A 401k Reality Check

By Jane White, President of the Retirement Solutions LLC and a former financial journalist. She can be reached via email at Jane@retirement-solutions.us. The Retirement Solutions Foundation is a non-partisan organization dedicated to educating the public about saving for retirement.

This year's 401k Day, sponsored by the Profit-Sharing/401k Council, coincides with the passage of the Pension Protection Act. We thought we'd take this opportunity to do a reality check to see what steps still need to be taken to make sure 401k savers nest eggs aren't half-full when they need them.

Myth 1: The recent pension reform legislation makes providing investment advice more appealing in order to help people save more in their 401k accounts.

Fact: This legislation has to do with what investments to pick, which matters way less than what percentage of salary folks should be saving in their accounts-depending on their age and current savings-to achieve a comfortable nest egg. For the most part, this communication is not taking place for 401k participants. What's worse, most advisers concentrate on the assets in the current plan, as opposed to rollover IRAs or the balances at previous employers.

As far as picking the right funds is concerned, if your adviser is offering your participants index funds, which simply track the market instead of trying to beat it, you can be assured of "high quality" AND low cost, because none of the fees are going to pay a fund manager. Unfortunately, only about 10 percent of 401k assets are in passively managed index funds. We're working on both of these problems and we'll keep you posted.

Myth 2: The annual limits on 401k contributions reflect how much participants should sock away.

Fact: The annual ceiling on tax-favored contributions--$15,000 in 2006-is not a savings formula but a cap set by Congress on how much can get a tax advantage. A big chunk of 401k investors who have waited until their mid 40s to save--which is most of them--will have to contribute outside of their plan to stay on target. If, for example, you're 45 years old, you earn $76,689 a year, and you haven't contributed a dime to a 401k plan, you would have to contribute about $19,000 a year to attain a $1.6 million nest egg. The $5,000 limit in "catch-up" contributions for people over the age of 50 is also not a target if you are just getting started. It is a beginning, not an end.

Myth 3: Employees who change jobs should take a lump sum distribution and pay down debt, not roll their contributions over to the new employer plan or an IRA.

Fact: That's never a good idea- "cashing out" means participants will owe taxes and penalties-- but a better idea would be to roll the money over to a new employers plan or an IRA. If a typical American worker has eight to 10 jobs during a lifetime the last thing they need is the stress of keeping track of old balances. Take it with you, whether to a new employer or an IRA.

Myth 4: Employees need to replace 70% of their pre-retirement income when they retire.

Fact: For most retirees this will be far too little once you consider future inflation, health expenses, and the possibility of long term care. Some will need as much as 300% or more. Another good formula would be what is the multiple of "final pay" participants need to accumulate to last a life expectancy; right now our theory is that it's "25 times final pay" (the salary you expect to earn right before retirement.) We're working on it and we'll keep you posted.

The Good News: The best-and least talked-about-- feature of the Pension Protection Act is that it "legalizes" the automatic enrollment of new employees as soon as they become eligible to join your plan, rather than waiting for them to "choose to save®." One of the biggest "gifts" you can give your employees is to adopt auto-enrollment, which will not only boost the retirement assets of the one in four employees who never join the plan but the three in four who wait until their 40s to do so. Now our big challenge is helping us procrastinating Boomers make up for lost time. We're working on it…

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