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Employers are increasingly shifting
responsibility for retirement saving over to their employees by offering 401(k) and
similar plans instead of, or in addition to, traditional "defined-benefit"
plans.
Recent statistics indicate, however, that
many people don't understand how to handle this money for their long-term benefit. Rather
than keeping it off-limits until retirement, they tap it earlier for more immediate needs,
in a sense robbing their own futures.
A fundamental shift has taken place in the way Americans
build their retirement nest eggs and, no less importantly, how they look at that money.
Many companies are moving from traditional defined-benefit retirement plans, in which
employees are paid a set amount after retirement based on length of service and other
factors, to 401(k) or other defined-contribution plans, in which the employee takes on
more responsibility by contributing pretax money based on a company-designed formula.
According to the Employee Benefit Research Institute
(EBRI), the number of defined-benefit plans in the private industry decreased by nearly 50
percent from 1975 to 1997, from 103,346 to 53,000. At the same time, defined-contribution
plans tripled in number, increasing from 207,748 to 647,000. Some companies have
maintained defined-benefit plans while adding a defined-contribution plan, while others
have made a total shift.
Whether this trend is beneficial or burdensome for workers
is outside the scope of this article. What is clear is this: As increasing numbers of
Americans have control of their retirement money thrust upon them, they need to be
educated about how to manage it.
"The switch from defined-benefit plans to
defined-contribution plans definitely increases the amount of information employees need
to get," said James Delaplane, vice president of retirement policy at the Association
of Private Pension and Welfare Plans (APPWP).
The question is, who is going to give it to them?
Shift in Responsibility
Recently, "... economic and social trends have turned
against ... defined-benefit pension plans," said David Blitzstein, an executive with
the United Food Commercial Workers Union, quoted in EBRI's April 2000 newsletter.
"This is leading to the displacement of the social-contract model by a model that
promotes individual responsibility, employee empowerment and corporate flexibility, but at
the expense of risk-sharing."
With defined-contribution plans, employees are generally
given numerous investment options, and they choose how to invest their money among those
options.
One reason defined-contribution plans, like 401(k)s, are
popular with employees is that the money they contribute can be taken with them when they
change jobs. With defined-benefit plans, job-hopping generally means forfeiting
accumulated retirement benefits.
This plan "portability," as it is called, comes
with increased responsibility not to use the money for nonretirement-related purposes.
Studies about how 401(k) participants behave when changing jobs indicate that many are
shrugging off this responsibility.
The Long-term View
Sixty-eight percent of generation Xers (age 20 to 39), baby
boomers (age 40 to 57) and veterans (age 58 to 59) participating in 401(k) plans opted for
cash payments when changing jobs, according to a 1999 Hewitt Associates study. Less than
one-third (26 percent) rolled their balances into IRAs and only 6 percent moved their
money to their new employers' plans.
By the year 2000, the average employee will work for over
11 employers over the course of his or her career, according to the 1999 Cerulli Report
Market Update: The 401(k) Industry.
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"Although pensions and retirement
planning can be complex and forbidding … there are places to go for help and to make
sure you are on track and taking the necessary steps. There are options, and it is
essential that you find the one that is right for you."
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| — The American
Savings Education Council. |
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Someone who cashes out his or her 401(k) with each job
change, and who may have to wait up to a year before being able to begin participating in
a new one, could have trouble building up a retirement account.
Employees are suffering from a crisis of perception:
They're looking at the money in their 401(k)s as disposable income rather than retirement
income. This may also be true for IRAs, which people can tap for education expenses and
first-home purchases. For a switch in perception to occur, workers are going to have to
wake up to the time value of money and tax-deferred compounding.
What Employees Are Missing
In 1998, almost one-half of participants had account
balances of less than $10,000 in their 401(k) plan, notes EBRI in its 2000 Retirement
Income Research Study. Of those with a balance between $3,500 and $5,000, 40 percent
chose to roll it over in 1998. For balances between $5,000 and $10,000, 42 percent were
rolled over in 1998.
Unfortunately, cashing out a small balance is more harmful
in the long run than it may seem at the time.
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"In general, they (employers)
have a moral obligation to offer information. The entire industry must get better at
education."
