Guest Commentary

401k Plans: Is the Story Under-told or Over-sold?

By Brooks Hamilton -- Brooks Hamilton & Associates. For over 25 years, Brooks Hamilton & Associates has created and managed custom retirement solutions for a select group of large, forward-thinking companies across the United States. Their mission is to help 401k plan participants retire in dignity, not despair. You may contact Brooks at 972.233.9168 or bhamilton@brookshamilton.com.

In support of his contention, Brennan offered two benefit illustrations - one pertained to a 401k plan participant now age 44 and one regarded a plan participant now age 22. While others may reply to Brennan's "myth" commentary, I will simply examine the "retirement mathematics" Brennan uses to support his argument that 401k plans will effectively meet employees' retirement needs; i.e., that such plans collectively constitute an effective retirement income delivery system which will reasonably retire employees in dignity.

To make his case, Brennan walks us through two hypothetical scenarios. While the following comments and observations apply equally to both illustrations, I will focus on just the illustration regarding a plan participant now age 44, with annual income of $59,000 and a current 401k plan balance of $24,000. This particular illustration further assumed future annual contributions of 9% (6% from the participant, plus a 3% employer match). In addition, Brennan assumed a diversified equity portfolio with a future annualized net investment return of 8.5%. To duplicate this 8.5% net investment return assumption, we assumed a gross return of 10.75% with total plan fees and expenses of 2.25%.

In conclusion regarding this age 44 example, Brennan observes that this participant's plan account will grow to more than $400,000 by the time the participant attains age 65, which will then produce a lifetime annuity income of over $37,000 annually, which will be a little over 62% of pay at retirement.

Since Brennan has provided all of the assumptions needed to "model" this participant's 401k plan account, from age 44 to age 65, we have constructed such a model to confirm Brennan's numbers and better understand the basis for his conclusions.

The following Table depicts this participant's plan account balance for the next 21 years, and indeed confirms that s/he will have an account balance at age 65 of $444,482, producing an annual annuity of $37,039 as Brennan stated, which is 62.8% of such participant's age 65 pay.

Does our mathematical CAT-Scan reveal anything else of interest?

Yes it does! There are four aspects of this benefit illustration which merit discussion, as follows:

• First, and generally speaking, benefit projections are either "frozen" or "dynamic" in nature. "Frozen" means that a person's future pay will not increase; it is simply frozen at its current level for all future years. "Dynamic" means that a person's pay will increase over the years based on some assumption as to future annual pay increases.

  While Brennan uses the "frozen" method, the reality is that a person's pay will increase over the next 21 years. Query: what if this age 44 participant had future annual pay increases averaging 5.5%? Well, if a person's pay increases over the next 21 years, it follows that s/he should accumulate a larger plan account at age 65. Thus the good news is that our age 44 participant will now have $612,064 at age 65; that is, an additional $167,582. But the bad news is that such person's annual pay at age 65 will now be $172,148. This means that such person's projected annual pension, which will be increased from $37,039 to $51,003, will also be reduced when expressed as a percent of pay at retirement to just 29.6% (51003 ÷ 172148).

  In short, reasonable future pay increases (which will obviously occur) serve to reduce this participant's annual pension from 62.6% of his future "frozen" pay at age 65 to 29.6% of his future "dynamic" pay at age 65.

• Second, our mathematical CAT-Scan also reveals that this benefit illustration assumed that the 9% annual contributions were deposited on day one of each future plan year, and thus earned interest all year long.

  Of course, in a 401k plan, all contributions for the entire plan year are not made on January 1st. Making contributions after each pay period means that on average one may assume that all contributions are made at mid-year. The effect of this change, while relatively modest, does reduce the larger plan account balance (see First above) at age 65 by $23,483, which in turn will reduce the annual pension from 29.6% to 28.5% of dynamic projected pay at age 65.

