America, Welcome to the Poorhouse

(Intro & Chapter 1)

Jane White

© 2010 by Jane White
Publishing as FT Press
Upper Saddle River, New Jersey 07458

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All rights reserved. No part of this book may be reproduced, in any form or by any means, without permission in writing from the publisher.

Introduction

Are You Better Off Than You Were as a Kid?

The nationally broadcast debate in 1980 between President Jimmy Carter and would-be President Ronald Reagan was summed up in 10 short words: “Are you better off than you were four years ago?”

For Carter, the situation was dire. Iranian radicals had held 52 American hostages for nearly a year. The economy had nose-dived while inflation skyrocketed. Nothing Carter said could counter Reagan’s rhetorical question. It was Reagan’s debate and a week later it was Reagan’s election.

Today if you ask yourself, “Am I better off than I was growing up?” the answer may very well be no. This time it’s not a war or hyperinflation that’s threatening America (although we’re still paying through the nose for gasoline prices), but financial stress.

Despite the fact that many Americans may appear to be wealthy, too many have been “living on leverage”—over their heads in debt—unless they’ve got “chief” and “officer” in their job titles because most of what they own is paid for with borrowed money—whether it’s credit card debt or home equity loans—not with rising wages. While in 1980 the average CEO wage was 42 times that of the average worker, in 2008 it was 208 times, averaging $7.7 million. At the same time, the average weekly earnings for Americans has actually decreased in the past 30 years, from more than $325 in the early 1970s to about $280 in 2005 (in 1982 dollars).

In March of 2009 a poll by CNN Opinion Research Corp. showed that only 39% of respondents thought they’d be able to keep up their quality of life—down from 45% the previous year. Only 50% of homeowners said they were very confident they could keep making mortgage payments, down from 58% a year earlier. Only 24% of parents said they were very confident they’d be able to afford to send their children to college. And only 22% of working people thought they’d be able to save enough for retirement.

The Four Biggest Sources of Financial Stress: Empty Nest Eggs, Unaffordable Homes, Overpriced Colleges, Credit Card Debt

What’s tragic is that outside of CNN’s reference to pension stress, the biggest financial crisis that the media isn’t covering is that most of us will be pensionless or pension-poor when we stop working—if we can afford to. From 1974 to 2004, the percentage of Americans covered by a defined benefit plan shrank from 44% of the workforce to 17%, according to the Employee Benefit Research Institute. At the same time, more than 80% of the private-sector workforce is employed by a company that only offers a 401(k) plan, in which you pretty much have to bankroll your own pension—because the U.S. employer contribution rate is the second lowest in the world. Bottom line: With few exceptions, nobody can retire if they have only a 401(k) plan. The you-know-what will hit the fan in 2011 when the first wave of Baby Boomers is scheduled to retire and can’t afford to.

I first observed the 401(k) crisis in 1993 shortly after landing a job as associate editor of a newsletter distributed to half a million 401(k) participants with their quarterly statements. While as a financial writer I had covered topics such as mortgages and the stock market, I wasn’t very familiar with 401(k) plans—and at that point, there wasn’t much media coverage of them—it wasn’t until the Enron collapse that the term “401(k)” was coin of the realm. Although most Americans participate in these plans, the plans’ names will vary with the employer.

Once I started digging, I was alarmed to find out that, unlike a traditional pension, in which the employer traditionally invests enough money that employees can replace 70% of their salaries until they die—assuming that they have worked for the company long enough to be “vested” in the plan—401(k) accounts have no such promises.

While there was some panic about 401(k) plans being risky in late 2008, the focus on the stock market slump was off-base. The problem with 401(k) plans isn’t that their investments are too risky, it’s that the cost of funding employee accounts is left largely up to the employees. Not only do many employers get away with not contributing a dime to their employees’ accounts, but when they do at best it’s typically only a matching contribution of 50 cents for every dollar you put in, or equivalent to 3% of your pay. This contribution rate is the second lowest in the world—even Mexico’s is higher, at 6% of pay.

The second source of financial stress for 50% or more of Americans is overpriced housing. When it comes to housing, we have two problems: an overpriced market whose bubble has burst and irresponsible lending practices that have yet to be reined in. Although the median home price was a little more than three times the median wage in 1976, a mere five years later it was more than four times the median wage and it’s currently six times the median wage.

In 2008, as the housing bubble was bursting, not since the Depression had a larger share of Americans owed more on their homes than they were worth—often referred to as being “under water.” Nearly 8.8 million homeowners, or more than 10% of the total, were under water in 2008, more than double the number in 2007. Although the housing slumps of the mid-1970s and late 1980s were confined to the coasts, the recent bust has cut a far wider path and has come at a time when home debt was at its highest level since World War II.

Why do we care about overpriced homes? Because a house isn’t just a roof over your head, it’s the fourth leg of the “four-legged chair” that makes up your retirement equity—along with pensions (if you’re lucky enough to have one), Social Security, and 401(k) savings. One reason the “Greatest Generation” could retire comfortably is that many of them had pensions and most of them stayed in their homes for most of their careers—in other words, they had a “buy-and-hold” home investment strategy as opposed to trading up to homes that they couldn’t afford, as is the case with many people today.

Many would-be homeowners who are living in areas where homes are overpriced and unaffordable may have to face the initially daunting prospect of moving to regions where homes are affordable and jobs are plentiful. What’s more, those of you who are living in depressed areas in Michigan and Ohio may need to consider the same thing, for precisely the opposite reason: It’s not affordability that’s the issue but the risk that your home will be worth less than what you paid for it when you retire because your local economy has tanked.

