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The Bad News: You Have a 401(k) Plan
This article is intended by the author to comprise Part Four of Four in a series on lawyer retirement planning. Parts One and Two, 'What In the World Is Going on with Lawyer Retirement Planning?' were published in the November and December 2005 issues of LFP&B. Part Three, last month, examined the history of the 401(k) and why there are problems with the popular retirement vehicle. In this part, we find out how to make things better.
Problems with 401(k) Plans ' the Results
Virtually all 401(k) participants are grossly under-funding their retirement accounts. Whatever the performance of your self-directed investments, you almost certainly have under-performed the market. And there is a good reason. You chased the market, buying what had done well in the past, and jumping from one historically good performer to another after the good performance, almost never before. You made inconsistent fund investments and failed to re-balance your portfolio.
Then came the tech crash of 2000-2002. You blame the severe 'erosion' of your investments on the 'tech crash,' rather than blaming the real culprit ' the one who made the decision to load investments heavily in the tech sector. You did not, you say? If you look at the top 10 investments in the mutual funds you held, odds are every single one was loaded in tech stocks, and usually the same ones.
The market also out-performed you because you were not in the market on all of the very few days the market actually performed well. After the tech crash, the market made a dramatic recovery, but you probably missed it because you had been scared out of the market. From 1984'1998, the buy-and-hold return for the S&P 500 was an astounding 17.89%. But if you missed out on just 40 days in this 15-year period, your return would have been cut in half. A few more days out of the market out of about 5475 total days, and you probably missed all gains.
How much do you need? A range of advisers say that in addition to anticipated Social Security benefits, you need from six to 10 times your final pay in your retirement fund. This assumes you have nothing but Social Security and your 401(k) account. According to the Employee Benefit Research Institute, the average 'worker' has about three times final pay in his or her account.
The alarming number is what level of contribution ' your and your employer's matching and/or discretionary contribution ' is needed to create an adequate retirement fund. 'They' say, with the 401(k) system just over 20 years old, the combined contributions would have had to have been between 15% and 18% of pay. For most, this would be impossible. If you are 40 and have not started, it could take as much as 25% of pay from now until retirement at 65. And this assumes returns of from 6% to 8%, which few realize. But rather than dwelling on these assumptions, run your own worksheets using the retirement calculator tools listed in the sidebar, below ' and be realistic when you do so. For example, many planners say you should assume you need 80% of pre-retirement income. But does this really cover what may be incredibly increased health care costs, or even a personal health care 'disaster?' Assume appropriate inflation and be painfully honest about expected returns. Some worksheets default to a 7% return, which is not likely to occur. There is a reason for this, aside from your own poor investment decisions. This reason is the actual hidden 'cost' of your investments.
John C. Bogle is the founder of Vanguard, one of the largest mutual fund companies, and the author of The Battle for the Soul of Capitalism, which is a mea culpa severely criticizing the mutual fund industry as the architect of our failing retirement system. You may not in fact want to read this book.
Bogle in particular warns against mutual funds' fees and costs, which he says consume a huge portion of returns over the long term.
On an annual basis, the 'financial system' will cost you about 2.5% of any return you otherwise make. That number alone may not alarm you, but it should. Bogle calls it the 'tyranny of compounding costs.' Here is his example: a 20-year-old investing $1000 a year for 65 years (45 years to retirement then 20 years of life on top of that). That $1000 earning 8% will grow to $140,000. However, the financial system takes about 2.5% of that return, leaving a net return of 5.5% for our retiree. The $1000 now only grows to approximately $30,000. This dramatic difference is due to the decrease in compounding between 8% and 5.5%. So, $110,000 'went' to the financial system.
This means the financial system put up none of the capital, took none of the risk and got 80% of the return. The retiree, putting up all the capital and taking all the risk, got 20%. That is a long-term example, but Bogle says that even over the short term (10 to 15 years), it is still something like 60% to you and 40% to the financial system. This is capitalism turned upside down ' the managers rather than the capitalist deriving huge returns with no capital and no risk. There is a scene from the Eddie Murphy movie 'Trading Places' where the Duke brothers are trying to explain the commodities futures market to the Murphy character, Mr. Valentine. Randolph Duke turns to his brother and says, 'Tell him the good part, Mortimer.' Mortimer smiles: 'Whether our clients make money or lose money, Duke & Duke gets the commission.'
