Why 401(k)s Failed

July 5, 2011

As Boomers are preparing to retire, the news is full of stories about how their 401(k) plans are coming up short.  Most of the stories imply that it’s the Boomers own fault for not saving enough.  That explanation, though, grossly distorts the cause of the growing retirement crisis in the United States that was fueled by the wholesale conversion of tradition pensions to 401(k) stock market investment schemes beginning in 1981.

To understand why 401(k) plans are coming up short, it is necessary to understand how they are supposed to work. 

The basic idea is that participants will individually save for retirement through private accounts that are invested in stocks and bonds.  The accumulations from those accounts during working years are supposed to grow enough to finance living expenses during retirement years. 

Most people understand that much.  But that is only half the story. The other half is what participants are supposed to do with their accumulated savings once they retire.  There are many possibilities, but the most recommended according to the original theory of the 401(k) approach is to use the accumulated savings to purchase life annuities, which are sold mainly by life insurance companies.  In return for surrendering their 401(k) savings, annuity purchasers receive back a percentage of the purchase amount each month or other period of time for the rest of their lives.   

Life annuities are comparable to traditional pension payments since both guarantee predictable income until death, thereby sparing recipients the risk of outliving their source of income.

The ability of a 401(k) plan to provide adequate retirement security depends, it follows, on the size of the retirement savings accumulated during the working years and the payout rates of annuities at the time of retirement.   

The size of accumulated savings, in turn, depends on how much was invested in the accounts and how those investments fared in the stock market.  An account with little invested in it obviously is not going to pay off with handsome returns for retirement. 

Most people with 401(k) accounts, it is true, do not put enough in them to ensure retirement security.  The main reason, though, for them coming up short is not because of a lack of a savings ethic on their part.  It is because the savings necessary to ensure retirement security under the 401(k) approach is beyond the ability of anyone with ordinary incomes and expenses, including home mortgages and children’s college expenses.

The stock market is the other factor that affects the size of the accumulations in 401(k)s.  Since 1981 when they began, the stock market has risen greatly, leaving participants with the illusion that those rising values were ensuring retirement security. .

But as those stock market values were rising, annuity payout rates were falling.  In 1986 a life annuity purchased for $100,000 yielded a monthly retirement income of $977 for men and $931 for women—annuity companies discriminate against women by paying them lower rates to compensate for them living longer.  In 2010, an annuity for that same cost yielded only $631 for men and $531 for women–35 percent less.

Average Monthly Payouts for $100,000 Annuity Bought at Age 65

Year                Male               Female


1986               $977               $931

1990               $958               $865

1995               $808               $718

2000               $759               $693

2005               $647               $596

2010               $631               $591


Source:  Calculated from www.annuityshopper.com

401(k)s thus failed to deliver retirement security not so much because of the improvidence of Boomers, but because even if they saved a lot, the value of those savings in terms of future retirement income were continually falling due to the decreasing payout rates of annuities.  Those falling payout rates easily outpaced rising stock market values.  No one should be under the illusion that low annuity payout rates are temporary.  As the above table indicates, they have been in steady decline since 1986.    

Thirty years after its inception, it is clear that the 401(k) approach has failed working people by not delivering predictable or adequate retirement income. At the same time it has been an enormous success for the financial services industry that has siphoned off the accounts a bonanza of commissions, management fees, and profits.  Therein lies the reason why these powerful financial interests will make sure that they continue to be able to control the collective retirement savings of working people.  

James W. Russell

Stockman’s March to Social Madness

April 24, 2011

David A. Stockman, Ronald Reagan’s Director of Management and Budget, came right out and said it in an April 24, 2011 New York Times op-ed, “The Bipartisan March to Fiscal Madness:”  Social Security should be reduced to a means tested program that would benefit only the poor.

Instead of being the primary source of middle and working class retirement income, it would become a welfare program.

At a time when 401(k) type retirement plans have been exposed for not being able to provide anywhere near the retirement security that the traditional pensions that they replaced provided for working and middle class retirees who are now more dependent than ever on Social Security, removing that source of retirement income from ordinary people would be a road to social madness.

Stockman’s advocacy is consistent with the World Bank’s 1994 Averting the Old Age Crisis report that led to widespread disastrous privatization of national retirement systems in Latin America.

