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The Pitfalls of 401(k)s and How to Avoid Them! Pt 1

Fiscal Cliff

 

 

Let’s start with the positives of the 401(k) plan before we get into the Pitfalls.

Number One, once you set up the plan your contributions are automatic; you do not have to think. You can view this as “forced discipline.”

Number Two, there may be a Company match; you make a contribution and they match your contribution , typically 25 or 50 cents for one of your dollars, and some will match dollar for dollar.

OK, that’s about all the positives…..now let’s reveal some “Pitfalls.” :

Market Risk

While this sounds like a no-brainer, many employees are under the impression that they cannot lose their money that is in “The Company Plan.” Setting the obvious aside, let’s look at the reality that most workers focus on what they are good at in their job, yet now that they are putting money into this plan they must now know how to navigate the choppy waters of the Stock Market!

This arduous task quite often leads to unwise behavior such as emotional based decisions, hyper-trading (frequently switching fund choices), timing the market and speculating and gambling. All of these factors, according to Dalbar Research, are why individuals investors on average earned a meager 4.25% annually over the past 20 years, while the S&P 500 averaged 8.21%.

[Dalbar’s Quantitative Analysis of Investor Behavior Dec. 31, 2013]

Income Risk

When the 401(k) was first introduced in 1981, one of the intentions was to direct your attention away from the “disappearing Company Pension Plan” and focus on the growth opportunity of having your retirement funds in the Stock market.

One of several risks that resulted was that workers went from having a Defined benefit plan, in which they knew with certainty (dependent upon age, years of service, and averaged salary) what their future monthly retirement income would be, to having no idea at all what their future income will be.

So instead of knowing that you are working towards a future monthly income of $3,800, for example, you are now encouraged to put your own money in the Stock Market, possibly matched by a contribution of the Company’s money, and are expected to figure the rest out on your own.

As I write this, the majority of public companies’ 401(k) plans have absolutely no income provisions at all! Meaning that when you get to the point of retirement and have say, $400,000 in your 401(k) (Should you be so fortunate), what do you do with it? Take withdrawals? How much? How long it last? What if the market keeps going down? Obviously a drop in value like we saw in 2008 will have a devastating effect on the income that can be generated from your retirement account. $200,000 doesn’t go quite as far as the $400,000 that was once in the account.

(Adapted from the book, Against The Grain, Avoiding the Financial Pitfalls of Conventional Wisdom, by Tim Rosen available for Kindle through Amazon, and paperback at www.AgainstTheGrain-Book.com

Follow Tim on Twiiter @timrosentv !