The problems summarized? Low participation rates, low contribution rates, poor investment choices and high fees. There has been massive retirement under-funding by the baby boomer generation. Are there solutions?
Solutions? At Least Making It Better
The defined contribution system ' 401(k)s and the like ' is what we have, so we have one choice: Make it work. There can be no 'government bail out.' It is a pretty dumb assumption to think 'they' will pay more taxes to bail 'us' out. 'They' are 'us.'
It should be noted with caution that one 'solution' emerging for low participation and under-funding is automatic enrollment. The theory is that, even for entry-level workers, if enrollment is automatic they will learn to live with it and the 'pain' of lower take-home pay will be invisible. We know very well this works because this is just the trick the government played on us when the system of mandatory withholding of taxes was imposed on wages. Very few know what they actually pay in taxes. The same principle is true for retirement funding. However, for such a scheme to work, federal law may be needed to override various states' laws that may make this difficult (such as laws against non-judgment garnishment or prohibiting 'automatic enrollment') without prior affirmative consent by the participant.
As was shown in Parts One and Two of this series on lawyer retirement planning, in the vein of 'automatic enrollment,' many law firm retirement plans require mandatory contributions, at least by partners.
As to investment choices, things are coming full circle. This whole avalanche of unintended consequences began with moving investment choices and decisions from companies to participants. This has not worked. Fund choice and participant education is being returned to the employer.
According to Warren Kingsley, an employee benefits attorney at my own firm, and Jack Calhoun of Capital Directions Investment Advisors, LLC, in Atlanta, (see last month's installment), the optimum is providing a limited selection (probably no more than 10 or so) of funds offering a variety of risk-return characteristics, heavy on index funds, with a small chance of 'style drift,' funds selected based on the lowest fees for the type of fund you are getting. Then, they say, participants must be adequately educated on how to choose the right mix of these funds.
Many plan managers are now turning to so-called Lifestyle Funds, in which a variety of underlying mutual funds are put together in a portfolio, which then becomes its own fund. However, according to Calhoun, they must be properly used. While the idea is that these funds-of-funds be used as all-or-nothing options, he says, many participants confuse lifestyle funds with individual funds that target a single asset class and therefore split their investments between lifestyle funds and other funds.
Some Other Options
In short, the decision-making responsibility needs to be placed in the hands of the competent, and fees and costs need to be known and managed. One way to do that is take investment choice selection away from commissioned sales people. Also, remove fund and fund manager choice decisions from human resources, and turn them over to your firm's financial managers.
A possible remedy for the investment decision and fee dilemma is to allow individual participants or small company plans to have their funds managed by large-scale not-for-profit funds managers such as state or other government retirement boards. The idea is to share in the returns garnered by very competent ' and usually conservative ' fiduciaries, and to drastically cut the costs of doing so. A few states are already doing this.
There are ways to take advantage of sophisticated investment management via a life insurance vehicle (works with mutual companies only). This only makes sense for younger lawyers who actually need, or think they will need, the death benefit of life insurance. Under this type of policy (called variously ECL, ACL or EOL policies), one is permitted, under applicable tax provisions, to deposit money with the mutual company above the actual policy premium cost, with the limit on such contributions tied to the face amount of the policy (ie, the policies can be over-funded with cash up to the limit that keeps the policy from becoming a 'modified endowment'). These funds then earn whatever return is realized by the mutual company on its general investments. The earnings are free of costs, are compounded and are tax-free until the funds are withdrawn, and then only when the withdrawals exceed the deposits made. Such a policy can provide a good cushion in addition to Social Security and a 401(k) plan.