The third source of financial stress is that college costs have skyrocketed at a time when the majority of Americans need a college education to succeed in a globalized world. With so many service and factory jobs being outsourced to India and China, we’ve got to aim for the majority of the next generation to get a college degree. The good news is that this crucial need is on President Barack Obama’s radar screen: In an address to a Joint Session of Congress in late February of 2009, he said, “I ask every American to commit to at least one year or more of higher education or career training. This can be community college or a four-year school; vocational training or an apprenticeship. But whatever the training may be, every American will need to get more than a high-school diploma.”

Finally, credit card debt and home equity loans have enabled us to live beyond our means—at the same time forcing us to pay many times the sticker price of an item because of the corrosive influence of compound interest in reverse—at a point when we need all the extra money we can get to save for retirement and pay for our kids’ college education.

This book is organized in order of “financial stress levels”: Retirement comes first because at least 80% of the population can’t afford to retire, mortgages are second because half of the population is under mortgage stress, college costs come third because most people need a college degree to succeed in a world where we’re competing against low-wage labor abroad, and credit card debt is fourth because 35 million people pay only the minimum balance on their bills, increasing the cost of the debt.

In each section, I’ll look at the cause of the financial stress, propose legislative reforms to solve the problems, offer advice on how you can manage your finances until we get reform, and suggest an action plan to get reform. In a nutshell, reform means tripling the employer 401(k) contribution rate to equal 9% of pay as is the case in Australia, outlawing adjustable rate mortgages, lowering the cost of college, and cutting down on credit card debt and home equity loans.

Why do we need reform when we’ve got a reform-minded President in the White House? Because there’s only so much President Obama can do when too many members of Congress and the Senate are compromised by campaign contributions from the business lobby.

The first reason we need to shut down K Street, the location in Washington where most lobbyists have their offices, is because of the influence that the business lobby has on politics. There are now 15,000 lobbyists in Washington—27 for every member of Congress. The second reason is that there’s no law against a politician becoming a lobbyist—there’s only a “cooling-off period” between the time the politician works for taxpayers and the time he or she works for lobbyists—which means these politicians are often likely to draft or change language to make legislation more business-friendly, versus taxpayer-friendly. According to Public Citizen, a consumer advocacy organization, between 1998 and 2004, some 42% of former House members and 50% of former senators who were available to do so became registered lobbyists.

The good news is that the internet has unleashed a revolution in fundraising, campaigning, and communicating. In the same fashion that small contributions from millions of voters—along with leverage from king-makers like Oprah Winfrey—catapulted Barack Obama from a long shot to a front-runner, the virtual grass-roots movement can ensure that Congress and President Obama continue to work for the electorate.

The better news is that we’ve got a new administration in the White House. President Obama has set up a Middle Class Task Force that promises to reach out to Americans and address the causes of their financial stress, from healthcare coverage to pension security. I’m hoping that my readers can convince him to aim for boosting Americans’ wealth so that more of them stay or move into the upper middle class.

It’s time for a second American Revolution.

Chapter 1

Why You Can’t Retire from a 401(k) Plan: You Won’t Have Ten Times Your Salary in Your Account at Age 65

Mention the word Australia and the images that come to mind are “shrimps on the barbie,” koala bears, and kangaroos. I’d like to add another image: people who can actually afford to retire.

A report issued in January 2008 by AMP Financial Services, a firm that manages Australian retirement funds and also reports on retirement readiness, revealed that Australians between the ages of 30 and 34 are projected to have assets of more than $540,000 in today’s dollars in their accounts by the time they are ready to retire; those between 20 and 24 will have nearly $700,000.

How do those six-digit projected nest eggs for the typical Australian compare with the nest egg of a typical American approaching retirement? Unlike its Australian counterpart, the Investment Company Institute (ICI), the U.S. trade group for mutual funds, doesn’t measure whether 401(k) participants are on track, only whether assets have grown. In 2007, the ICI issued a news release reporting that Americans held $2.75 trillion in 401(k) plans. While ICI President Paul Schott Stevens was quoted as saying, “Ensuring that working Americans are preparing for retirement is a public policy of vital concern,” nowhere in its report is it stated whether this amount divided by 52.2 million 401(k) participants equals an adequate nest egg.

Here’s the bad news: According to Fidelity Investments’ 2007 report on its clients, the median balance for workers on the cusp of retirement, age 60 to 65, was a measly $43,000—not enough to last most people a year or so—and that would apply only to people earning $43,000 in that age group. The formula that’s often used by pension actuaries to calculate a benefit is ten times “final pay”—or the salary you’re earning right before retirement. If most 65-year-olds have only around $43,000, they won’t be able to afford to retire for another decade or more—higher earners are in an even worse predicament.

Australian Employers Must Contribute the Equivalent of 9% of Pay and Can’t “Suspend” Contributions to Employee Accounts

The reason Australians’ nest eggs are fuller than those of their American counterparts? Very simply, Australian employers are required to contribute to workers’ superannuation (Australia’s word for pension) accounts—the current contribution rate is the equivalent of 9% of salary—three times the typical U.S. employer contribution rate—up to a salary ceiling of $137,880 up to age 75. In addition, the contribution is made regardless of whether the employee contributes—it’s not simply a “matching contribution.” One in four Americans doesn’t contribute to a 401(k) account and therefore ends up with nothing.