What neither he nor the Times disclosed is that since leaving the Reagan administration, he has become very rich through positions in the financial services industry, including in Salomon Brothers, the Blackstone Group, and his own company, Heartland Industrial Partners.  That industry stands to profit handsomely from all diversions of current retirement savings from Social Security to its own 401(k) like plans.

And, of course, Stockman has become so rich from the financial services industry that he has no personal need for Social Security benefits during his own retirement.

James W. Russell

Removing the Income Cap and Taxing Property Income: Two Easy Ways to Assure Social Security Solvency

April 19, 2011

The alleged long term shortfall in Social Security revenue can be easily remedied if the rich were required to pay taxes for the program based on their total incomes as they are required to for other parts of the federal budget such as defense. Right now they pay Social Security taxes on currently only the first $107,000 of their wage and salary income and nothing on their property income, which is the largest source of their total income.

As the below table indicates, for those earning under $100,000, about 79 percent of their Adjusted Gross Incomes come from wages and salaries. But for those receiving over $100,000, forms of property income – profits, dividends, interest, rents, etc. – make up increasing shares of AGI. At some point between $300,000 and $500,000 property incomes surpasses wage and salary income. As a result, those who receive more than $100,000 together receive a greater share of national income than under $100,000 earners but they collectively support Social Security less.


Income Class and Tax Support for Social Security


Adjusted Gross Income           % Income Subject to

                                                             Social Security Taxation


Under $25,000                                             78.6

$25,000 under $50,000                              82.2

$50,000 under $75,000                              79.4

$75,000 under $100,000                            78.2

$100,000 under $200,000                          63.9

$200,000 under $500,000                          28.4

$500,000 under $1 million                         11.5

$1 million under $5 million                           4.0

$5 million under $10 million                       1.1

$10 million and greater                               0.3


Source: Calculated from Internal Revenue Service, Table 1.4 “Individual Income Tax, All Returns: Sources of Income, Tax Year 2006, http://www.irs.gov/taxstats/indtaxstats/article/0,,id=134951,00.html#_pt11

The higher the income over $94,200 in 2006 – the last year for which full tax statistics exist – the greater the proportion of AGI that is shielded from Social Security taxation for two reasons. First Social Security taxes (6.2 percent for both the employer and employee) were collected on only the first $94,200 of wage and salary income. Second, no Social Security taxes are paid on property forms of income.

Social Security revenue could be significantly increased by removing the cap on wage and salary income and exposing property income to taxation.  Removing the cap, by my calculation, would have added $111.6 billion to the $677 billion collected that year – a 16.5 percent increase that would have been much more than sufficient to insure solvency. Revenue could have been enhanced a further $91.1 billion if enough of the nonwage income of those receiving over $100,000 was included so that at least 79 percent of their Adjusted Gross Income was exposed to Social Security taxation as is that of those earning less than $100,000.

These reforms would go far beyond insuring the current benefit levels of Social Security. They could and should be the first steps toward expanding Social Security benefits.

James W. Russell 


From Connecticut to Chile: The Neo-Liberal Assault on Retirement Security (video)

March 28, 2011

You Tube video of James W. Russell speaking at the Left Forum, Pace University, New York City, March 19, 2011.  Click here.

401(k) Open and Hidden Fees

February 16, 2011

Management fees, commissions, and profits severely compromise what can be accumulated in 401(k) and other defined contribution retirement plan accounts. Defined contribution participants typically lose from 20 to 30 percent and more of their accumulations to investment management fees charged by the financial services industry.  The administrative overhead costs for defined benefit plans are much lower, though, surprisingly, there are no national comparative studies.  A part, but only a part, of the reason why defined contribution plans have more administrative costs is because it takes more time to manage fifty individual defined contribution personal plans than it does to manage one common defined-benefit plan.  Beyond that honest difference, the financial services industry has multiple opportunities to charge fees and commissions for its services to defined contribution plan participants.  Most of these fees are hidden.  By law defined contribution plan participants must receive regular statements with information about their accounts.   That doesn’t mean, though, that the statements must disclose what fees have been taken out.  Nor does it mean that the statements have to present their information clearly.  Most people who I know are at a complete loss for deciphering the information in their statements. They instead immediately look for how much  has been accumulated in the account, which is usually more than the amount on the previous statement.  What they don’t see is what the account balance was before management fees and commissions were taken out. 