• Third, Brennan's benefit illustration uses an annual contribution rate of 9%, which he states is the median contribution in the plans administrated by Vanguard (i.e., half are higher; half are lower). What if annual contributions are 6% (4% by the participant with a 2% match)? which many gurus believe are more illustrative of the contributions made by the typical worker. Obviously, reducing the contributions will reduce the benefit. And sure enough, the participant would now retire on just 21.1% of his dynamic projected pay at age 65.

• Fourth, and finally, Brennan's benefit illustration assumes that plan assets will compound over the next 21 years at a net 8.5%. But what if future net annual investment returns are 5% instead of 8.5%? And before thinking that a 5% net investment return is unreasonably low, one should read pages 106 - 107 of John C. Bogle's latest book, The Battle for the Soul of Capitalism, for a solid discussion of estimating reasonable future investment rates of return.

  Once again, reducing future invest returns will reduce the future pension benefit. And if 401k plan assets grow at a net 5% instead of a net 8.5%, the participant would now retire on just 13.5% of his age 65 pay.

Final thoughts about future net investment returns: even a 5% net return is pre-inflation. That is, if future inflation averages 2%, the real future net return is just 3%. And since many/most 401k plan participants "lag" fund average returns by around 2.5% (gulp!), the actual real future net return for many/most plan participants may approach zero.

Summary

Summing up, what has this analysis taught us? Well, if regarding a worker now 44 years of age we assume:

• s/he now earns $59,000 annually with $24,000 already saved, and that his/her
• pay will not increase over the next 21 years; and that
• all future plan contributions will be deposited in the plan on the first day of each plan year;
• and that such plan contributions will total 9% of pay; and finally, that
• future net annual investment returns will be 8.5%, then

it would appear that such a 44 year old participant will be OK when s/he retires, especially if such participant lives modestly. In short, it appears that a 401k plan could meet such a participant's retirement needs.

On the other hand, if we assume that our plan participant will receive future pay increases (which is the obvious reality whether it helps or hurts one's argument); recognize that future contributions will arrive evenly over the course of a plan year (which equates to arriving at mid-year); conservatively assume that a participant contributes 4% of pay to the plan and receives a 2% match; and finally, also conservatively assume that future net annual investment returns are 5.0%, it appears that there is NO WAY for our plan participant to be OK when s/he retires, based on retirement benefits provided by the plan.

To many gurus, the risk appears great that the current 401k plan paradigm is a flawed vessel unlikely to float for too many, perhaps even most workers. And please remember, this conclusion is made well before weight is given to the fact that a majority of workers are not even offered a plan by their employer, while of the minority of workers who are offered such a plan (assume 45% of total workers), about one-third of those don't even elect to participant.

In conclusion, a mere 30% of our workers are even in a position to look forward to a potential retirement income benefit such as the one suggested by Brennan's age 44 benefit illustration. And of those 30% how many may fall prey to one or more of the four "what if" scenario modifications in the above Table? That is, perhaps receive a plan benefit that is less than 15% of pay rather than one that is over 60% of pay.

Sadly, 70% of our workers now look forward to nothing at all. And if one adjusts (i.e., downsizes) the best case scenario pension benefit that one might be able to illustrate (as Brennan did) for the 30% of workers eligible for a pension benefit, such downsizing triggered by one or more of the four "what if" scenarios suggested by the Table at the top of this page, the number of workers "in trouble" may approach 90% or more.

As unfortunate as the current situation may appear, it is steadfastly believed that these problems can be confronted and effectively fixed in a positive way. But it will take an independent and passionate effort by new and noble leadership not profiting from the current condition.

Too many focus on the "outcome" desired. Others believe that since "process" drives "outcome" it is the "process" which We must get right, for bequeathing freedom and liberty to our children is at stake.

In short, our problem is not that the fox is guarding the henhouse; our problem is that the fox is actually guarding other foxes already in the henhouse!

Mark Twain: "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so!"

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