And that appears to be happening, according to a study released last week by the liberal Economic Policy Institute. This study, by New York University economics professor Edward Wolff, found the "retirement wealth" of all but the wealthiest workers nearing retirement (households headed by someone between age 47 and 64) declined between 1983 and 1998.

Wolff had expected the shift to 401(k) and related retirement plans from traditional defined-benefit pensions, combined with the stock market boom, would have left today's pre-retirement workers "far ahead of those of 15 or 20 years ago," he said last week. Instead, most such workers lost ground in the 1990s.

The one group that gained was workers with a net worth of $1-million or more. Even those worth between $500,000 and $1-million fell back, he said.

"The people who benefited most from the switchover from defined-benefit plans were those who were already wealthy," Wolff said.

The picture may not be as bleak as the numbers suggest, however.

The EBRI findings reflect only active 401(k) accounts, according to Jack VanDerhei of Temple University and the institute. If a worker did very well with a 401(k) at a previous job and rolled the balance over into an IRA, that money doesn't show up in the data.

David Wray, president of the Profit Sharing/401(k) Council of America, said Wolff's methods tended to overvalue traditional pensions and undervalue 401(k)s. And he said Federal Reserve figures show that total retirement savings climbed almost 60 percent between 1995 and 2001, most of that in 401(k) and similar plans and IRAs.

But clearly the EBRI average represents a lot of people, which suggests big problems for many 401(k) participants, especially older ones who have fewer years left during which to invest.

If a 45-year-old worker has $62,000 in his account and contributes $5,000 annually before retiring at 65, he'll end up with about $600,000 if he can achieve an annual return of 9 percent.

And with the new limits, a 50-year-old worker could invest far more, assuming he could afford it and his company would allow it. Investing the maximum, experts at the big Baltimore-based mutual fund family T. Rowe Price figure, a single 50-year-old starting from zero could pile up $700,000 by age 65.

That sounds like a lot. But consider this: Suppose a person retires with a $600,000 nest egg and decides he needs $3,000 a month to live on and wants to maintain that level of buying power (meaning he will withdraw increasing amounts to keep up with inflation). If he lives 20 years, to age 85, he has about a 3-in-10 chance of running out of money, according to calculations devised by T. Rowe Price.

The retiree could, of course, get a better investment return than T. Rowe Price expects, spend less or die earlier. If he dies after 15 years, at 80, he has a 99 percent chance of not exhausting his account. But is that what we call retirement security?

If 401(k) plans were used as originally intended, as a mechanism to supplement private savings, it would be. A worker with a traditional pension, Social Security and a $600,000 401(k) plan likely would make out very well.

But the numbers show that a retiree without a traditional pension is at risk. First, can he accumulate $600,000? He must make the contributions and get the investment returns. Then there's the question of how well the stock market will do in the coming decade. If the market reverts to its long-term average, there could be years of very modest returns.

The post-Enron bills now in Congress don't really address these problems, except for a measure intended to encourage companies to offer traditional pension plans. That bill, sponsored by Sen. Edward Kennedy, D-Mass., would give companies with traditional plans more freedom to use their stock in 401(k) plans.

Most of the other changes required by the bills involve giving employees more investment latitude and advice -- then hoping they make good use of it.

Under most bills, employers would be limited in the restrictions they can put on company stock they contribute to workers' accounts. Enron required workers to hold such shares until they reached age 50, and many other companies have similar requirements. But at Enron and most other companies, workers are free to sell employer stock they buy with their own contributions at any time -- but often they do not, loading up instead on company stock.

The bills also encourage employers to provide investment advice to workers. The House measure has been criticized because the employer could use an adviser that does other work, such as investment banking, for the employer. As for the rules written last year, some aspects, especially for the catch-up provisions, are very complicated, and some companies are balking.

Where does all this leave working Americans? With many new and improved ways to save money for the future -- more pockets than most people have money to fill them.

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