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Retirement Wreck
Are 401(k)s Still Viable for Saving?

By Nancy Trejos
Washington Post Staff Writer
Sunday, October 12, 2008

For many Americans, 401(k) plans were supposed to be their own little golden parachutes into retirement.

Now, it seems, those parachutes may not open in time.

The global financial crisis that revealed the flaws of Wall Street has also exposed the vulnerability of America's retirement system. Employers have increasingly abandoned traditional pensions, forcing workers to rely on 401(k)s and similar plans that have a lot more exposure to the stock market. The assumption was that even if the market suffered short-term losses, over time it would rise, allowing workers to recoup their savings. But the steepness of this year's market collapse and the still-uncertain depth of the economic downturn has prompted lawmakers, academics and economists to question the wisdom of letting workers hitch their retirement fortunes to the precariousness of the stock market.

So far this year, the Dow Jones industrial average is down 36 percent, eroding the savings of millions of Americans and forcing those who had planned to retire in the next few years to reconsider their plans.

"Right now, we're really seeing the risks come home, and people are recognizing the extent to which their retirement savings are on the line when the stock market goes down drastically," said Jacob Hacker, a political science professor at the University of California at Berkeley who chronicled the advent of 401(k) plans in "The Great Risk Shift."

Until three decades ago, Social Security and pensions, formally known as defined-benefit plans, were the main sources of retirement income. Now, Social Security is in danger of eventually running out of money. And defined-benefit plans, in which employers made the investment decisions and promised to pay employees a set amount each month for the rest of their lives, are quickly disappearing.

Favored by the "ownership society" movement, defined-contribution plans, which 401(k)s fall under, have picked up the slack. In 1985, there were 29 million participants in defined-benefit plans and 10 million in 401(k)s. In 2005, there were 21 million in defined-benefit plans and 47 million in 401(k)s. The government has encouraged that shift, providing $80 billion in tax breaks each year to people who store their money in 401(k)s. But in return, workers have had to assume the investment responsibilities even if they know little about the stock market. They have also had to give up their lifetime guarantee of income.

"Everyone wiped their hands of any obligation for retirement, and the burden shifted from the employer to the employee, and the risk is shifted from the employer to the employee," said Rep. George Miller (D-Calif.), chairman of the House Committee on Education and Labor, who last week convened a hearing to examine 401(k)s. "In the beginning, no one ever said, 'Would this be sufficient? Would it work?' and what you see is a plan that is highly responsive to external events unlike Social Security, unlike defined-benefit plans, unlike a public pension plan."

Proponents of 401(k)s say with those greater risks come greater rewards. "If you own equities, you really have to believe in the American capitalist system in that the dollars will find the highest and best use," said Mickey Cargile, a managing partner for WNB Private Client Services, a financial advisory firm in Texas. "Along with that, there will be a period in which the excesses in the market will be purged. That's what we're seeing now. That's what we saw in 1987."

In the past15 months, Americans have lost about $2 trillion worth of retirement savings both in pensions and 401(k)-style plans, Peter R. Orszag, director of the Congressional Budget Office, told Miller's committee last week. Because 401(k)s tend to have more stocks in their portfolios than pensions do, Orszag concluded that 401(k)s have been the biggest losers.

This year, the average account balance of 401(k) participants has dropped 7.2 to 11.2 percent, according to an analysis of 2.2 million plans by the District-based Employee Benefit Research Institute. But many workers have seen even sharper declines in recent months, analysts and economists say. Further draining retirement accounts is that many workers have been allowed to dip into their 401(k)s for loans or so-called hardship withdrawals. That trend has been increasing in recent months because people can no longer tap the equity in their homes to pay down credit card debt.

The experts disagree over how long it takes to recover from a bear market. The financial firm T. Rowe Price found that in the past five bear markets going back to 1976, the longest it took for stocks to recover from their peak and then provide a 10 percent annual compound return was eight years. The shortest was five months.

Sarah Holden, senior director of retirement and investor research for the Investment Company Institute, which tracks mutual funds, looked at the bear market of 2000 to 2002. She found that among participants who stayed in their 401(k) accounts, the average account balance fell 8 percent from 1999 to 2002. But in 2003, the average balance increased 30 percent. Overall, the average balance almost doubled from the 2002 bottom through 2006, she said.