There need to be stricter penalties for pulling monies out of the retirement system early, and strict limits on borrowing from retirement funds. In Freakonomics, by Levitt and Dubner, economist Steven Levitt says that these incentives can be placed in three categories: economic, moral or social. For example, one might feel morally or socially guilty about withdrawing 'retirement' money and spending it on a new car. The government imposes a monetary penalty for early withdrawal, an economic incentive. However, because the current penalty of 10% is so low, and even though the withdrawal is also subject to income tax, many appear to be willing to pay this level of economic penalty to be free of the moral and social guilt of squandering their retirement money. The government thus has put an acceptable price one can pay to be guilt free. Thus, the penalty must be higher than an acceptable price to buy off some guilt.
One additional consideration is to require some significant portion of participants' funds at retirement to be annuitized.
A likely mandatory 'retirement' option for many will be to keep working at some level. The traditional 'retire at 65' social scheme is no longer all that relevant, especially in the service-based industry of practicing law. Law firms are abandoning mandatory retirement ages. Of course, practicing law in later years will also require advance planning to adjust your practice, even your specialty, depending on where you have concentrated in the past.
Conclusion
Run the financial planning and retirement planning tools on the Web sites listed in the sidebar below, or hire a (fee-based, not commission-based) financial planner to do so. You can even tell the software where you want to be, and it will tell you what you need to do to get there. You may not like the result, but there it will be. If you cannot meet your financial desire to totally retire at 60 or 65, then plan for the alternative, including the possibility of a whole new law career you can phase into over a few years.
The ultimate key to retirement planning is lifestyle management ' manage your present lifestyle to put aside more for retirement, and manage your retirement lifestyle expectations to be able to afford to retire. Asks Kingsley: 'Are you going to be an ant or a grasshopper?'
Sidebar:
Retirement and Financial Calculators
For a huge variety of calculators:
Variety of retirement worksheets for a fee (savable if you subscribe to Smart Money Select):
Find your spot to retire:
Bruce Jackson is a partner in the Atlanta law firm of Arnall Golden Gregory LLP, where he is a member of the Corporate Practice Group and a member of the firm's Benefits Committee. He is a member of the Board of Editors of Law Firm Partnership & Benefits Report. His practice includes general tax, corporate and partnership matters (including mergers and acquisitions) and counseling companies, individuals and professional firms on tax planning, transaction planning and transition planning. He can be reached at 404-873-8590 or at [email protected].
This article is intended by the author to comprise Part Four of Four in a series on lawyer retirement planning. Parts One and Two, 'What In the World Is Going on with Lawyer Retirement Planning?' were published in the November and December 2005 issues of LFP&B. Part Three, last month, examined the history of the 401(k) and why there are problems with the popular retirement vehicle. In this part, we find out how to make things better.
Problems with 401(k) Plans ' the Results
Virtually all 401(k) participants are grossly under-funding their retirement accounts. Whatever the performance of your self-directed investments, you almost certainly have under-performed the market. And there is a good reason. You chased the market, buying what had done well in the past, and jumping from one historically good performer to another after the good performance, almost never before. You made inconsistent fund investments and failed to re-balance your portfolio.
Then came the tech crash of 2000-2002. You blame the severe 'erosion' of your investments on the 'tech crash,' rather than blaming the real culprit ' the one who made the decision to load investments heavily in the tech sector. You did not, you say? If you look at the top 10 investments in the mutual funds you held, odds are every single one was loaded in tech stocks, and usually the same ones.
The market also out-performed you because you were not in the market on all of the very few days the market actually performed well. After the tech crash, the market made a dramatic recovery, but you probably missed it because you had been scared out of the market. From 1984'1998, the buy-and-hold return for the S&P 500 was an astounding 17.89%. But if you missed out on just 40 days in this 15-year period, your return would have been cut in half. A few more days out of the market out of about 5475 total days, and you probably missed all gains.
How much do you need? A range of advisers say that in addition to anticipated Social Security benefits, you need from six to 10 times your final pay in your retirement fund. This assumes you have nothing but Social Security and your 401(k) account. According to the Employee Benefit Research Institute, the average 'worker' has about three times final pay in his or her account.
