When you're in your 20s, just starting your career, retirement seems a lifetime away. But in the first of a three part series on retirement, The Early Show's financial contributor Ray Martin explains why it's never too soon to start saving.
401(k) Plans Coming Up Short — Make Yours Measure Up
According to a new brief, "401(k) Plans Are Still Coming Up Short," from the Center For Retirement Research at Boston College, a close look at the Federal Reserve's latest Survey of Consumer Finance gives rise to some serious concerns about the role 401(k) plans are playing in providing for the retirement security of American workers.
This report concludes that 401(k) plans today are the main vehicle workers have to create financial security for retirement, but these plans require workers to decide whether or not to join, how much to contribute, how to invest contributions, when to rebalance, what to do about company stock and what to do with these accounts when changing jobs.
The findings in the report indicate that on each of these decisions, a significant proportion of workers make the wrong choices. About 20 percent of workers eligible to join a 401(k) do not do so. Only about 10 percent of workers participating contribute the maximum. Over half fail to diversify their investments by holding no stocks or too much stock. Many participants in plans of large employers over-invest in the stock of their company. Finally, a large proportion of workers cash out their 401(k) plan balances when they change jobs.
What makes the findings in the report so alarming is that over the past 25 years, the roles of providing for retirement income played by pensions and 401(k) plans have seen a dramatic reversal.
In 1983, most workers (56.4 percent) were covered by pension plans and only a small percentage (12.7 percent) was covered solely by a 401(k) plan. In fact, at that time 401(k) plans were viewed mainly as supplements to traditional retirement plans funded solely by employer contributions and workers presumed that their basic retirement income needs were covered by the employer funded plan and Social Security — therefore, 401(k) plans and participation in such plans were largely viewed to be optional.
But today, the roles of pensions and 401(k) plans have reversed: most workers (62.7 percent) are covered by 401(k) plans and only a small percentage (19.2 percent) is covered solely by a pension plan.
Today, workers need to know that their personal savings in a 401(k) plan will be their main source of retirement income with the distributions from such plans providing for their basic retirement income needs. For many workers covered solely by 401(k) plans, avoiding mistakes in such plans is critical to accomplishing financial security in retirement.
To help workers covered by 401(k) plans, the following is a list of the biggest mistakes many workers make with their 401(k)s and some important things to know to avoid these mistakes.
Mistake No. 1: Not participating
According to the report, younger workers are much less likely to participate in a 401(k) plan than older workers. For example, below is the breakdown of the percentage of eligible workers who participate in a 401(k) plan:
20-29: 62 percent participating
30-39: 78 percent participating
40-49: 83 percent participating
50-59: 83 percent participating
60-64: 88 percent participating
All: 79 percent participating
For many young workers just starting off in the workforce, fresh out of school, retirement is probably the last thing on their mind. The most urgent financial issues can be paying off student loans and credit card debt and getting a reliable car. But putting off saving for retirement in a 401(k) plan is not a smart move, particularly since fewer new workers will have any pension plans and Social Security will provide less for them in the future.
The most common excuses given by younger workers for not joining a 401(k) plan include:
Answer: So many people assume that they will only stay in a job for a short amount of time, and therefore they figure they will hold-off participating in the 401(k) plan until they land a more permanent job. The problem with this thinking is that a few months turns into a year, one year turns into two years and so on. What typically happens is that you end up with the employer longer than you thought you would and passed up making any contributions and getting any employer matching contributions into a 401(k) account.
Answer: The truth is that you can't afford not to save for your retirement. Remember, your personal savings in a 401(k) plan will be the main source of income for basic living needs in retirement. Start small, and contribute at least enough to get the matching contributions from your employer (6 percent in most plans) and increase your contributions every time you get a raise. If your cash flow gets tight, at the very minimum, contribute enough to earn your employer's match, if one is offered
As you can see from the age breakdown above, older workers "get it" as their participation in 401(k) plans is typically among the highest. But it is interesting to see that participation increases even more in the group of workers age 60 and older.
Workers in the middle-age group may have a few more job transitions and will have to know when they will be eligible to join their new employer's 401(k) plan and be prepared to do as soon as possible, in order to minimize the gap in retirement savings and accumulation. If their new employer will not allow them to join the new plan until after one year of service, then these workers need to either contribute to an IRA or increase the contributions made to a spouse's 401(k) plan, until they are allowed to join and contribute to their new employers plan.