Teresa Ghilarducci, a professor of economic policy analysis at the New School for Social Research in New York, provided a bleak assessment for what might happen this time around. She calculated what you would end up with in 10 years if you had $100,000 in your account in August and lost 20 percent of it last month. If you were paying 2 percent in administration fees, as many 401(k) plans charge, and the stock market remained flat for three years, a real possibility given how it has performed, and then earned 1 percent per year, as it did in the 1970s, you would have $67,000 by the end of the decade, she said.

"With a flat market at best and high fees, it is likely they will have less than they and their employer put in," she said.

What if you were planning to retire in three years? The loss of the retirement savings coupled with declining home values, higher household debt, a higher cost of living and many banks' unwillingness to grant credit could spell disaster for many retirees, economists said.

To make up for it, soon-to-be retirees will have to spend less now in order to have more later, which will further weaken an economy largely dependent on consumers' dollars, economists and analysts said. Or they will have to work past the traditional retirement age of 65, which poses its own macroeconomic problems, they said.

"That has a perverse effect on the business cycle," Ghilarducci said. "In a defined-benefit plan, people tend to retire when jobs are scarce. That has a stabilizing effect on the macroeconomy. They pull out of the job market, leave jobs open for young people, and still have the spending power. 401(k)s are destabilizing . . . You stay on the job when jobs are scarce, you don't have money, and you have no spending power. You keep that job just when we need jobs to open up for younger people."

Proponents of defined-contribution plans say the naysayers are feeding into the hysteria gripping investors these days. They point out that defined-benefit plans are not immune to the shocks of the market because they too invest in stocks.

"We're in the middle of a financial crisis of confidence, and it should be no surprise at all that 401(k) investors are caught up in that," said Ed Ferrigno, vice president of Washington affairs for the Profit Sharing/401(k) Council of America. "By the way, so are defined-benefit participants. You can be sure the people running those assets are just as concerned as the 401(k) folks."

There are other risks with pensions, he said.

"Here's what you can't control in a defined-benefit system," Ferrigno said. "A) You can't control your ability to stay with one employer for 30 years. B) You can't control the ability of your employer to offer a plan. C) You can't control your employer from going bankrupt. There's risks in both systems."

The beauty of the 401(k) system, he and other proponents said, is that it allows for more wealth accumulation than pensions do. "Yeah, the risk is shifted to you and the reward is shifted to you. There is no free lunch. There's clearly an element of personal responsibility, but the government and the employer are partnering with you," he said.

Still, according to global consulting firm Watson Wyatt Worldwide, from 1995 to 2006, defined-benefit plans actually outperformed defined-contribution plans by about 1 percentage point per year, translating into a cumulative difference of nearly 14 percent for money invested at the start of the period.

The authors of the study attributed that to the fact that pensions are managed by professionals with financial education and access to sophisticated investment tools.

Indeed, part of the problem with 401(k)s, economists and advisers said, is that too many workers make bad investment decisions. The Employee Benefit Research Institute found that more than one in four of the oldest 401(k) participants, including those at retirement age, had 90 percent or more of their assets in equities at a time when they should have far less than that. Another mistake is that they don't rebalance their investments every once in a while.

"The main thing is that too many people have too much risk in their portfolios and when a crisis hits, they tend to react in ways that hurt them even more," said Christian E. Weller, senior fellow at the Center for American Progress.

Therein lies another problem. Recent surveys have shown an uptick in the number of people taking their 401(k) assets out of stocks and parking them in what they consider safer places, such as Treasury bills. But they fail to consider other risks, such as inflation, that Treasury bills or cash won't shield them from.

The better way to handle the crisis, advisers said, is to stay put. Don't pull money out of stocks because you will lock in your losses. Keep as much in your 401(k) as your employer will match; otherwise, you are leaving free money on the table. But if you feel you do have too many risky investments, and it's making you toss and turn at night, go ahead and rebalance your portfolio, advisers said.

Lawmakers, too, have to do some reassessing of the entire retirement system, Miller said. "I think when you have this kind of calamity, you get a chance to go back to the fundamentals and ask basic questions," he said. "This is an opportunity to really look at what value taxpayers are getting for the $80 billion [in tax breaks]. What value is the saver and retiree getting from this plan? And are they really equipped to handle the risk?"

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