The alarming number is what level of contribution ' your and your employer's matching and/or discretionary contribution ' is needed to create an adequate retirement fund. 'They' say, with the 401(k) system just over 20 years old, the combined contributions would have had to have been between 15% and 18% of pay. For most, this would be impossible. If you are 40 and have not started, it could take as much as 25% of pay from now until retirement at 65. And this assumes returns of from 6% to 8%, which few realize. But rather than dwelling on these assumptions, run your own worksheets using the retirement calculator tools listed in the sidebar, below ' and be realistic when you do so. For example, many planners say you should assume you need 80% of pre-retirement income. But does this really cover what may be incredibly increased health care costs, or even a personal health care 'disaster?' Assume appropriate inflation and be painfully honest about expected returns. Some worksheets default to a 7% return, which is not likely to occur. There is a reason for this, aside from your own poor investment decisions. This reason is the actual hidden 'cost' of your investments.
John C. Bogle is the founder of Vanguard, one of the largest mutual fund companies, and the author of The Battle for the Soul of Capitalism, which is a mea culpa severely criticizing the mutual fund industry as the architect of our failing retirement system. You may not in fact want to read this book.
Bogle in particular warns against mutual funds' fees and costs, which he says consume a huge portion of returns over the long term.
On an annual basis, the 'financial system' will cost you about 2.5% of any return you otherwise make. That number alone may not alarm you, but it should. Bogle calls it the 'tyranny of compounding costs.' Here is his example: a 20-year-old investing $1000 a year for 65 years (45 years to retirement then 20 years of life on top of that). That $1000 earning 8% will grow to $140,000. However, the financial system takes about 2.5% of that return, leaving a net return of 5.5% for our retiree. The $1000 now only grows to approximately $30,000. This dramatic difference is due to the decrease in compounding between 8% and 5.5%. So, $110,000 'went' to the financial system.
This means the financial system put up none of the capital, took none of the risk and got 80% of the return. The retiree, putting up all the capital and taking all the risk, got 20%. That is a long-term example, but Bogle says that even over the short term (10 to 15 years), it is still something like 60% to you and 40% to the financial system. This is capitalism turned upside down ' the managers rather than the capitalist deriving huge returns with no capital and no risk. There is a scene from the Eddie Murphy movie 'Trading Places' where the Duke brothers are trying to explain the commodities futures market to the Murphy character, Mr. Valentine. Randolph Duke turns to his brother and says, 'Tell him the good part, Mortimer.' Mortimer smiles: 'Whether our clients make money or lose money, Duke & Duke gets the commission.'
The problems summarized? Low participation rates, low contribution rates, poor investment choices and high fees. There has been massive retirement under-funding by the baby boomer generation. Are there solutions?
Solutions? At Least Making It Better
The defined contribution system ' 401(k)s and the like ' is what we have, so we have one choice: Make it work. There can be no 'government bail out.' It is a pretty dumb assumption to think 'they' will pay more taxes to bail 'us' out. 'They' are 'us.'
It should be noted with caution that one 'solution' emerging for low participation and under-funding is automatic enrollment. The theory is that, even for entry-level workers, if enrollment is automatic they will learn to live with it and the 'pain' of lower take-home pay will be invisible. We know very well this works because this is just the trick the government played on us when the system of mandatory withholding of taxes was imposed on wages. Very few know what they actually pay in taxes. The same principle is true for retirement funding. However, for such a scheme to work, federal law may be needed to override various states' laws that may make this difficult (such as laws against non-judgment garnishment or prohibiting 'automatic enrollment') without prior affirmative consent by the participant.
As was shown in Parts One and Two of this series on lawyer retirement planning, in the vein of 'automatic enrollment,' many law firm retirement plans require mandatory contributions, at least by partners.
As to investment choices, things are coming full circle. This whole avalanche of unintended consequences began with moving investment choices and decisions from companies to participants. This has not worked. Fund choice and participant education is being returned to the employer.
