Reality About 401(k)s

by Don Boudreaux on January 19, 2009

in Reality Is Not Optional

Duquesne University economist, and Mercatus Center scholar, Antony Davies has this spot-on letter in today's Wall Street Journal:

In the article "Big Slide in 401(k)s Spurs Calls for Change"
(page one, Jan. 8), 35-year-old project manager Kristine Gardner says
in response to the 44% drop in her 401(k) last year: "There's just no
guarantee that when you're ready to retire you're going to have the
money." Newsflash: Higher returns are the compensation for incurring
risk, and lower returns are the price of safety. Ms. Gardner's 401(k)
would have been completely safe had she shifted her investment
allocations into money markets. As money markets yield a paltry 1%, Ms.
Gardner's real complaint isn't that 401(k)s are unsafe, but rather that
financial markets require her to incur risk in exchange for being
compensated for incurring risk.

Retirement consultant
Robyn Credico claims that "This is the biggest test that the 401(k)
plan has seen . . . and it has failed." Au contraire, 401(k) plans have
worked exactly as designed. It is the workers (and their retirement
consultants) who have failed. There is only one reason why the average
person close to retirement should have lost 50% of his 401(k):
incompetence. Most workers at that age should have long since shifted
the bulk of their 401(k)s into bonds and money markets. The 401(k) is a
powerful investment tool but can be dangerous when abused.

If you aren't willing to
put forth the effort to learn the principles of investing, that's your
choice. But don't hobble the rest of us by asking for government
regulation of a tool that works perfectly well just so that you can be
spared the effort of figuring out how to use it.

Antony Davies, Ph.D.
Associate Professor of Economics
Duquesne University
Pittsburgh

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{ 24 comments }

Randy January 19, 2009 at 7:43 am

I have no problem with the risk, I do have a problem with the early withdrawal penalties. The 25% penalty would have made it practically impossible to get the money out of my Simple IRA if I hadn't been able to use if for college tuition for my daughters. I don't think there should be any tax penalties for early withdrawal, but 25% is plain extortion.

geoih January 19, 2009 at 8:22 am

"If you aren't willing to put forth the effort to learn the principles of investing, that's your choice."

And there is the crux of the matter. Too many people have no desire or intention of learning anything about investing, let alone long-term management of their basic assets. They believe that they shouldn't have to. That all they really should have to do is go to work and then walk away to retirement when they're 55.

If the free market can't supply that without any effort from themselves, then have the government take it over. That is what they will vote for.

They'll say that it isn't fair that some people are still making money in the markets when so many other people aren't.

How long do you think it will be before we see 401(k)'s nationalized? Prof. Davies success will be collectivised along with all successes observable by the state.

Martin Brock January 19, 2009 at 8:28 am

Davies' analysis obscures what's really happening with talk of financial abstractions. Short-term paper with low yields may be intrinsically "safer" for other reasons, but money markets are safe largely because states sell entitlement to tax revenue, like T-bills, in these markets.

Ms. Gardner's real complaint is one I hear occasionally in this forum, that the Fed is "keeping interest rates too low" by paying dearly for T-Bills in open market operations. If the Treasury didn't sell so much entitlement to tax revenue into this "markets", demand for "safety" might keep the T-bill rate even lower, and if demand for future entitlement to consume were very high, as it is now, we'd accept even lower rates for even higher risk on genuine market securities. As a libertarian, this outcome is exactly what I want.

Some securities may be safer than others, and the "safer" securities may yield less, in theory, but there are no "safe securities" yielding anything other than entitlements to tax revenue, and even these entitlements offer only a nominally "safe" yield.

Real yields are very low at this time, because an unprecedented proportion of the population expects to retire for an unprecedented period of time. Unless states simply impose suffocating rents on the relatively dwindling population of taxpayers, real yields will remain low, because productivity does grow at an arbitrarily high rate simply because people want greater entitlement to consume.

Martin Brock January 19, 2009 at 8:38 am

They'll say that it isn't fair that some people are still making money in the markets when so many other people aren't.

Davies doesn't say here that anyone is making money in the markets at this time. His "paltry 1%" in "money markets" isn't making anyone any money, really, because the rate of inflation is much greater than 1%, regardless of a few months of falling fuel prices following an even greater rise in these prices. So you can lose value gradually in the "money markets", or you can lose it quickly in shares. That's where we are right now. If you want to make loads of money, have Dubya contract for some munitions you're building.

