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A 401(k) plan is described as an agreement that allows employers to choose between accepting their salary in cash and deferring a portion of it to an account under a plan. The deferred balance is normally not taxable until it is removed. However, a recent system has emerged in which employers can delay previously taxable sums and thereby collect the amounts later without being taxed. 401(k) plans are eligible plans that are further known as fixed benefit plans. A survey by Investment Company Institute (2016) revealed that over 71% of the American population does not really know how much their 401(k) costs them. The costs associated with these plans are classified into three broad categories according to the Department of Labor (2016). These are; plan administration fees, investment fees, and individual service fees. Plan administration fees are the expenses involved in the day to day operation of the fund. They may include accounting, legal and trustee services. It is charged progressively meaning that those with higher investments pay more. On the other hand investment fees are by far the largest component of the plan. They are fees for the investment manager and other investment related services. They are usually charged as a percentage of the invested assets. In addition to those fees, there are individual service fees. These are overall administrative expenses associated with additional optional features offered under a plan.
With all these charges involved in a plan, it is no wonder that the 401 K system is failing and taking down a large proportion of the American population with it. It is estimated that one-third of the population between 26-62 years are uncertain of their retirement future. This is because the system has eaten away into their savings. For instance at a savings rate of $10000 p.a. one expects a return of $920000 but due to the cost implications of a 401 (k), the total amount lags just under $800000. Pushing on with the agenda of the cost implications the current economy does not advocate for savings due to the large debt luggage and the high cost of living (Department of Labour and Statistics).
Another reason that the system is failing is that it was never intended to be a mainstream retirement plan. It was only meant to supplement the already existing benefit plan. This clause in the byzantine tax code has been taken up by employers so as to save money. Since it is voluntary may employees never participate until their retirement comes knocking and different employers just pass down charges making the system impossible to maintain. Many employers also never audit their plans thus even if a change in the 401 (k) becomes cheaper it is never reflected on the employee.
It has also been noted by various investment research groups that the employee is not a shrewd investor. Most employees are either too reckless and invest in very risky portfolios which leave them grappling with poverty in their old age. Other employees are too risk-averse and end up using their contributions on a portfolio that earns them little to nothing meaning that they still lack the financial security that is reasonable during retirement.
Legislations to enhance the 401 (k) to make it universal and law cost always fails due to employer and financial services lobbies. Thus due to the lack of adequate transformations, the entire retirement plan is doomed to fail.
Many of these plans offer too many choices to the employee. With limited knowledge in the investment industry, many employees often than not make the wrong decisions. Another problem is that even with the right investment the retirees often withdraw their money in a lump sum and put it in IRRs (Andrews). This brings in extra charges that significantly limits their savings and leaves them vulnerable to conflicting investment advice. Conflicting financial advice is estimated to cost pensioners an average of $ 17 billion annually (Wasik).
The ways to mitigate the consequences of this failed system is by ensuring for one the presence of sound legislative systems to guard retirees from the greedy grasp of fund managers. The fiduciary standards should as well delink the plan from employers and commoditize it. This may make the entire plan way more affordable.
Innovation can also be used to curtail the devastating effects of the 401 (k). Innovations such as the Secure Choice Plan in Carolina should be embraced. This pools all the funds and hence keeps costs down and is open to all parties of the population. Also, the plan has a contingency reserve funds that protect against adverse losses.
Another solution to counter this failing system is to strengthen the only remaining working retirement system, Social Security. This still remains the one program that cuts across race, income and education spectrums. The fud should be improved despite it taking a long time because it offers more benefits than the current 401 (k) system.
Every 18 year old in the country should receive substantive education on the basics of such items as compound interest, investment risk, debt management and investment expenses and risks. This will create a generation of elite investors hence reduce the chances of losing millions in poor investment practices.
To show the effect of higher expense ratios the following example is taken. There are two people with equal mutual fund asset capabilities and their investments are to last 30 years. Annual savings amount to $15000 and a 2% inflation rate. Person A has an internal rate of return equal to 8% and a 1% expense ratio on their 401 (k). Person B has 7.5% internal rate of return and a two percent expense ratio. Their asset values will be as follows after the thirty years lapse. Their total assets would be $840000 for person A and $700000 for person B.
Andrews, Nancy H. Kiplinger. 01 January 2017. Web. 12 November 2017.
Department of Labour and Statistics. Retirement Benefits Schemes. Thesis. Washington: Government Press, 2016. Document.
Investment Company Institute. Why the 401(k) Plans are Failing. Corporate Document. New York: Free Press Publishers, 2016. Document.
Wasik, John. "Why 401(k)s have Failed." Forbes 12 June 2017: 16-18. Document.
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