What’s So Great About 401(k)s, Anyway?


After I wrote my Thursday post on 401(k) plans, I got a fair amount of pushback. Essentially it boiled down to “What’s so good about them compared to old-style pensions? Why not just get rid of them and expand Social Security instead?”

The answer to the second question is simple: 401(k)s are meant as supplements to Social Security. If we want to expand Social Security, that’s fine. But that’s no reason not have additional options to save privately for retirement.

Fine. But why 401(k)s? What is so good about them? The basic answer, of course, is that they’re set up to encourage monthly contributions in a hassle-free way and the money you contribute is tax-deferred. Beyond that, though, there are several advantages that a 401(k) plan has over a traditional pension. Here are five:

  • 401(k) plans are portable. They begin accumulating immediately (or close to immediately) when you start a new job, and if you leave your job your 401(k) comes with you. This isn’t true of old-style pensions.
     
  • If you want, you can withdraw your 401(k) as a lump sum when you retire. This can be handy if you want to use a portion of your retirement savings for a single large purchase, like a house or a motor home.
     
  • If you die early, your kids will inherit your 401(k). They won’t get a dime from Social Security or an old-style pension. This may or may not be something you personally care about, but a lot of people do.
     
  • The main drawback of a 401(k) is that it’s risky: since you don’t know how long you’ll live, you can never be sure how much you can safely withdraw each year. But in 2014 the Treasury issued guidance that made it easier for 401(k) owners to allocate all or part of their contributions into an annuity fund that pays out steadily upon retirement.
     
  • Annuities are getting better, but it’s still true that you have to be pretty careful selecting one. Some are bad deals. But there’s another way to effectively annuitize your 401(k) without paying a dime: delay your Social Security retirement age. Here’s how it works.

    More and more people are retiring at age 62, but this reduces your Social Security payment by about 20 percent compared to retiring at age 65. For example, a $2,000 monthly Social Security payment would be reduced to $1,600 if you retire at 62.

    Instead, use your 401(k) to fund your retirement from 62 to 65. In this example, it would require a final 401(k) balance of about $72,000 or a little less. You’d draw out $2,000 per month and then, at age 65, switch over to your Social Security payout. You’ve basically guaranteed yourself a lifetime income of $24,000 per year instead of $19,200 without any worries about whether your 401(k) will last forever.

Nothing in life is perfect. There are also advantages to old-style defined-benefit pensions, as well as to a simple expansion of Social Security. And 401(k)s require workers to shoulder more responsibility for figuring out how to invest their savings. They also have to shoulder more of the risk of market downturns.

Nonetheless, 401(k)s aren’t bad. The 2006 Pension Protection Act improved them by allowing employers to sign up workers automatically (they can opt out if they want), and this has significantly increased the number of workers who participate. It’s especially raised the number of low-income workers who participate. The PPA also allowed employers to automatically increase the contribution rate over time (again, workers can opt out), which promises to make 401(k)s more substantial retirement vehicles. It also encouraged the use of low-fee lifecycle funds that make riskier investments when you’re young and slowly switch to safer investments as you get closer to retirement.

All of these things have improved the 401(k) landscape. The economic recovery has too: a lot of the scare stories about 401(k) plans were based on using data through 2011 or 2012, which meant choosing an end date literally in the middle of the worst recession since World War II. That’s cherry picking of the worst kind. 401(k) plans were bound to recover within a couple of years, and they did. If you look at data through 2014 or 2015, average 401(k) returns look pretty good. When it comes to retirement funds, you have to look at the long term, not just the best or worst years.