Martin Brock January 19, 2009 at 8:40 am

Correction: productivity does not grow at an arbitrarily high rate simply because people want greater entitlement to consume.

John Dewey January 19, 2009 at 8:50 am

geoih: "If the free market can't supply that without any effort from themselves, then have the government take it over."

The free market does exactly supply investments by which a worker can put money away for 30 years or for 40 years and then walk away to retirement. The income available in retirement is dependent on:

1. the amount the worker puts away each year;

2. the number of years the worker contributes;

3. the risk the worker decides to assume.

Only a very limited knowledge of investment choices is required, and the free market provides counseling for those who lack that knowledge.

Free markets will always require some effort from adults to acquire knowledge of their options and will always require that adults remain aware of their financial situation.

I find what you suggest, geoih – that government must become a nanny and bottle-feed adults who refuse to grow up – to be somewhat insulting and disgusting. Surely you don't mean that.

geo January 19, 2009 at 8:52 am

maybe she needs a bailout…quick add her to the list

John Dewey January 19, 2009 at 8:59 am

geoih: "How long do you think it will be before we see 401(k)'s nationalized?"

Only after they pry this gun from my cold, dead fingers.

They chance that elected officials in the U.S. will confiscate and "manage" all the savings of Americans is zero.

Nobrainer January 19, 2009 at 9:11 am

This provides some ammunition against the idea of enrolling all new employees in such programs by default.

The role 401(k)s and other government crafted retirement plans could be a good topic for many future Cafe Hayek posts. If government actions helped to cause recent housing problems by perhaps encouraging unknowledgeable people to buy houses, it should not be unexpected that encouraging unknowledgeable people to buy stocks and bonds will cause problems.

Martin Brock January 19, 2009 at 9:22 am

The income available in retirement is dependent on:

This list of dependencies is not very instructive under the circumstances. The yield of a real means of production is inversely proportional to its price. The price depends upon the demand for entitlement to these yields relative to the supply of this entitlement. Risker investments that actually yield something return more than less risky investments, but when demand is very great, all yields are lower. Riskier investments yield less, and less risky investments yield still less.

Furthermore, this analysis of "risk" vs. "yield" over "time" leaves naive investors with the impression that they can expect high yields "in the long run" by investing long enough in the riskiest assets with the highest yields. This logic is nonsense. The riskiest investments have a negative expected yield, even if a few of these assets return very great yields.

Investors don't earn high yields by holding risky assets for a long time. They earn a high yield by choosing particular assets that turn out to have a high yield, and there is no simple formula for making this choice. If there were a simple formula for choosing high yielding investments, other than being close to statesmen channeling vast entitlements with their mighty pens, market efficiency would soon drive its price up and its yield down.

Martin Brock January 19, 2009 at 9:30 am

… it should not be unexpected that encouraging unknowledgeable people to buy stocks and bonds will cause problems.

I agree, but this assertion begs a question. What is the source of the "knowledge" one needs to buy stocks and bonds? If I take a course in economics from Russ and Don, will I possess this knowledge? If I let a flat on Wall Street and sit around the NYSE every day, will I gain the knowledge? If I follow every rumor of the next gold rush, will I find the knowledge? Can I ask Bill Gates or Warren Buffet? Do they know?

John Dewey January 19, 2009 at 10:05 am

Martin Brock: "Investors don't earn high yields by holding risky assets for a long time. They earn a high yield by choosing particular assets that turn out to have a high yield, and there is no simple formula for making this choice. "

Oh, I very much disagree. Just look at the returns since the 1970's for a few Vanguard funds:

Prime Money Market Fund: 6.35%
Long-Term Investment-Grade Fund: 8.5%
500 Index Fund: 10.03%

The relartionship between risk and return is very clear. Unsophisticated long term investors can choose the level of risk and return they deem appropriate.

Investing in an S&P index fund for the long run requires only a very simple formula.

Of course, if you are being completely unrealistic – if you define "high yield" to be a 16% or 20% annual return, for example – then your are correct. There is no simple formula.

Martin Brock: "market efficiency would soon drive its price up and its yield down"

Perhaps we disagree about what "risk" means. The relatively short term variation in returns is what allows an S&P Index fund to continue to outperform bond funds and money market funds. The long term investor earns those higher yields because the short term investor requires them in order to accept the short term variation in returns.

persiflage January 19, 2009 at 10:07 am

geoih: "How long do you think it will be before we see 401(k)'s nationalized?"

