More Workers Ignoring Savings Benefits of 401(k)s
A disturbing trend has emerged 30 years after the launch of the 401(k): Fewer employees are using them.
The accounts, named after the Tax Code section that authorizes them, allow workers to set aside their own money for retirement. Companies normally help by “matching” worker contributions -- most often kicking in 50 cents for every $1 contributed by the employee, according to a survey by Hewitt Associates.
Over the last two decades, the plans have become ubiquitous, with about 90% of large companies offering them. But surveys have found that the percentage of eligible employees contributing to the plans has been sinking.
A recent survey by Fidelity Investments found that 66% of those eligible were saving through the plans, versus 68% a year ago. In the last six years, participation rates have fallen by nearly 10 percentage points, according to Fidelity, which as a plan administrator has a glimpse of what people do, rather than what they say.
Other studies have revealed the same trend, although a recent report by the Employee Benefit Research Institute has found that the rate of participation appears to have leveled off.
Why are so many workers choosing not to take part? Some experts believe that investors are too worried about the stock market to contribute, even through an employer-sponsored plan. Some blame residual economic distress from the recession -- previously unemployed and underemployed people feeling the need to catch up on bills before starting a savings plan.
Others believe that the financial scandals of the last few years may have taken a toll, particularly now that securities regulators are scrutinizing the fees within 401(k) plans. Finally, some speculate that the lower figures reflect a greater number of young people coming into the workforce -- and they are less likely to save for retirement.
Nonetheless, a decision by employees not to participate is foolhardy, said Don Cassidy, senior research analyst with mutual fund research firm Lipper Inc. in Denver.
“Even the government is starting to break the veil of silence about the fact that Social Security is underfunded and what it might mean,” Cassidy said.
“You can’t rely on your employer to provide a pension; you may not get as much from Social Security as you might think. People have to save for themselves.”
Even though 401(k) plans can have shortcomings, they are generally the most effective way for most workers to save, he added.
The plans offer tangible benefits. Contributions to 401(k)s are taken out of workers’ paychecks before taxes are computed.
For someone paying 30% in federal and state income taxes, that means each $100 contributed costs only $70 (the amount put in minus the $30 in taxes he or she would ordinarily have paid on that income). The employee doesn’t have to pay tax on the 401(k) contributions -- or on investment earnings accumulating in the account -- until he or she retires and begins to withdraw the money.
Additionally, most companies match worker contributions, kicking in a percentage of every dollar contributed by the employee. The match rate varies from 25% to 100%. The most common match is 50% of as much as 6% of the worker’s pay, according to Hewitt Associates. From the employee’s standpoint, that matching amount is free money. And the effects of the match and tax-free compounding are tremendous over time.
The benefits are particularly dramatic for younger workers. Consider a 25-year-old earning $50,000 a year whose employer matches 50 cents for each $1 she contributes to the plan. Assuming she’s also paying 30% of her income in tax, each $100 she saves is really costing her only $70, but with the employer match she builds a $150 nest egg. That generates a 114% investment return -- before she even invests her savings.
This same worker opts to save 6% of her salary, or $250 a month ($3,000 a year). Her out-of-pocket cost is $175 a month; but because of the employer match, her nest egg increases by $375 each month. And let’s say she earns an average investment return of 7% with a diversified portfolio of stocks, bonds and cash within the plan.
(Incidentally, that’s a conservative guesstimate. Average annual returns on diversified portfolios range from about 8% to more than 9%, according to Ibbotson Associates, a Chicago-based market research firm that has tracked investment performance since the mid-1920s.)
Over the course of the employee’s 40-year career, the 401(k) plan contributions reduce her take-home pay by $84,000. The net result: She retires at age 65 with almost $1 million in her 401(k) -- $984,305 to be exact -- a nest egg nearly 12 times the amount she put in.
Moreover, that calculation assumes the worker keeps her contributions at $3,000 a year. Typically, employees boost their contributions as their incomes increase over time.
That million-dollar nest egg is big enough to generate $39,372 in annual income at a 4% return -- without touching the principal -- forever, essentially. If the worker wants to start spending down the principal, she can have an income of $4,114 a month, or $49,365 a year, until she’s age 105.
What if you need money before retirement? Most big-company plans let workers borrow as much as half the account balance or $50,000, whichever is less, for major expenses such as buying a house or sending a child to college. Some advisors warn of drawbacks in borrowing from a 401(k), but the main thing to remember is that you do have access to the funds.
What if the investment options within the plan aren’t as good as those you could choose elsewhere? If the company’s 401(k) matches employee contributions, it is still likely to be the best choice, Cassidy said.
“With the exception of the Enron model, where you have no choice -- they give you company stock and you can’t sell it -- you should probably still take it,” he said. “In a worst case, put your money into the money market fund. If you have a company match, you still get a 50% return.”
Kathy M. Kristof, author of “Investing 101” and “Taming the Tuition Tiger,” welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof @latimes.com.