 401(k) balance statements vary in how much information they disclose about fees and commissions.  Some only disclose account balances.  Others include information on expenses, but it is deceptively limited information.  The most accessible fee is that charged by the administrator of the plan, sometimes called the third party administrator fee.  That company will charge a percentage of the account balance.  But since the administrator is putting your money into other funds, the administrative charges don’t stop there.  Each of those funds has its own administrative fees.  To determine that, you have to find the “expense ratio” of the fund.

 Deloitte Consulting LLP surveyed 130 defined contribution plans in terms of what it called “all-in” fees, which combined the third party administrator and expense ratio fees.  It found a range between .35 and 2.37 with a median of .72.  In general, the greater the assets and number of participants in a plan, the lower the fee was likely to be.  Plans with fewer than 100 participants paid an average of 2.03 percent of assets in fees compared to 0.49 percent for plans with 10,000 or more participants.

That though may be the just the tip of an iceberg in which there are greater more deeply hidden fees.  If I invest in a fund that is made up of other funds, a fund of funds, each of the combined funds will have separate fees that are not reflected in the fees of the parent fund.  Commissions that are paid by mutual funds to brokers for purchases and sales are not included in expense ratios and thus also hidden.  There are multiple other hidden rake offs to which you could be subject.  These have such financial services industry names as wrap fees, mortality and expense charges, surrender charges, money market spreads, and floats.  Then, not to be forgotten, wherever your investment ultimately lands, you will not receive all of the profits that it facilitates.  The company where the investment is made will deduct its expenses, which could include large CEO bonuses, before distributing dividends to shareholders.  By treating bonuses as expenses rather than profits, top managers essentially using an accounting trick to expropriate profits for their own use rather than distributing them to owners, including 401(k) investors.  It is a practice that is all the more easier when the 401(k) “owners” are so far removed from any actual control over what they theoretically own.

When the fees, commissions, and profits are added up, their impact is far greater on accumulations than the sum would indicate.  If the growth rate on your fund is 7 percent, a reasonable sounding 1 percent fee amounts of a loss of one-seventh or 14 percent of its value in the first year.  It gets worse as time goes on.  Over 25 years it results in close to a 21 percent loss of accumulation if the average growth in value stays at 7 percent because of the combined effect of compounding.  For lower average growth rates, proportionate losses to the fees will be still greater.  If, as predicted by many, the stock market growth rate will be low or flat for the coming years, the impact of 401(k) and other defined contribution plan fees, commissions, and profits will grow.

The financial services industry collects fees whether or not you change your investments.  I did nothing with mine from 1994 to 2010, but they inexorably collected their fees based on my growing balances, which of course produced growing fees for them for doing nothing.

James W. Russell

How 401(k)s Discriminate Against Women

February 4, 2011

401(k)s are set up so that participants will accumulate funds during their working lives and then purchase annuities with those funds to finance their retirement.  They could also actively manage their portfolios during retirement, but most experts agree that annuitizing produces more stable income security.

The annuity business is based on calculating life spans.  Since women live on average longer than men, they will collect annuities longer.  To compensate for making more payments to women, issuers of annuities lessen each payment to female retirees.

Vanguard’s annuity calculator allows a test of this.  Inputing a 65 year old male with $100,000 to spend produces a quotation for a single life fixed monthly annuity of $692.60. Changing the gender produces a new quotation of $633.67–8.5 percent less.

While this discrimination may make sense actuarially, it does not make human or social sense. We can safely assume that the monthly cost of living of women is not 8.5 percent less than that of men.

The formulas for determining traditional defined benefit pensions by law do not distinguish men from women.

James W. Russell

State Bankruptcy: A Right Wing Fantasy to Enable Confiscation of Employee Pensions

January 23, 2011

States currently cannot declare bankruptcy.  If the right has its way, that would change, according to an article, (“A Path is Sought for States to Escape Their Debt Burdens,”)  by Mary Williams Walsh in the January 20, 2011 New York Times.