Mistake No. 2: Not contributing
In 2006, the maximum annual contributions a worker younger than 50 can make to a 401(k) plan account is $15,000. But less than 1 percent of workers earning between $20,000 and $60,000 (many of whom are younger workers) make the maximum contributions allowed. The average 401(k) plan contribution rate is six percent, which translates to an average annual contribution of $1,200 to $3,600.
Of course, a worker earning $40,000 (close to the median household income for workers in the United States.) would have to contribute over 37 percent of his gross income to reach the maximum annual contribution limit, which for most people in this situation is not practical.
But many employers provide an incentive for workers to contribute to their 401(k) plans in the form of an employer paid matching contribution made when an employee contributes a specified amount. The typical matching contribution is three percent on the first six percent of employee contributions.
But too many workers stop there, as evidenced by the fact that the average contribution rate by workers in 401(k) plans is 6 percent. Workers today, particularly those who are covered solely by a 401(k) plan, need to save and contribute at least 10 percent of their gross income into their 401(k) plan account.
In fact, employees who are faced with a freeze in future pension benefits (which are mostly younger workers) need to save more than the typical 6 percent. How much more you will need to save will depend on a number of factors, including the number of years you are from retirement.
Below is a breakdown of additional savings amounts workers affected by pension cuts may need to put away:
35: 6 percent extra
45: 10 percent extra
50: 13 percent extra
55: 16 percent extra
60: 19 percent extra
Source: Employee Benefits Research Institute
Why should I contribute to a 401(k) when I still have college loan debt and credit card debt to pay-off?
Answer: The typical 401(k) plan includes a matching contribution made by the employer to the account of every worker who contributes. The typical matching contribution is 3 percent paid to employees who contribute 6 percent.
Think of this in terms of what a bank will give you if you make a deposit into an account. If you could find a bank which would add $3 to your account every time you deposited $6, that would be a great deal. In fact, such a matching contribution would be equal to a 50 percent guaranteed return on your contributions.
The catch is that you have to contribute to get the match, and you should do this before you decide to pay extra payments on other debt. But based on the above, contributing six percent is not even enough. Many workers, especially younger workers, need to save and contribute at least 10 percent of their earnings over their entire career toward their 401(k) plan. Think of 10 percent as the new 6 percent.
My child's college tuition is due in five years and my retirement is many years down the road. What's wrong with cutting back on my 401(k) to save more for a child's college tuition?
Answer: Anyone who has flown on a commercial airline has heard the attendants give this safety advice, "In the event of a loss of cabin pressure, oxygen masks will appear. Please put your mask on first and then assist a child sitting next to you."
The simple message is that unless you have oxygen, you won't be much help to your kids. The same thing goes for your financial security. Don't put your retirement savings on hold for any reason, not even your child's education fund.
Does this sound selfish and cold? Remember this: there are many options when it comes to financing a child's education, scholarships, grants, loans, public service, etc. But there are no such options for financing your retirement. More workers are on their own when it comes to funding their retirement and an increasing amount of retirement income will come from your 401(k) plan.
Workers over age 50 are also eligible to contribute an additional amount of $5,000 in 2006. It's called a catch-up contribution, or CUC. But only about 12 percent of those workers eligible to make catch-up contributions make them. Perhaps it's because the annual limit of pre-tax contributions is already set high enough at $15,000, that trying to swing another $5,000 into a 401(k) is not affordable. For older workers, an ideal time to max out their 401(K) contributions (pre-tax and CUCs) is when the college tuition bills end.
Some older workers, particularly those who earn $100,000 or more, are often prohibited by their plan's rules from contributing more than seven percent of their pre-tax pay into their 401(k) plan. That's because of regulations that prohibit highly compensated employees from contributing disproportionately more than non-highly compensated employees. If this happens to you and you are over age 50, make certain that you are also making CUCs, since these are excluded from these rules.
Mistake No. 3: Failure to diversify
In addition to not participating and not contributing, the report also found that many 401(k) plan participants failed to diversify. Over 31 percent of participants held no stock funds, 21 percent held mostly all stocks and participants in plans of larger employers held over 33 percent of their accounts in company stock.
The last point about company stock is particularly troubling considering the lessons learned by the fall of Enron, WorldCom and others, in which employees lost their jobs and all of their retirement savings seemed to have gone unnoticed.