What’s more, Australian employers aren’t allowed to stop or “suspend” making contributions when the economy sags, as is the case in the U.S. More than 60 major U.S. employers announced that they were lowering or suspending contributions in the U.S. as of early 2009, including Reader’s Digest, Sprint Nextel, U.S. Steel, Unisys, FedEx, and Eastman Kodak.

Australians Can Sell Homes to Boost Their Retirement Accounts

While contribution limits for American workers over age 50 are capped at $22,000 in 2009 (indexed to inflation), Baby Boomer Australians can sell a home or another asset and add the proceeds to their accounts. Under changes introduced in the 2006 budget, workers over age 60 can make after-tax superannuation contributions of $150,000 a year, or $450,000 over three years. Unlike their American counterparts, the Australian government realizes that Boomers need this brute-force opportunity to jump-start their savings because the 9% guarantee was only instituted in 2002—with the result that Boomer Australians will benefit from fewer years of super contributions than their Gen X or Gen Y counterparts.

The result of this stewardship? Australians actually contributed more to their accounts than their employers did in the second quarter of 2007; according to the Australian Prudential Regulation Authority, employees contributed $22.4 billion, compared to $18.9 billion by employers on their behalf.

Other Countries Are Pension-Richer

Australia’s pension system isn’t the only one that’s putting ours to shame. According to a report by the Organization for Economic Cooperation and Development, the United States ranks near the bottom of the 30 member countries in pension generosity. Only six of the member countries had lower pension wealth than the U.S.

Australia is one of eight countries that has a mandatory 401(k) style system and six of them are more generous than ours; the average employer contribution rate is equal to 7.25% of pay. Denmark’s is equal to 11.8%, Hungary’s is 8%, Mexico’s is 6.5%, Poland’s is 7.3%, the Slovak Republic’s is 9%, and Sweden’s is 4.5%.

CEO Pay Is 208 Times the Average Joe’s, Whose Wages Are Shrinking

Not only do much of the rest of the world’s pension systems put ours to shame, but pension poverty for the middle class is occurring at a point when the “CEO class” is taking home sky-high paychecks. In 1980, the average CEO wage was 42 times that of the ordinary worker. As of 2008 it was 208 times—averaging $7.7 million. At the same time, the average weekly earnings for Americans has actually decreased in the past three decades, from more than $325 in the early 1970s to about $280 in 2005 (in 1982 dollars).

If the median wage had increased at the same rate as that of the top brass since 1980, it would be $79,000 instead of the current median wage of about $37,000. With that kind of salary, many more middle-class Americans would be able to afford a bigger chunk of their kids’ college bills rather than needing loans to pay for most of them. More of them could afford to put 20% down on a home purchase and therefore avoid taking out risky adjustable-rate mortgages. They could even afford to contribute more to their 401(k) accounts, perhaps closer to the 12.6% of pay contributed by Australians versus about 5% for Americans.

If anything, it’s the increasing productivity of the average American worker that is boosting America’s bottom line. According to Mercer Human Resource Consulting, while corporate profits rose 15% a year from 2002 to 2005 and CEO compensation rose by an average of 7.2% per year, wages of exempt employees rose by an average of 1.1% per year—which instead of a raise is actually a “lower” if you factor in yearly inflation rates of about 3%.

How Good Times, Bad Times, and “Pension Reform” Took a Wrecking Ball to Our Pension System

Before we look at how you can make the most of your 401(k) plan and offer strategies for getting Congress to pass my proposed 401(k) Security Act, which would mandate 9% employer contributions, it’s worth it to learn how our pension system went astray.

If you grew up in the 1950s through the early 1970s, there was a good chance that your dad was covered by a regular pension, also known as a defined benefit plan, because the economy was booming, unions had more clout, and employers needed to offer perks to lure employees. (I’m saying dad and not mom because in those days it was rare for moms to work outside the home.) However, starting in the 1970s, companies started cutting back on pensions, as “stagflation” and increased competition from Japanese manufacturers threw our economy into a tailspin.

From 1974 to 2004, the percentage of Americans covered by a defined benefit plan shrank from 44% of the workforce to 17% of it, according to the Employee Benefit Research Institute. At the same time, more than 60% of the workforce is employed by a company that offers only a 401(k) plan. What’s remarkable about this downward trend is that while the law that governs pensions, the Employee Retirement Income Security Act (ERISA), has been amended at least 40 times in the past 30 years, the result is fewer pensions, not more or better pensions.

In fact, during the nine months after ERISA was signed into law, the Pension Benefit Guarantee Corporation, the agency that insures pensions, was socked with 5,000 terminations (plans that were ended), a result that has not registered on the minds of members of Congress or the general public, since few in the media have covered this trend. At the same time, in the following three decades, employers proceeded to raid and shut down pensions when times were good and terminate them when times were bad.

Remember the 1980s? The images that come to mind aren’t just bad fashion and big-lens glasses, but also corporate greed—remember Gordon Gekko? High interest rates earned on pension investments created “surpluses” that the companies could use to acquire other companies. The companies would simply terminate the pensions and pay out the smaller pension in the form of an annuity. At the same time, corporate raiders targeted companies with “overfunded” plans, using the surpluses to pay off debt associated with their leveraged buyouts. Congress put an end to this practice in 1990 by imposing a 50% excise tax on reclaimed surpluses. (Needless to say, in a logical world there would be tolerance for the concept of overfunding, since this so-called surplus is needed to bolster balances when the stock market is heading south.)

