The Retirement Crisis: Is the 401(k) To Blame?

Baby Boomers are waking up to the fact that many of them don't have enough money saved for retirement. So what's the cause of this retirement mess? A popular scapegoat is the 401(k) plan. But the 401(k) has little to do with it.

Consider that it's not just Baby Boomer 401(k) plans that are coming up short. Most defined benefit pension plans are also underfunded, just look at the mounting liabilities for public pensions that are estimated at anywhere from $1 trillion to $3 trillion.

So what's to blame for the lack of retirement preparedness? Two things: inadequate savings and risky investment strategies.

In general, you've got to save between 12% and 15% of pay every year if you want some reasonable chance of retiring on an income that is comparable to what you earned prior to retirement. And by every year, I mean every year from ages 25 to 65. It takes about 40 years worth of savings, not just a couple of years.

The 401(k) plan is basically a pre-tax savings account. And in fact, it allows most people to save plenty of money for retirement, if they choose to do so. With the 401(k) contribution limit at $16,500, that means anyone who makes $110,000 a year can save 15% of pay in their retirement plan. And if you're over age 50, the limit is $22,000, so that means anyone making up to $146,600 can save 15%. That basically covers more than 90% of all employees. So just about everyone can save enough for retirement using only their 401(k) plan.

But, people just don't save enough. The savings rate in the US is about 5%, and was as low as 0% a few years ago. This country hasn't saved 12% of pay since the early 1970s. So for almost 40 years we've been under-saving, and that's the main problem.

You see the same issue with public pension plans. Some have contribution levels that are too low, and others have adequate contribution requirements, but they just don't make them. And most have contribution cycles that are too short, allowing people to retire after 25 or 30 years of service. It takes a good 40 years of consistent contributions at the 12% to 15% range to accumulate sufficient assets for retirement. So the funding cycle for many public plans is 25% too short.

Secondly, most people take too much risk with their retirement money. They invest almost all their funds in equities and then are shocked when 50% of their savings disappears with each financial crisis. As they say, fool me once, shame on you, fool me twice, fool me three times ... now who's to blame? If people were more conservative with their money, they wouldn't see their life's savings evaporate every few years. Yes, there would be declines in bear markets, but they would be modest and manageable.

• But if you're more conservative, it means you have to assume a lower long-term rate of return, which means you have to save more to reach your goals. And since most people don't want to save more, they try to make up for low savings by taking more risk. That's not a good strategy for retirement security.

You see the same issue with public pension plans. Many of them have stock and equity investments in the 70% to 80% range. Well, if the equity markets can fall 50% at any time, even if you're 100% funded this year, you could find yourself only 60% to 70% funded after the next financial crisis. By the way, if public pension plans were more conservative with their investment strategies, then they too would have to use lower assumed rates of return, which would drive up their contribution rates, and nobody wants to face those numbers.

Accumulating enough assets for 30 years of retirement leisure takes a lot of money, and that money should be managed more conservatively. Not too many people want to face those facts.

Bottom line. Saving more and taking less risk is the formula for a more secure retirement plan.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.

Above material does not constitute investment or tax advice. Consult your individual financial advisor prior to making any financial decisions.

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