The typical 401(k) plan today offers 12 to 18 investment options, which include diversified funds that focus on stocks of large, mid-size, small and foreign companies. Younger workers, who typically have many years until retirement, should consider an allocation of their 401(k) savings primarily in stock funds, because over long periods of time (15 years or longer) stocks have provided the best returns versus bond funds and stable value funds.
Most investment experts say that your age is the most important factor in determining how you should invest your 401(k) plan account. I like to say that your number of years until you begin drawing on your 401(k) plan account for retirement income is a more appropriate measure. If you have 15 years or more until drawdown, then an allocation mostly in stocks may be appropriate.
I also think your account balance is an important factor. The smaller your balance is the more risk you may be willing to take. For example, suppose you have a $10,000 balance in your 401(k) plan account, you are invested mostly in stock funds, and the stock market falls 10 percent.
Although your account declines $1,000, your contributions total $9,000 (your contributions and employer matching contributions), so you can "recover" and keep your total account balance moving ahead. But suppose your balance is $100,000, and you experienced a 10 percent decline. Your account would fall by $10,000 and it would take over a year of additional contributions to make up for this. For this reason, investment diversification becomes more important for older workers who tend to have larger 401(k) plan account balances.
Average 401(k)/IRA Accumulations by Age Group
Source: Federal Reserve 2004 Surveys of Consumers Finances
For younger workers, who typically have a smaller 401(k) plan account balance, the primary factor that will increase their account balance will be contributions. Investment risk, or the up and down volatility of market values, will have a greater chance of working in their favor as they make contributions over time.
But just allocating your 401(k) account to a few of the stock funds that recently had the best performance is not proper diversification and doing so can lead to disastrous results. From 1995 to 1998, large company stock funds had the best returns of all stock funds and many workers bet their 401(k) this would continue.
But since 2000, small company and foreign stock funds have outperformed large company stock funds, the lesson being that you should not only diversify between stocks and bond funds, but also diversify within an asset category, holding large, mid, small and foreign stock funds.
Here are some typical investment allocations that could be suitable for workers of various age groups, assuming younger workers are either just starting out in building their 401(k) plan account, and older workers have larger account balances and are concerned about taking too much risk:
Age 20 to 30: 20 percent
Age 30 to 40: 30 percent
Age 40 to 50: 45 percent
Age 50 to 60: 55 percent
Age 20 to 30: 30 percent
Age 30 to 40: 30 percent
Age 40 to 50: 25 percent
Age 50 to 60: 25 percent
Age 20 to 30: 15 percent
Age 30 to 40: 10 percent
Age 40 to 50: 10 percent
Age 50 to 60: 5 percent
Age 20 to 30: 15 percent
Age 30 to 40: 10 percent
Age 40 to 50: 5 percent
Age 50 to 60: 5 percent
Age 20 to 30: 20 percent
Age 30 to 40: 20 percent
Age 40 to 50: 15 percent
Age 50 to 60: 10 percent
Over time, the most aggressive and riskiest funds (mid, small and foreign stock funds) should grow faster than the large stock funds and bond funds, and therefore could become a greater proportion of the account's value.
This will happen as your account balance grows, which can gradually increase investment risk of your account when you should be gradually decreasing risk. To counteract this, you need to do something called rebalancing, which is to reset your account allocation back to what you originally selected. In most cases, people should rebalance their 401(k) plan account at least once per year with the objective of maintaining their risk level until they need to change it.
Mistake No. 4: Cashing Out
According to the issue brief, one of the biggest weaknesses of 401(k) plans is that they allow workers to cash out when they leave or change jobs. About 45 percent of workers cash out their 401(k) savings when they change jobs, even though they had to pay personal income tax and a 10 percent penalty for early withdrawal.
Most of the workers who do cash out are younger workers with smaller balances and these workers figure it's a small amount of money and not worth the trouble to try and save it. But over time, cashing out even small balances can have a significant impact on ultimate retirement accumulations. Younger workers are likely to change jobs five to seven times before they settle into a long-term job, and if they do this every two years, they could be cashing our their retirement savings with nothing to show for it over 10 to 14 years.
All workers need to know that the best option available in many plans is to transfer their 401(k) plan account from a previous employer's plan into the new employer's 401(k) plan (this of course assumes that the new employer's 401(k) plan is as good as or better than the previous plan).
If your new employer's 401(k) plan does not permit plan-to-plan transfers, then consider either leaving the balance in the previous plan or rolling it over to an IRA — either way, you can continue to invest and grow your retirement savings.