Walsh cites such right-wing politicians as Newt Gingrich and conservative media as The Weekly Standard who are backing legislation that would allow states to declare bankruptcy.  Such a legal declaration would then allow judges to reduce or eliminate pensions. 

Most of the Times article is devoted to the advantages of that course of action and the obstacles that it faces as legislation. It is built though on a false premise—that “some states have deep structural problems, like insolvent pension funds, that are diverting money from essential public services like education and health care.” 

The author of the article has confused  the existence of unfunded liabilities with insolvency.  The former, as explained in an earlier posting (see “Unfunded Public Employee Pension Liabilities:  a Red Herring”) means that a pension funds does not have sufficient reserves to immediately pay off all obligations to retired and current workers should contributions completely stop—a condition that only bankruptcy could allow.  Insolvency means that a fund does not have enough income to pay its bills.  A number—but not all—state pension funds have unfunded liabilities; but none are insolvent or near there.  All state pensions have sufficient funds to pay obligations to retirees.

The right wing wants the possibility of state bankruptcy in order to confiscate the current state pension trust funds and divert them to other uses—such as to pay off state bondholders or balance budgets.  That would of course be an expropriation of state workers’ retirement savings.

It would be as if  Congress voted to seize the Social Security Trust Fund to balance the budget of the general fund.

The right’s long term goal is to eliminate all defined benefit pensions, which state bankruptcy legislation would facilitate, and force people to rely only on private stock market investment accounts such as 401(k)s.

Fortunately, there is not much likelihood of the state bankruptcy campaign succeeding in at least the near future.  State bankruptcy, aside from being threatening to pension participants, would also threaten the interest of bondholders and stability of financial markets.  State tax revenues are already increasing, however slowly, as the economy recovers. As they increase, the crisis atmosphere around state financing will decrease, and with it any temptation by politicians to entertain right-wing radical proposals such as allowing states to declare bankruptcy. There is also the reality that guaranteed contractual claims to pensions represent legally binding property rights; and if there is anything that this country seems to honor, it is property rights.

James W. Russell

401(k)s versus Social Security: Comparing the Rates of Return

January 12, 2011

A common claim of advocates of Social Security privatization is that private accounts deliver much higher rates of return for participants. The Cato Institute, for example, in its Cato Handbook for Policymakers tells us that:

�Social Security taxes are already so high, relative to benefits, that Social Security has quite simply become a bad deal for younger workers, providing a low, below-market rate of return. This poor rate of return means that many young workers� retirement benefits are far lower than if they had been able to invest those funds privately. However, a system of individual accounts, based on private capital investment, would provide most workers with significantly higher returns. Those higher returns would translate into higher retirement benefits, leading to a more secure retirement for millions of seniors.�

But is that true? To test the claim I compared my Social Security statement with my TIAA-CREF statement for a 401(a) plan which is essentially the same as a 401(k). Both list the total contributions made by the employers and myself. The Social Security statement indicates my benefit at 66, the age of my full retirement. My TIAA-CREF statement has the total accumulation. Since I am nearly 66 I can know much an annuity income it is worth.

My first year Social Security benefit was 12.61 percent of my total contributions. The first year TIAA annuity was 12.06 of total contributions�lower not higher than the return on my Social Security contributions as the Cato Institute so confidently claims.

It is important to point out so that as a professional employee, I am in a relatively high income category with a Social Security rate of return that is less than that of lower-income participants. For them, the rate of return for Social Security compared to private accounts would be much higher than mine, making it an even better deal.

Like the optimistic projections of the financial services industry whose interests it serves, the Cato Institute�s claim is based on before-the-fact overly optimistic assumptions of future market returns. My comparison was based on after-the-fact actual experience.

Addendum: from a reader of Social Insecurity: 401(k)s and the Retirement Crisis who ran his own numbers:

“I looked at my last Social Security statement that was mailed to me, which covered the years
from 1967 to 2011.  The contributions of my employers and my own added up to $115,000.
From then to retirement, another $8,000.  Thus a total o $123,000 gives me a retirement
income of just over $1800/month.
“For a 401K to achieve this at a 5% rate, I would need to save an amount of $432,000.  That is
being generous with the rate;  I think they are now around 4%.
“The above reminds me of a quote you included from Lawrence Summers.  To paraphrase,
its all about efficiency-99% of contributions go to benefits.”