According to Warren Kingsley, an employee benefits attorney at my own firm, and Jack Calhoun of Capital Directions Investment Advisors, LLC, in Atlanta, (see last month's installment), the optimum is providing a limited selection (probably no more than 10 or so) of funds offering a variety of risk-return characteristics, heavy on index funds, with a small chance of 'style drift,' funds selected based on the lowest fees for the type of fund you are getting. Then, they say, participants must be adequately educated on how to choose the right mix of these funds.
Many plan managers are now turning to so-called Lifestyle Funds, in which a variety of underlying mutual funds are put together in a portfolio, which then becomes its own fund. However, according to Calhoun, they must be properly used. While the idea is that these funds-of-funds be used as all-or-nothing options, he says, many participants confuse lifestyle funds with individual funds that target a single asset class and therefore split their investments between lifestyle funds and other funds.
Some Other Options
In short, the decision-making responsibility needs to be placed in the hands of the competent, and fees and costs need to be known and managed. One way to do that is take investment choice selection away from commissioned sales people. Also, remove fund and fund manager choice decisions from human resources, and turn them over to your firm's financial managers.
A possible remedy for the investment decision and fee dilemma is to allow individual participants or small company plans to have their funds managed by large-scale not-for-profit funds managers such as state or other government retirement boards. The idea is to share in the returns garnered by very competent ' and usually conservative ' fiduciaries, and to drastically cut the costs of doing so. A few states are already doing this.
There are ways to take advantage of sophisticated investment management via a life insurance vehicle (works with mutual companies only). This only makes sense for younger lawyers who actually need, or think they will need, the death benefit of life insurance. Under this type of policy (called variously ECL, ACL or EOL policies), one is permitted, under applicable tax provisions, to deposit money with the mutual company above the actual policy premium cost, with the limit on such contributions tied to the face amount of the policy (ie, the policies can be over-funded with cash up to the limit that keeps the policy from becoming a 'modified endowment'). These funds then earn whatever return is realized by the mutual company on its general investments. The earnings are free of costs, are compounded and are tax-free until the funds are withdrawn, and then only when the withdrawals exceed the deposits made. Such a policy can provide a good cushion in addition to Social Security and a 401(k) plan.
There need to be stricter penalties for pulling monies out of the retirement system early, and strict limits on borrowing from retirement funds. In Freakonomics, by Levitt and Dubner, economist Steven Levitt says that these incentives can be placed in three categories: economic, moral or social. For example, one might feel morally or socially guilty about withdrawing 'retirement' money and spending it on a new car. The government imposes a monetary penalty for early withdrawal, an economic incentive. However, because the current penalty of 10% is so low, and even though the withdrawal is also subject to income tax, many appear to be willing to pay this level of economic penalty to be free of the moral and social guilt of squandering their retirement money. The government thus has put an acceptable price one can pay to be guilt free. Thus, the penalty must be higher than an acceptable price to buy off some guilt.
One additional consideration is to require some significant portion of participants' funds at retirement to be annuitized.
A likely mandatory 'retirement' option for many will be to keep working at some level. The traditional 'retire at 65' social scheme is no longer all that relevant, especially in the service-based industry of practicing law. Law firms are abandoning mandatory retirement ages. Of course, practicing law in later years will also require advance planning to adjust your practice, even your specialty, depending on where you have concentrated in the past.
Conclusion
Run the financial planning and retirement planning tools on the Web sites listed in the sidebar below, or hire a (fee-based, not commission-based) financial planner to do so. You can even tell the software where you want to be, and it will tell you what you need to do to get there. You may not like the result, but there it will be. If you cannot meet your financial desire to totally retire at 60 or 65, then plan for the alternative, including the possibility of a whole new law career you can phase into over a few years.
The ultimate key to retirement planning is lifestyle management ' manage your present lifestyle to put aside more for retirement, and manage your retirement lifestyle expectations to be able to afford to retire. Asks Kingsley: 'Are you going to be an ant or a grasshopper?'
Sidebar:
Retirement and Financial Calculators
For a huge variety of calculators:
Variety of retirement worksheets for a fee (savable if you subscribe to Smart Money Select):
Find your spot to retire:
Bruce Jackson is a partner in the Atlanta law firm of
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