Dewey: Only after they pry this gun from my cold, dead fingers.

A high level of caution is necessarily in order when folks like Gov. Corzine of NJ (among others with like sentiments) have stated that the 401(k) is "government welfare for the rich". IOW, your self-funded, self-managed retirement account contains money that rightfully belongs to the government, according to such newspeakers. It's government "welfare". And all these years you thought it was your retirement savings…

Chris January 19, 2009 at 10:08 am

If Davies were talking about IRAs, I would completely agree with him because I have the power to invest my IRA in a billion different ways.

401(k)s, though, are a poor cousin to IRAs because the number of investment options can be very limited. At my current employer, for example, EVERY 401(k) option (including those primarily invested in bonds) lost money over the past six months. There simply was no place to diversify into.

Martin Brock: here's the course: (1) diversify — invest over a broad range of industry and asset classes. (2) As you get older or closer to your need for money, you should move money into "safer" asset classes. (3) Cash is "safest," but is susceptible to inflation, then T-bills, money-market, corporate bonds, corporate stock, options and other derivatives. (4) make sure you have good insurance to cover risks that your investments can't. (5) Pay as few fees or commissions as possible — investing is a game where a 1% fee makes a huge difference over the long haul.

John Dewey January 19, 2009 at 10:42 am

persiflage: "A high level of caution is necessarily in order when folks like Gov. Corzine of NJ (among others with like sentiments) have stated that the 401(k) is "government welfare for the rich".

First, I don't think that the governor of NJ can change the laws of the U.S. Congress, so I'm not very concerned about statements he makes.

I also don't think Gov. Corzine has said anything as politically stupid as calling for the nationalization of existing 401K's. That's the future geoih was implying, and which I claimed has zero chance.

Congress could eliminate 401K's as a future savings vehicle, but I doubt that will happen. 401K's are simply far too popular.

Jeff Albertson January 19, 2009 at 11:14 am

What Chris said about IRAs v 401ks. I have a modest 401k that I've always kept in money-market mode, usually earning about 3-4%. When the return dipped below the "official" inflation rate, I started to look at the six other funds available, including bond funds (PIMCO). At that time all the other options were closed to new investments. It was then being managed by a bank that has since folded and I'm not even sure whats happening to it now, other than my last statement showed a 1.2% return and all the other options were large negatives between -8 and -21%. It was suggested that I move this into an IRA that I could more effectively manage. (I didn't do this, because I can withdraw without penalties in about two years, when I'm 61.)

401k's are a mug's game. You should talk to any financial advisor about moving these funds into an IRA without incurring penalties, but the options are designed to be limited and depend upon employment status and age. Ordinary 6mos and 1yr CD's are by far the best choice for the risk-averse right now, some in the neighborhood of 5%, although I expect these rates to also dwindle in the next couple of years to between-the-mattresses rates, and in fact I'm already trying to hold more cash and boxes of ammo, the ultimate hedge.

John Dewey January 19, 2009 at 11:44 am

Jeff Albertson: "other than my last statement showed a 1.2% return and all the other options were large negatives between -8 and -21%"

S&P 500 index funds are found in many if not most 401K plans. S&P index funds have lost 37% the past 12 months. But their returns over 30 years have been significantly higher than those of money market and bond funds. Over 30 years, that difference in returns can mean hundreds of thousands of dollars additional accumulation.

Jeff Albertson: "401k's are a mug's game"

Perhaps some are better-designed than others.

Over the past 25 years many of us who invested our 401K's in equity funds have easily accumulated $500K or even $1 million in savings. And that's even after factoring in the 2008 stock market decline.

The undeniable advantage of most 401K's is the comapny match. In most companies the match amounts to a couple of thousand $ a year. That's free money an employee just gives away if he opts to forego 401K's.

Mesa Econoguy January 19, 2009 at 11:57 am

While I agree with the sentiment of the letter, a few points require correction or clarification.

Ms. Gardner's 401(k) would have been completely safe had she shifted her investment allocations into money markets.

This statement is only partially true, as we have seen, several MMs have “broken the buck” i.e. had their NAV slip below the benchmark $1/shr level, mostly as a result of exposure to Lehman (or similar) debt. Whether or not any 401ks had exposure to this was plan-dependent. So not even traditionally "safe" investments have been spared risk exposure in this incredibly violent capital markets environment.

