Government Guarantee For Your 401(k) Is a Bad Idea

(MoneyWatch)  The New York Times recently ran an editorial on the problems they see with 401(k) plans, and suggested a solution to our retirement challenges would be some sort of government guaranteed return on our 401(k) plans. While it sounds nice, a guarantee would actually create more risk in the financial markets.

Moral Hazard. If the government were to guarantee a positive return on your retirement money, it would create a massive moral hazard for indiscriminate risk taking in the financial markets.

• Before this recent crisis, it was no secret that the stock market can decline 50 percent without warning. It happened in 2000, in 1973 and during the Great Depression. Plus, we've had many declines in the 20 to 30 percent range over the years.
• Yet in the face of such big declines, people still loaded the boat on stocks in their retirement plans.
• So if you remove the risk of loss from your stock holdings, people will pump even more money into stocks. Why not? You get the gains and don't get the losses.

Wall Street Bonanza. Moreover, this type of guarantee would unleash a stampede of risk taking by Wall Street. They would be busy marketing all kinds of risky ventures to retirement plan investors because everyone wins and no one loses. That would be a goldmine for investment firms.

Government Disaster. But Wall Street's gains would eventually become a government disaster. If you guarantee returns in the stock market, it will create incentives to fund all kinds of businesses and ventures that shouldn't otherwise be funded. And when they eventually collapse, the government will be left to pay the bills.

Risk Imposes Discipline. The only thing that keeps investors rational is the risk of a severe loss. As tough as it is to bear, we need risk in the markets to help us better allocate money.

• When you invest, you're buying an interest in a business and have a right to a percentage of their profits. When profits grow, the value of the business usually grows. And when they decline, the value usually declines. This is roughly how the stock market works over long cycles.
• Risk of loss makes investors cautious, and over time they generally invest in good businesses, which is why over time the stock market generally grows. The good businesses get funded and the bad businesses die.
• If you take the risk of loss out, then you'll fund lots of terrible businesses that can't create profits and our economy will suffocate.

Bottom line. I'm sure the NY Times was well intentioned in their 401(k) proposal, but taking the risk out of investing has no basis in financial reality. Investing involves risk, and risk creates profits that tend to make us all richer. The key to long-term success is learning how to manage risk, not avoid it entirely.