On the other hand, the bear market during the first eight years of this century was also damaging for defined benefit plans. With stocks plunging and the Fed cutting interest rates, many companies were forced to kick in substantial amounts of cash. While employer contributions to pension plans averaged about $30 billion a year from 1980 to 2000, during 2002 and 2003 companies had to kick in close to $100 billion annually.

In the same fashion that the creation of ERISA caused the death of the very pensions it was intended to protect, the so-called Pension Protection Act of 2006, which makes funding requirements more costly, may protect pensions for some but will shrink them for many others. Roughly 20% to 25% of the nation’s $2.3 trillion of assets in defined benefit plans have recently been frozen—meaning that some or all of the employees stop earning benefits, and others who are new hires won’t have any coverage.

Too Many Rules + Voluntary Pension Plans = Dead Plans

The problem with putting too many rules on a voluntary scheme is that employers react by dropping out of the scheme. As Thomas Donlan of Barron’s put it, “The new pension law will drive companies in financial stress to put their pension plans into the care of the government insurance agency. At the same time, it will drive prosperous companies to take their retirement plans out of the defined benefit system.” In 2007, more than 1,200 employers ended their pension plans, according to the Pension Benefit Guarantee Corporation.

ERISA: Simultaneously Complex and Useless

Former Secretary of Labor Robert Reich called ERISA the “single most complicated piece of legislation ever to be enacted, subsequently providing guaranteed livelihoods to thousands of lawyers and administrators”—detractors have nicknamed it “Every Rotten Idea Since Adam.” The irony about 401(k) plans is that although ERISA has strict requirements for the “fiduciaries” of the plan, the people responsible for overseeing the investments—which include acting solely in the interest of plan participants, diversifying plan investments, and charging only reasonable expenses, there is no requirement to carry out the most prudent practice of all, which is to tell people how much to contribute to their accounts.

Although 401(k) plans are also called defined contribution plans, to my knowledge no elected representative has ever attempted to amend ERISA to require that the necessary contributions be defined so that the participant can retire with a benefit as generous as that of a defined benefit plan. While the Pension Protection Act provided clarification on the ability of 401(k) advisers to tell participants which funds to invest in, it provided no guidance on advising the participants on their required contribution rate based on how much they’ve already saved and their “investment time horizon,” that is, how many years they are away from retirement—communication that is vastly more vital to help participants achieve retirement readiness than advice on which funds to invest in.

While the Department of Labor is constantly issuing guidance and regulations about investment advice—the latest is allowing participants to get advice by a “computer model certified as unbiased and through a fiduciary adviser compensated on a level fee basis,”—there is no component of the advice feature that deals with how much you need to contribute. What’s more, nobody should have to pay a human being for this advice. Participants should be able to buy software that essentially gives the same advice to everybody, which is to contribute the maximum, don’t time the market, and stick with index funds—advice that I’ll detail in the next chapter. (Disclosure: I’m interested in developing this software.)

Finally, investment advice that takes place at the workplace flies in the face of common sense: If the typical American changes jobs an average of every four years, most of their 401(k) assets are often in rollover IRAs or at previous employers, not in their current 401(k) accounts.

Why Has There Been No Retirement Reform? Most So-Called Experts Are Clueless About What’s Needed to Make 401(k) Plans Walk, Talk, and Quack Like a Pension

In reality, the 401(k) plan is an “accidental pension.” The IRS code that spawned the 401(k) plan was meant to clear up a dispute over the taxation of profit-sharing plans, not to create retirement security. According to Ted Benna, the consultant who “invented” the 401(k) plan in 1980, his idea was to redesign a retirement program to capitalize on tax breaks and add security to an existing defined benefit plan—not to replace it.

The problem is that very few people who advise 401(k) plans or sponsor the plans seem to know the formula for making a 401(k) account adequate enough to replace a defined benefit pension. One exception is David Wray, the president of the Profit-Sharing/401k Council of America, a group of 1,200 employers, who was quoted in the Seattle Times in 2005 as saying that 401(k) participants need to aim to have the equivalent of ten times their final pay in their accounts. “Ten times final pay gets it done,” Wray said. “The issue is the 40 years. You’ve got to start at 25 to retire at 65.”

Wray hit the nail on the head. Or if 401(k) participants haven’t started contributing to their accounts at age 25 and are contributing less than 10% of their salaries to their accounts, they’ve got to goose up their contributions—even higher if they’ve waited until age 35, 45, or 55, as I’ll explain a little later.

Incredibly, at the time this book was going to print, if you Google the phrase “ten times final pay,” you’ll only get nine results. Why is this phrase no longer coin of the realm? That’s because the pension actuaries who used to be hired by employers to make sure they followed ERISA’s rules for funding pensions aren’t required to play this role when it comes to 401(k) plans. Since there are no rules for funding 401(k) plans, pretty much the only role pension actuaries play is to help employers follow other ERISA rules pertaining to 401(k) plans, such as “nondiscrimination” testing and other counterintuitive rules that prevent highly paid people from contributing enough to their accounts so that they can retire.