–James W. Russell

Unfunded Liabilities of Public Pensions, A Red Herring

January 6, 2011

Rarely have so many people believed as an article of faith something so fervently that wasn�t true: unfunded liabilities of public pensions are speeding us toward fiscal Armageddon. Unless something drastic is done very soon, we taxpayers will have to bailout overly generous, fiscally irresponsible public employee pension systems. A class war is looming, according to one New York Times columnist, between taxpayers and the beneficiaries of these systems.

But ask most people who believe this what an unfunded liability is and they�re not exactly sure. They only know that it is bad, very bad, and threatening to them.

To understand what an unfunded liability is, it is necessary to look at how most pensions used to be funded, on pay-as-you-go bases. That meant that as contributions from employers and employees came in, they were paid out to retirees. It worked for government pension funds because you could assume that they would always be around with workforces to make contributions, unless one believed in the arch libertarian fantasy of total privatization, a government without government employees.

Without going to those extremes, one could reasonably believe that one day there might be fewer employees supporting more retirees and the fiscal balance would be upset. That possibility plus the reality that private corporations with pension funds might go bankrupt stimulated the call for prefunding of pensions. With a fully pay-as-you-go system, if contributions stop, as when a company goes out of business, pension payments have to stop too and current workers receive nothing for their contributions.

The whole idea of prefunding is to build up enough of a reserve in pension funds so that should contributions stop, there will be enough to keep paying pensions for the rest of retirees� lives and pay off current workers for what they have contributed. That is a good prudent fiscally conservative goal. Any pension fund can be so measured according to how close it has come to achieving it.

Some public pension funds are fully funded, others overfunded�yes, overfunded�and others underfunded, the ones that selectively receive all the press attention and ire. I�m still waiting to see a newspaper article about the many public pension funds that are in very good shape despite the recession.

Being underfunded in itself is not a problem so long as enough contributions are coming in to meet current�as opposed to all current and future�obligations. There is no need to reform the balance between revenues and expenses if there is progress toward full funding.

Even if progress is stalled or going in the other direction, there may be no fiscal need for reform if the condition is temporary, as when a recession decreases revenues from pension fund investments�what is currently beleaguering many public as well as private pension funds.

Reforms are only needed for those pension funds whose balances of unfunded liabilities are growing on a long term basis. In the worst of those cases, slight changes in contribution rates deliver dramatic revenue increases. Such abuses as spiking�the artificial driving up of final salaries with overtime and other means to increase benefits�can and should be eliminated. Employer underfunding by skipping contributions that are not made up can be reduced or eliminated. Early retirement incentive programs that offer workers unearned pension credits can be eliminated.

The real aim of the enemies of public pensions, though, is not prudent stewardship of the funds. It is to eliminate them entirely and replace them with 401(k)s.

Public as well as private pension funds can have unfunded liabilities because their benefits are guaranteed. That requires that they be funded properly. Because 401(k)s have no guaranteed benefits, by definition they have no liabilities, funded or unfunded. Their sponsors are thus completely absolved of any responsibility for proper funding.

If a state skips payments to a public pension fund as a means of making up for revenue shortfalls during recessions, that will come back to haunt it in the form of an increased unfunded liability which must be addressed when the economy improves. If an employer skips payments to a 401(k), it can be done without fear of having to face any future reckoning. All future consequences will be borne by workers at retirement.

It is curious that when 401(k)s began in 1981, they were sold on a promise�but with no guarantees�that they would deliver greater benefits than traditional pensions. Now that that claim has been exposed to be false, the argument has shifted to traditional pensions are too expensive. To sustain the new claim, the proponents of 401(k)s have exaggerated the fiscal problems of public pensions�to manufacture the perception of imminent crises where none exist�and attempted to whip up resentment against those who still have secure pension plans.

It is a manufactured crisis that diverts attention from the real crisis: American retirement security is declining rapidly precisely because 401(k)s have increasingly replaced secure, fiscally sound for the most part, traditional pensions.

–James W. Russell