What's Wrong With The 401(k)?

Over the last year, there have been lots of people complaining about the 401(k). Academics and policy makers lament the fact that the 401(k) isn't providing people with the foundation for a secure retirement. Well, it's true people aren't prepared for retirement, but the 401(k) has nothing to do with it.

You only need to look at one statistic to know why Americans aren't positioned for a secure retirement and that's the savings rate. The savings rate has been on a steady decline since the early 1970s, when it stood at about 11% and then hit an all time low of 0.8% in 2005. The savings rate today is about 5.8%, and for most of the last decade has hovered around the 1% to 3% range.

• And that savings rate doesn't really mean the money is being invested for retirement. It just means it's not being spent, and much of the savings lately has gone to debt repayment, not investments. In any event, the savings rate is anemic and has been so for over 30 years. That's why people aren't prepared for retirement.

No matter what kind of retirement system you have, if you don't put any money into it, there won't be any money available to support you when you want to stop working. In general, for any retirement plan system to provide a reasonable level of retirement security, you must save about 12% to 15% of pay every year for about a 35 to 40 year working career. If you're putting in less than that, or for a shorter period of time than that, then don't expect to be able to retire on an income that is anywhere close to the income you were making when you were working.

• Here's the basic formula:

Save 12% to 15% of pay + 40 Years = Retirement Security

If you violate either one of those fundamental requirements, there won't be enough money in the plan to provide for a secure retirement. It doesn't matter whether the money goes into a 401(k), profit sharing plan or a defined benefit pension plan. That's why you're also seeing many public and private pension plans with so many funding problems. They weren't putting enough money into the plans and they weren't making contributions for a long enough cycle.

• Allowing someone to fully retire after 25 or 30 years with an employer isn't enough. Because of the volatility of financial returns, and the fact that people generally earn more in their later years of work, you really need about 40 years of contributions into a retirement plan.

It's important to note that the 401(k) itself is just a tax provision that allows employees to save money for retirement on a pre-tax basis, and gives employers a convenient way to match employee contributions or make additional contributions at their discretion. It's a good idea, and works great if you adequately fund it.

If you only save 3% of pay, as American had been doing for the last decade, then expect that you'll have a retirement plan that will be able to replace about 15% of your wages. So unless you can live on about 1/6th of what you're making, you need to increase you're savings rate.

We need to start giving people the real numbers for retirement savings and stop sugar-coating the figures. When we do things like automatic enrollment at 3% of pay or encourage people to open automatic IRAs with tiny contributions, it really doesn't do them much good. Often, people think that the default amount is the correct amount for their savings goal, and in fact, it's completely deficient.

I think the biggest frustration people have with the 401(k), or retirement systems in general, is that employers are no longer taking on the responsibility to pay you for 25 or 30 years after you stop working for them (which is essentially what it means to guarantee someone a retirement income). That's just the way it is. And in reality, the era of corporate sponsored retirements was actually quite short. It spanned about 30 years, from 1950 to about 1980. For the most part, companies completely underestimated what it would cost to assume this liability for you. Once they figured it out, they gave it back to you.

Those are the facts, and the quicker you come to terms with the costs of funding your own retirement, the better the odds are that you'll take the steps necessary to do it. If you're hoping someone else will take on this responsibility for you, it's unlikely to happen.

Bottom line. If you only work on one thing over the next several years, it should be to increase your savings rate.

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.

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