My Testimony Before the U.S. Department of Labor on Recommended Disclosure of Required Contribution Rates

Until we get genuine 401(k) reform, at a minimum, 401(k) participants have the right to know how much to contribute to their accounts—their “co-pay” if you will—to fund a nest egg that will equal ten times their final pay at retirement. With the input of pension actuary James E. Turpin of the Turpin Consulting Group, I developed formulas for contribution rates required based on the current typical employer match of 3%. I was invited to present these findings as a witness before the Department of Labor’s (DOL) 2007 ERISA Advisory Council’s Working Group on Financial Literacy and the Role of the Employer. As a result, the Working Group ultimately recommended to the DOL that employees should be told how much they need to contribute to achieve a multiple of their salary nearing retirement. Unfortunately, even if the DOL agreed that this communication was necessary, its recommendations aren’t laws that employers have to follow.

What was disclosed in my testimony is that the most important advice that 401(k) participants need isn’t which investments to pick but the percentage of their salary they need to sock away depending on their investment time horizon. In other words, the earlier you start saving, the smaller the percentage of income you have to set aside—and vice versa.

Also, assuming a typical employer contribution rate of 3% of pay, even the tiny minority of participants who are savvy enough to start contributing at age 25 must save 10% of their salary to build an adequate nest egg by age 65. The longer the participant postpones starting to contribute, the greater the required contribution. For example:

• Waiting until age 35 increases the contribution rate to more than 17%.

• Waiting until age 40 increases it to more than 23% of pay.

• Finally, waiting until age 50 requires nearly a five-fold increase from the rate at age 25, to 48% of pay. Needless to say, this over-50 requirement flies in the face of the meager current $5,500 limit on “catch-up contributions” currently allowed by the IRS.

Mutual Fund Companies Are Unaware Their Clients Can’t Retire

Unfortunately, few pension advocates appear to have consulted pension actuaries to figure out what’s needed—and therefore they don’t appear to know how far behind most Americans are. Nor to my knowledge, have any mutual fund executives lobbied Congress to make 401(k) plans work—this is particularly outrageous because they are stewards of 401(k) participant assets—especially since reform would mean they’d have more assets under management. Nor has anyone proposed mandating that employers contribute more to each account so that the “co-pay” required by the participant isn’t unaffordable for those who have waited until their 30s or later to start contributing—that is, most of us.

In a November 2006 Wall Street Journal article titled “As the 401(k) Turns 25, Has It Improved with Age?” a spokeswoman for the Investment Company Institute offered the oblique assessment that “the 401(k) is hitting its stride” without offering evidence that participants are on track to achieve an account balance equal to ten times their final pay.

In addition, while several of the large mutual fund companies produce annual reports on the 401(k) assets under management with detailed statistics on account balances, asset allocation, loans, and withdrawals, I’m unaware of any report on whether their clients are on track to reach a nest egg goal of ten times final pay—or any goal. And while many of them have launched “target date” mutual funds that gradually shift the asset allocation of the participants’ accounts from stocks into bonds or cash equivalents as the participant gets closer to retirement, there is no advice to investors on the contribution rate needed to meet that target, nor is the target ever defined.

In a rare departure, Fidelity Investments issued somewhat of an alarm, albeit one that you had to dig hard to find, in its November 2007 report on corporate defined contribution plans. In the report, Fidelity introduced a “new measure of retirement readiness” called the Retirement Income Indicator, which “measures employees’ progress toward accumulating sufficient workplace savings to replace at least 40% of their preretirement income.” Why such a low replacement ratio? Because Fidelity assumes that participants can count on other sources of income such as a rollover IRA and/or a defined benefit pension for the rest of the income stream. Fidelity should know better, especially when it comes to the topic of shrinking defined benefit pension coverage, given that Fidelity froze the pension plan covering its 32,000 employees in March of 2007.

At least Fidelity attempts to use a measure of retirement readiness and acknowledges that a portion of its participants face bleak financial futures. In contrast, the Vanguard Group’s 2007 “How America Saves” report describes 401(k) plans as “broadly successful in encouraging millions of employees to save for their retirement.” What’s more, it depicts enrolling employees in the plan as putting the participant “squarely on the path for success: plan participation, regular savings increases and a balanced investment program.”

Nor do mutual fund managers appear to know what contribution rate is necessary for 401(k) participants—or the fact that the rate increases the later the participant starts to save. According to T. Rowe Price’s 2005 report on its clients, “Some financial experts recommend that employees save 10% to 20% of their salaries each year.” Gee, T. Rowe—aren’t you supposed to be financial experts?

A lack of knowledge by the mutual fund industry about how much participants need to save and what size nest egg they should aim for based on their salary near retirement is evident by the flawed assumptions offered by at least two of the mutual funds in their online calculators. At the time of this writing, Vanguard instructs its users to “estimate the percent of your current [italics mine] income you’ll need to maintain a comfortable lifestyle in retirement,” as if it didn’t matter whether the user was 20 or 50 years old. On the page on Fidelity’s website titled, “Are You Saving Enough?,” it tells users to determine how much they need based on how much they’ve currently saved and when they are going to retire, not their projected salary at retirement.

Media Is Unaware of Retirement Crisis

Perhaps the most frustrating obstacle to progress is the lack of media interest in the crisis. Despite sending out press releases half a dozen times a year for two years, the only publication I could convince to address the problem is the Employee Benefit News, for which I used to write a column.