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| — Laurie
Fleischman, vice president of marketing at Diversified Investment Advisors. |
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To illustrate compounding and the time value of money,
think about this. If, when you were 20 years old, you started contributing $2,000 a year
into a Roth IRA and it grew at 10.6 percent every year (the average historical return of
the stock market), at 70 years old you would have $3.1 million. IRAs currently have an
annual contribution limit of $2,000. The annual pretax contribution limit for 401(k)s is
$10,500.
One reason investors with smaller account balances cash
them out is that they think their account will never amount to much. If they understood
the potential over time, they might think differently. Tax-deferred accounts make the
biggest increases at the end of a 30-year saving cycle.
Further, any distribution will be subject to federal and
state income taxes, at your current bracket, and also to a 10 percent early withdrawal
penalty if you are under 59ý. Assuming a 28 percent federal tax, a 5 percent state tax
and a 10 percent early withdrawal penalty, this can shave a $10,000 retirement account
balance down to $5,700 of usable money. Of course, you do have to pay taxes on 401(k) or
traditional IRA money when you withdraw it at retirement, but you avoid the 10 percent
penalty and may also be in a lower tax bracket at that time.
The Employees' Responsibility
Employees face numerous choices in handling their
retirement money. In 401(k) plans, the median number of investment options is nine,
according to a 1999 Hewitt study. Over 40 percent of plans in the study offered 10 or more
options. Other decisions participants need to make include: how much to contribute, how
much they will need in retirement, how much risk they are willing to take, how often to
rebalance, and many more.
"More and more, it (education) is the employee's
responsibility," said Laurie Fleischman, vice president of marketing at Diversified
Investment Advisors, a national investment advisory firm specializing in retirement plans.
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"More and more, it (education) is
the employee's responsibility."
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| — Laurie
Fleischman, vice president of marketing at Diversified Investment Advisors. |
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The American Savings Education Council encourages
individual investors to seek information. "Although pensions and retirement planning
can be complex and forbidding … there are places to go for help and to make sure you
are on track and taking the necessary steps," said a press release. "There are
options, and it is essential that you find the one that is right for you."
One of those sites is the one you're reading now, the
401Kafe. There are a number of other Web sites that can also help you
with different aspects of retirement planning.
The wealth of information on the Internet "... is
forcing major changes in the expectations and behavior of retirement plan sponsors
(employers) and participants (workers). Both are demanding a wider range of choices and
options, fast and individualized response, and better control over defined-contribution
plans and accounts," EBRI said in its April 2000 newsletter.
Through legislation, policymakers have given employees
greater latitude in overseeing their retirement accounts. But, implicit in this has been
the idea that employees should not use their 401(k) or IRA money for purposes other than
retirement savings.
The Employers' Responsibility
Some employers may feel they are caught between a rock and
hard place; they want to provide employees with education and advice, but worry they could
be held liable if the employee is unhappy with the end result.
Increasingly, employers are deciding that the risk of not
providing advice and education outweighs the potential risk of providing it. The field of
online investment advice companies has grown to more than a dozen, indicating that there
is increased interest in this type of benefit for employees.
The Department of Labor, in guidelines issued in 1996,
urges employers to encourage their employees to:
- Participate in available plans as soon as they are eligible
- Make the maximum contribution possible to the plan; and
- If they change employment, refrain from withdrawing their
retirement savings, and opt instead to directly transfer or roll over their plan account
into an IRA or other retirement vehicle.
However, the only legal requirement for an employer is to
provide a departing employee with a 402(f) notice, a written explanation covering three
topics:
- How the employee may transfer his or her 401(k) money to
another eligible retirement plan.
- The requirement that income taxes be withheld from the
distribution if the money is not directly transferred to a qualified account.
- That the rollover will not be subject to tax if it's
submitted to another retirement plan within 60 days.
Beyond this, the employer is off the hook. But, employers
should provide more information for the benefit of their employees. For one thing,
defined-contribution plans have never really been tested in a down market. Since the
inception of the 401(k), the economy has boomed. Fortunes have been made in tax-deferred
retirement accounts alone.
But, what will happen in a market downturn? Will employees
be equipped with the education they need to make smart retirement investing decisions?
Blitzstein, quoted in the EBRI report, predicted that if a
prolonged market downturn proved the individual responsibility model was inadequate,
"Congress may turn to laws that mandate minimum employer-paid retirement
contributions, similar to the federal minimum wage."
"In general, they (employers) have a moral obligation
to offer information," commented Fleischman. "The entire industry must get
better at education."
Useful Education Links
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