A recent column on 401(k) plans that I wrote attracted a lot of attention. On the positive side, most agreed the benefits of these retirement plans are eroding due to changes in tax rates and interest rates since they were created some 40 years ago, more employers reducing or eliminating matches, and the failure of some plans to keep up with declining fees on other financial products. On the negative side, many objected to my contention that for some young median-wage workers in bad plans, contributing to a 401(k) no longer made sense, and that these accounts might become poor choices for a significant portion of workers if current trends continue.
My proposed solution was for the U.S. Congress to restore the tax benefits that 401(k) plans originally enjoyed for median household income workers. But as some rightly pointed out, waiting for Congress to solve your problems is not a winning strategy. It’s fair to ask what I think individuals should do to help themselves save for retirement. I have some answers, but they’re not great.
Young median-wage workers face overwhelming financial retirement issues. Very few have access to private defined-benefit plans. Social Security, Medicare and most State and local pension plans have no money to pay for benefits 15 or 20 years down the road, and are taking more money from young workers and reducing their access to benefits to pay for retired workers. Under any plausible analysis I can come up with, these retirement systems net reduce the retirement wealth of young workers today.
The tax benefits of 401(k) and other deferred-tax accounts are still healthy for upper-income workers, and these people are more likely to be in good plans with employer matches, low fees and good investment options. And retail financial services outside of 401(k) plans have improved enormously in quality since 1980, while costs have plummeted. If you earn a lot, you can save a lot.
My recent column looked at 25- to 34-year-old workers with household incomes between $40,000 and $50,000 per year in 2017 (the last year for which data are available). This covers roughly the 40th to the 60th income percentile(1) for the age group. Households in this income range are generally in the 12% marginal tax bracket for federal income taxes.(2) Income taxes are not the big problem for this cohort, as they pay only 1.8% of pretax income in federal income tax and 1.9% in State and local income tax, after all exemptions and deductions.
A much bigger problem is the 9.4% of their paychecks that goes for Social Security and other mandatory pension contributions -- benefits these workers may not see. And you should really double that figure because employer contributions (which equal employee contributions for Social Security and could be more or less for pension plans) probably come out of employee wages in an economic sense.
As a result of heavy pension contributions, those with the average household income of $41,682 cannot cover the $42,731 of average expenditures. You might say workers should reduce their expenditures, but a look at the line items in the Consumer Expenditure Survey reveal it’s not easy to find fat. Yes, a healthy, single person in a low-cost area without student debt should be able to save money out of an $800 per week paycheck before deductions, but it’s a lot to ask of a family in a high-cost city.
It’s not like further education would improve their prospects. Some 70% have college degrees already, and 82% of the adults in these households are working (the remainder are mostly unemployed or taking care of children and homes). Some can hope for higher earnings in the future, but hope is not a plan.
As a result, the average household in this group sank deeper into debt by $3,731, or 9.0% of pretax wages, in 2017—a year when the S&P 500 Index rose 19.4% and the Bloomberg Barclays U.S. Aggregate Bond Index gained 3.54%. Rising markets don’t directly help people who can’t find the money to invest. But when markets go down, as in 2008 and earlier this year, it inflicts pain on everyone.
So what advice do I have for a younger worker in this wage bracket who has a high-cost 401(k) without a match and with poor investment choices? Sure, there is some psychological advantage to making regular automatic contributions to a savings plan. But it probably makes more sense financially to pay down high-interest debt or making extra mortgage payments if they are homeowners to reduce outstanding principal at a faster rate. And buying a home might be a better strategy for renters who can manage such a purchase financially. Also, without an employer match, a self-directed tax-deferred account, or a tax efficient exchange-traded or mutual fund, can beat a high-cost 401(k).
The biggest criticism of my original column was that even discussing whether 401(k) plans are good investments might cause many workers to stop saving altogether rather than switching the money to superior financial options.
Ultimately, people have to either take charge of their financial future or depend on Congress for help. Right now, Congress does not seem to be up to the challenge.
(1) It's actually 41st to 58th for those who like precision. All numbers come from the Bureau of Labor Statistics Consumer Expenditure Survey.
(2) Even a single filer earning $50,000 with no dependents or other exemptions or deductions would have taxable income of $37,600 after the 2020 standard deduction, and the 22% bracket doesn’t kick in until $40,126. In my original column, many people objected to my applying 2020 tax rates to 2017 income figures, but I’m trying to get at what a 401(k) is worth going forward, not what it was worth in 2017 with higher marginal tax rates.
Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of 'The Poker Face of Wall Street.' He may have a stake in the areas he writes about.
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