At a forum sponsored by the Employee Benefit Research Institute in 2004 on the decline of defined benefit plans, journalist Michael Clowes, then of Crain’s Pensions & Investments, suggested that the media won’t provide much coverage of this crisis. “I think the general press has missed the overall direction of the impending demise of the corporate defined benefit plans and its implications,” Clowes said. “What’s more, if the media does cover 401(k) plans it will happen during a bull market and focus on the excitement of having a 401(k) plan.”

Clowes almost hit the nail on the head, but perhaps even he didn’t realize that having a 401(k) account in a bull market isn’t anything to get excited about, a point that is also lost on most journalists when they write about the plans. After a 1997 Wall Street Journal article during a bull market titled “Waking Up Rich: Retirement Accounts Stashed in Stocks Make Employees Millionaires,” Ted Benna, the creator of the 401(k) plan, wrote an article in a benefits publication that served as a “correction” to the Journal piece. Most likely Benna was forced to do so because the Journal refused to publish his letter or op-ed because it would be an exposé of a poorly researched article.

“Frankly, I have been amazed at the attention that the recent Wall Street Journal article about 401(k) millionaires has received,” Benna wrote in Compensation and Benefits Review. “The average account balance for these participants is generally regarded to be around $35,000. Study after study indicates that the average participant is not saving enough for retirement. As a result, the major concern of most knowledgeable individuals is that we may be facing a serious retirement crisis.... In fact, ever since 401(k) plans began, they have been attacked as not being real retirement plans.”

Even if the average account balance were $1 million, it doesn’t make you a millionaire—it’s the minimum for those earning $100,000 at age 65. What’s tragic about The Wall Street Journal article is that the employees in the article were among the tiny minority in the United States who have accumulated what they need for a secure retirement—for example, a human resource manager pulling down a $100,000 salary who had $1 million in his account. But because the mutual fund companies aren’t required to communicate what size nest egg is necessary to be able to retire, he didn’t realize that $1 million is the minimum needed to replace 70% of a $100,000 salary for 20 years or more, as opposed to a windfall. So he decided to cash out part of his 401(k) account to buy a sports car.

Another 55-year-old couple with a combined annual income of $200,000 decided that their $800,000 joint account balance was a windfall and quit their jobs, paying $180,000 for a 42-foot boat—when in reality they needed to pass up on yacht purchases and stay in the workforce in order to save up a minimum of $2 million to replace their incomes. As a result of these self-defeating maneuvers, those profiled in the article will end up in the same or worse predicament as those participants who don’t have the resources to save enough.

The Wrong 401(k) Reform: Replacing an Employer Match with Taxpayer-Subsidized Investments

One of the problems with the field of finance is that remedies to problems are too often viewed through an ideological lens, rather than a logical one—resulting in a lack of “evidence-based finance.” For example, many Democrats typically view stocks as scary and reckless and bonds as safe and secure—witness AARP’s lobbying efforts against privatizing Social Security. And many Republicans view the stock market as magical—witness the popularity of Jim Cramer’s Mad Money TV show.

Unfortunately, like just about everything else in life, the truth is somewhere in the middle. Over the long haul, everyone needs to own stocks because you are a part owner of companies whose shares will be worth many multiples of what they were when you first bought them once you retire. Over the short haul, as you get closer to retirement you need to convert to cash equivalents, such as money market accounts, because stock values run the risk of short-term slumps. On the other hand, nobody should own government bonds because they are a long-term investment whose premiums are generally less than the rate of inflation, so you’re actually losing money. The proof is in the pudding: Examining 20-year-holding investment periods from 1926 to 2001, large-company stocks yielded better than 5% returns in all but 19 of the 56 holding periods. In contrast, long-term government bonds lost money in all but eight of the holding periods.

If logic had trumped partisan ideology during the debate over privatizing Social Security when former President George W. Bush tried to overhaul it in 2005, its shortfall would have been addressed by a combination of tax increases and a shift of much of its assets into stock index funds rather than stuck in poorly performing short-term and long-term government bonds, as is currently the case. Rather than privatizing Social Security and allowing investors to shoot themselves in the foot by attempting to time the market with brokerage accounts as Bush proposed (some say at the behest of the brokerage industry), the assets would be managed by a government-sponsored enterprise that would invest in a mix of stock and money market index funds, as is the case with the Thrift Savings Plan, which covers many government employees. Unfortunately, since the Social Security Administration is scheduled to take in fewer taxes than the benefits it pays out starting in 2016, a combination of a lack of a bipartisan dialogue and ignorance about finance has produced another retirement disaster.

So it’s no surprise that this lack of financial literacy on the part of Congress and some who purport to be financial experts surfaced during the stock market slump in October 2008. There was a brief media flurry over whether 401(k) plans were working, but the attention was directed not at the paltry employer match but at the misguided notion that stocks they hold are risky and shouldn’t be in the plans, despite the fact that they dominate the assets in pension plans.

Testifying before the House Committee on Education and Labor on October 7, 2008, Teresa Ghilarducci, an economics professor, proposed replacing 401(k) employer matching contributions with an annual government deposit of $600 that would be invested both in “safe and risky” investments whose investment returns would be subsidized by the taxpayers, along with requiring that employees contribute 5% of their pay into these investments.

However, replacing an employer contribution with a one-size-fits-all $600 government contribution would devastate nest eggs for 95% of Americans—and the other 5% are probably poor enough that Social Security replaces most of their income at retirement.

