Why 401(k)s Failed

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

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