By Pam Martens: January 18, 2013

Only one in five employees in private industry today has a defined benefit pension plan that will pay a fixed amount in retirement. The rest of the private workforce is left to the volatile markets of the 401(k) plan and other savings to supplement their Social Security benefits. Adding to the dilemma, less than half of private industry workers are participating in any form of employer-sponsored plan at any moment in time. This is shaping up as a disaster for the next generation of retirees.

A study conducted by the Center for Retirement Research at Boston College using data from the Federal Reserve’s 2010 Survey of Consumer Finances found that the typical household approaching retirement is ill prepared financially. (The Survey of Consumer Finances is conducted every three years and will be updated again this year.)

The study found that 401(k)s have been battered by the financial markets. As a result, median 401(k)/IRA balances for households approaching retirement remain at $120,000, roughly the same as in 2007. (IRAs are included because these are mostly rollovers from 401(k) plans, according to the study.)

For those not immediately approaching retirement, account balances declined. According to the study, “households 45-54 actually had lower balances in 2010 than in 2007 — $70,000 versus $75,000, and younger households held only $35,000 in 2010 compared to $44,000 in 2007. Those figures are not adjusted for inflation. “With prices rising more than 5 percent between the 2007 and 2010 Survey of Consumer Finances, balances have fared even worse in real terms,” notes the study.

Boston College researchers found that the $120,000 available for households nearing retirement would provide only $575 in monthly income, assuming a household purchases a joint-and-survivor annuity. Even that $575 in monthly income is likely too generous, as a large segment of the public does not even know such a thing as an immediate annuity offering joint and survivor benefits exists. The average household would likely simply draw down on the $120,000 to survive in retirement until it was depleted, leaving themselves in financial straits in later years.

Adding to roller coaster markets, another dangerous feature of 401(k)s is the offering of company stock. According to the Boston College study, in 2010, ten percent of all assets were invested in company stock. As we discussed in the personal financial column last Friday, investing one’s life savings in a concentrated position is the perfect recipe for disaster. Investing in the stock of the company upon which you also depend for your livelihood, means that if the company fails you likely lose both your investment in the stock as well as your wages. I know many people who felt it would appear disloyal not to put some of their savings into the company’s stock. To that I would say, company management at Enron and dozens of others did not share this feeling of loyalty to their workers.

Even the sponsors of 401(k) plans don’t believe the system is working. According to a 2011 Deloitte study that surveyed 430 plan sponsors, only 15 percent believe most employees will be prepared for retirement.

The wholesale gutting of defined benefit plans and the ascendancy of 401(k) plans was likely one of the greatest sellouts of the American worker in history and one of the most generous gifts to the financial services industry which benefits lavishly from fees charged on the accounts. But given this current reality, there is one avenue still open to holders of the plans to shore up their accounts before they retire.

A tax-deferred account such as the 401(k) allows interest and dividends to compound without a bite from taxes.  Only when funds are withdrawn from the 401(k) is the money taxed. Since it is quite likely that a retiree’s tax bracket will be lower than that of his or her working years, focusing on the tax-deferred benefit of the 401(k) and maximizing that benefit is about the last hope for making this system work for retirees.

According to the Boston College study, in 2010, 45 percent of workers who took a lump sum distribution from their 401(k) when switching jobs did not roll over the money to an IRA, simply cashing out the account and paying taxes on the distribution.

The Federal government imposes a 10-percent penalty on withdrawals from 401(k)s before age 59 1/2 in addition to ordinary income taxes. Those assets lost to taxes are assets that will not compound to the benefit of the worker over ensuing decades. Untaxed compound interest over long periods is one of the few blessings inherent in a 401(k) plan. (For more on compound interest, see our article and graph here.)

Workers who cashed out because they were watching their account balances dwindle in the stock market carnage following the 2008 debacle, could have instead liquidated the mutual funds inside the 401(k) and rolled over the cash to their own IRA at an institution of their choice. Unlike the 401(k) plan which typically limits investments to company stock and mutual funds, IRAs can be invested in FDIC insured certificates of deposit, individual blue chip stocks, and S&P index funds with low internal fees. The individual can select certificates of deposit with maturities coinciding with when funds will be needed and diversify into quality stocks with long histories of reliable earnings and dividends.

All of the above, of course, requires a worker with the time and energy to acquire knowledge of investing, tax issues and the power of compound interest. Given the strains and stresses on the American household and the American worker, this may be an unreasonable expectation for many.

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Pam Martens, the Editor of Wall Street On Parade, managed the life savings of average Americans for 21 years on Wall Street. Her personal finance columns seek to help the public better understand the jargon, complexities, and conflicts of Wall Street. The information that appears on this site cannot, and does not, take into account your particular investment goals, your unique financial situation or income needs and is not intended to be recommendations appropriate for you. When it comes to making your own investment decisions, you should always consult in advance with your financial advisor and accountant.

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