Another academic who is frequently quoted in the media on pension matters also appears to use faulty math to address the empty nest egg dilemma. Alicia Munnell, who heads up the Center for Retirement Research, appears to have come to the conclusion that all Americans need to do is work two to four years longer. She says that “in theory workers could accumulate substantial wealth” simply by contributing 6% of pay at age 30 and ending up with a nest egg of $380,000. Why she thinks this one-size-fits-all number would equal retirement adequacy is not clear since it works only if the person’s income near retirement is $38,000 ($380,000 equals ten times pay at an income level of $38,000). Since the median income for that age group is around $65,000, these calculations don’t add up.

Auto-Enrollment: Better Than No Reform, but Not a Cure for Pension Poverty

The only reform to 401(k) plans has been to automatically enroll employees in an inadequate plan rather than requiring employers to contribute more to these workers’ accounts. The Pension Protection Act (PPA) of 2006 makes it easier for plan sponsors to automatically enroll their employees at a starting contribution rate of 3%, which can be raised by at least 1% of salary per year until it reaches 6%. However, although auto-enrollment will give people nest eggs that are better than nothing, it won’t fill them.

The problem with the preceding formula is twofold: First, a 3% starting contribution rate is too low for everybody. It’s less than one-third of the rate required at a starting age of 25 and less than one-seventh for a starting age of 40—and these scenarios assume an employer match! Second, auto-enrollment keeps the default rate artificially low for job changers, at least for those enrolled in a plan that would have raised their contribution rate each year. For example, workers who changed jobs every seven years would accumulate only 40% of what they’d need—and that’s assuming an employer match at each job. Job changers working for companies without a matching contribution would accumulate less than one-third of what they need.

To make matters worse, employers aren’t required to adopt auto-enrollment, and the ones that have adopted it typically don’t enroll current employees who aren’t participants, only new hires. Nearly two-thirds of employers use automatic enrollment only with new hires, according to a survey of almost 5,500 plans by Plansponsor.com, a retirement research firm in Stamford, Connecticut. In addition, they enroll employees at a “default” contribution rate that is lower than what they would have saved on their own. A Vanguard Group study shows that employees tend to save at an average rate of 2.9% when they are auto-enrolled, versus a 5% rate under voluntary enrollment.

Unfortunately, unless there is a public uproar—instructions for participating in it are included in the next chapter—the best the Obama Administration may do is require auto-enrollment rather than mandating higher employer contributions. The director of the Office of Management and Budget, Peter Orszag, is a proponent of auto-enrollment, having co-authored a book, Aging Gracefully, that promotes it. President Obama has also called for requiring employers that don’t offer a retirement plan to enroll employees in a “direct deposit” IRA account, covering the 75 million people who don’t have plans. Again, President Obama’s intentions are good, but as is the case with auto-enrollment, simply enrolling employees in a plan that requires them to foot the bill for their retirement is unheard of in other advanced countries. All companies except those run by the self-employed in Australia are required to contribute an equivalent of 9% of pay into their employees’ accounts.

Automatic Annuitization: Ripping Off People Who Can’t Afford to Retire

Not only has the mutual fund industry avoided the responsibility for telling their 401(k) clients how much to save in their accounts to achieve their goals, but many of the fund companies and their counterparts in the insurance industry have no compunction about selling annuities or other investment products such as managed payout funds to Baby Boomers who have reached retirement age without sufficient retirement assets. An incorrectly headlined front-page article in The Wall Street Journal, “Golden Years: As Boomers Retire, Insurers Aim to Cash In,” described the insurance industry’s push to sell annuities to retiring Baby Boomers despite a “checkered past” because of high fees, churning, and other issues. According to the Journal, sales of variable annuity products have increased more than 50% from 2002 to 2007.

Along with conveying the false impression that most people can afford to retire from a 401(k) plan, the article never addresses the most problematic potential feature of annuities: They can’t make empty nest eggs full. The function of an annuity is to make your adequate retirement savings last a lifetime even if you live to age 100 or more. If you haven’t accumulated enough, you need to keep working—a fact that sellers are not required to disclose to their customers.

Unfortunately, some pension advocates are favoring “automatic annuitization,” which means that workers with inadequate nest eggs will be sold a costly product that won’t enable them to retire—what’s more it’s likely that an unscrupulous insurance broker will try to earn commissions by selling annuity owners a new one shortly thereafter.

The so-called Retirement Security for Life Act of 2007, most likely dreamed up by the annuity industry and introduced in 2007 by Representatives Stephanie Tubbs Jones (D-OH) and Phil English (R-PA) and the ultimately defeated Sen. Gordon Smith (R-OR), would amend the Internal Revenue Code so that 50% of the income generated by the annuity would be excluded from tax; for the typical retiree the tax break would be up to $5,000.

The tax deduction, however, could be totally offset by the fees and frequently deceptive sales practices of the industry; the misdoings by some annuity salespeople include misleading investors about investment returns and how soon investors can access the money, along with generating commissions by convincing the customer to buy a new annuity. What’s more, the product isn’t even necessary, because the mutual fund industry offers an investment product called a managed payout fund that accomplishes the same goal at a lower cost.

In 2006, the National Association of Securities Dealers (now Financial Industry Regulatory Authority) issued an investor alert regarding annuity salespeople who conducted workplace seminars in which they convinced employees to retire early, cash out of their 401(k) accounts—and very likely causing them to pay “penalty taxes” if they were under age —and open an IRA that consists of a variable annuity. In one disciplinary case that NASD prosecuted, the broker told the employees, “You can make as much in retirement as you can at work,” saying that he could generate annual investment returns of 18% and assumed annual returns of 11% to 14%—which no investment can guarantee.