Also as noted by several folks above, the scope of investment funds available to 401k investors is usually quite limited, often 5-10 fund choices only. Because IRAs lack any such constraint, they are a far more flexible vehicle, and can now make limited use of options (for income or insurance).

I do completely agree here:

But don't hobble the rest of us by asking for government regulation of a tool that works perfectly well just so that you can be spared the effort of figuring out how to use it.

Or, in my case, don't steal part of my paycheck to fund a redistributionist asset pool(Socialist Security) and force me to incur subpar returns.

geoih January 19, 2009 at 12:59 pm

Quote from John Dewey: "I find what you suggest, geoih – that government must become a nanny and bottle-feed adults who refuse to grow up – to be somewhat insulting and disgusting. Surely you don't mean that."

I was speaking figuratively and for the masses who have elected our soon to be president (and most of those who voted for the other guy, too).

MnM January 19, 2009 at 1:05 pm

I agree with Mesa, with one small point of contention.

"Ms. Gardner's 401(k) would have been completely safe had she shifted her investment allocations into money markets."

Nothing about this statement is true (that is, if I've understood his meaning properly). Any changes you make to your investment allocation are only on investments going forward. They don't affect anything retro-actively.

John Dewey January 19, 2009 at 1:54 pm

geoih at 8:22 AM: "If the free market can't supply that without any effort from themselves, then have the government take it over. That is what they will vote for."

geoih at 12:59 PM: "I was speaking figuratively and for the masses who have elected our soon to be president "

I'm still assuming that you are referring to 401K's, which was the subject of this blog.

What is the basis for your claim to be speaking "for the masses"? You say that "they" will vote to have the government take over their 401K's. Can you offer a poll result showing that 401K investors wish their 401K's to be taken over?

What do you mean when you say your are "speaking figurateively"? that the government will not take possession of our 401K savings but instead will take away any choices we have about how those funds are invested? If you are going to speak figuratively, then the burden is on you to be clear enough that your words are not misinterpreted, geoih.

John Dewey January 19, 2009 at 2:14 pm

Only a few employers have eliminated the company match for 401K contributions. Most are finding ways to continue this form of employee compensation.

A 2006 Deloitte Consulting study found that:

"The average matching formula is 68% of the first 6% of employee wages"

A young engineer earning $60,000 would lose $2,448 in compensation if he chose to forego his company's 401K plan in favor of an IRA.

Even if IRA's are "far more flexible", as Mesa Econoguy suggests, it is unclear to me how this flexibility would offset the loss of the employer match.

Many financial advisors suggest saving with a 401K up to the level of maximum company match. Any "financial advisor" who suggests otherwise may not be focused on the client investor's best interest.

Val January 19, 2009 at 2:19 pm

I am a financial advisor, and provide advice to participants in about 20 401k's.

In response to the comment on people losing money because investment options were too few, well, please show me a properly diversified portfolio of any investments that didn't. Gamblers who bet it all on the very few asset classes that managed to end 2008 in positive territory were just that: Gamblers. No place for that in retirement planning. On the flip side, those who have heavy positions in bonds or money markets and have a medium to long term investment horizon, will not generate enough return to fund their retirement (in all likelihood). Numerous studies have been done to assess the performance of market timers, and the results do not favor those individuals. So, a properly diversified portfolio without trying time the market is the way to go. Most 401k's now offer single investment funds of funds that are managed according to the participant's time line, and change allocation models as they approach retirement. These offer an ideal portfolio for just about any investor to set up and maintain.

The problem that I see over and over again is people who watch the business shows, read newsletters, and listen to their friends, and are always chasing return. These people lose often, especially this last year, and they blame it on the market, or Wall Street greed, or President Bush, or… Well, anything but themselves. Many of them sell out near the bottom when their fear is greatest, and buy when they feel comfortable again, usually after most of the rebound has occurred. Or they stay in cash, which kills their return and thus their retirement. And did I mention they never, ever, listen to the financial professional?

In response to the first commenter: Your SIMPLE IRA only has a 25% penalty for the two years from the date of your first contribution. After that it is 10%. There is a very good reason for the penalty. Without it, people like to use their IRAs as bank accounts, which defeats the purpose. It also makes reporting vastly more time consuming than it already is, which increases costs. If you thought that college planning was a priority, you should not have been contributing so much to your SIMPLE; there are other, better vehicles for this, including numerous 529 plans. Please don't excuse your planning mistake by blaming reasonable rules.

Baughman January 19, 2009 at 2:40 pm

Amen!!!!

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