What follows are just a few of the numerous examples of actions taken against annuity sellers in various states.

• In 2008, Florida Governor Charlie Crist signed a law increasing penalties on annuity salespeople who pressure clients to buy annuities they don’t need or want. The law increases fines from $100,000 to as much as $150,000 for certain “unfair or deceptive annuity sales activities,” including “twisting,” in which a salesman lies about the benefits of his annuity to get clients to sell their current annuity from a different company, or “churning,” which involves replacing the annuity they have with a new product from the same company.

• In 2006, New York Attorney General Eliot Spitzer announced an agreement in which the Hartford Financial Services Group would pay $20 million in restitution and fines and implement reforms designed to bring fair play and transparency to the marketing of retirement products.

“This investigation shows how payoffs and deception influenced major deals for retirement products,” Spitzer said. The Hartford Financial Services Group also reached an agreement with Connecticut Attorney General Richard Blumenthal.

• In 2005, New Jersey launched its Senior Citizen Investment Protection Act, which limits how long annuity sellers can impose surrender charges in the event the annuity owner wants to sell the product.

How did an industry with such a shameful track record manage to convince some members of Congress to help boost its revenues? Along with the fact that campaign contributions from the insurance industry often influence decisions made by Congress, the industry was probably able to dupe nonprofit organizations representing women and minorities into supporting the legislation, thereby giving it credibility. It probably could do so because the annuitization option does shine a spotlight on one of the more unfortunate features of 401(k) plans, which is that unlike most defined benefit pensions, retirees with 401(k) accounts can and often do take their payments as a lump sum—even before they’ve reached age , causing them to have to pay taxes and penalties. With no good advice, they might spend the money foolishly rather than banking it and taking payments that will last a lifetime—or, more likely, banking it and continuing to work, which most of us need to do.

Unfortunately, neither the advocacy organizations nor Smith and his co-sponsors appear to have researched the track record of the industry before buying into the idea that an annuity is the solution to this problem. For one thing, for the tiny percentage of 401(k) participants who have saved enough, there are other options for providing income streams for life. For example, the mutual fund industry offers “managed payout” or “target distribution” mutual funds that feature lower fees than their annuity counterparts. What’s more, the mutual fund companies offering these products don’t employ salespeople who “twist” or “churn” the funds to generate sales commissions.

Bottom line: Anyone who is turning retirement age and is looking at a 401(k) account that’s significantly less than ten times their salary needs to keep working—that is, stay in the “accumulation phase” of investing until they have reached that goal, in which case they can study their best options in the “distribution phase.” There is no investment product that can turn a “sow’s ear” nest egg into a silk purse.

401(k) Security Act: Mandatory 9% Contribution for Companies with Ten or More Employees, Government Contribution for the Rest

Rather than continuing to “reform” defined benefit plans out of existence by putting too many shackles on them, we should work to improve 401(k) plans because they are the right plan for the 21st-century U.S. worker, who switches jobs an average of every four years—the highest turnover rate in the world. Someone with that job-changing history who worked exclusively for companies with only a traditional pension could end up never being vested in any plan—that is, pensionless.

To make a 401(k) plan walk, talk, and quack like a defined benefit plan but without the counterintuitive DB shackles, we should require that companies that are successful enough to have at least 10 employees contribute the equivalent of 9% of pay as Australian employers do, to an account that is portable when the employee leaves work. We should also propose a program that features a government contribution for those companies with nine or fewer employees, along the lines of the Universal 401(k) Plan proposed by Michael Calabrese of the New America Foundation (Disclosure: Calabrese was on my company’s board of directors when it was a nonprofit). More than 70 million American workers don’t participate in a tax-subsidized, payroll deduction saving plan. Calabrese observes that although 65% of full-time workers at firms with more than 100 employees participate in retirement plans, that rate sinks to 45% at firms with fewer than 100 employees and 25% at firms employing fewer than 25.

Calabrese’s Universal 401(k) plan would give every employee of a small company an Individual Career Account in which the government would match voluntary contributions by workers and their employers with refundable tax credits deposited directly into their accounts.

As is the case with Australia’s version of the 401(k), the country already has an employer-based government-matching program for low-income workers in place called the “co-contribution.” On top of the mandatory 9% of pay that workers at all employers regardless of size receive to their super accounts, Australians who earn less than $28,980 receive a $1.50 match from the government for every $1 the workers contribute, up to a total of $1,500; co-contributions reduce as income increases, phasing out completely at $58,980.

We Are on a “Countdown to 2011”

In a nutshell, we are looking at a retirement nightmare. The first wave of Baby Boomers, those born in 1946, is scheduled to retire in 2011 and can’t afford to—at the same time my daughter’s generation, one of the largest in history, is scheduled to graduate from college. Will a big percentage of the 4 million graduates wind up jobless because my generation’s 3.4 million Boomers can’t afford to retire? We’re witnessing a “perfect storm” of pension-poor Boomers, who will need to stay on the job, resulting in potentially jobless Gen Yers, many of whom also have college loans to pay off.

We need a public groundswell to get President Obama to enact the 401(k) Security Act described in this chapter. The next chapter lays out more details of the Act, what you can do to get the Obama Administration to enact it, and some smart 401(k) investing steps you can take in the meantime.

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