The retirement scam


The startup I work at recently introduced a 401(k) plan, after months of clamoring by my fellow employees. My employer will not match 401(k) contributions, which means that the plan is effectively just a tax deferral device: I avoid taxes now, when I (theoretically) make more money and pay higher taxes, in order to pay them later, when I (theoretically) make much less and pay lower taxes. I’d rather have a 401(k) than not, but to call it a “retirement plan” does a grave disservice to the term. Most of my coworkers don’t know how much to contribute per month, in which assets to allocate their contributions to match their desired risk (let alone what their desired risk is), the fees taken by the 401(k) provider, the implications of those fees for their retirement savings…the list goes on. According to the plan administrator’s website, there’s a flat fee of $40/year plus a yearly fee of almost 1% of assets. Plugging those numbers into an Excel workbook I made, that fee of 1% wipes out most of the benefits associated with the tax deferral, so any 401(k) contributions I make essentially just take money from the government and give it to the financial sector.

Contrast that with a pension system. Let’s consider the Federal Employees Retirement System (FERS), since Andrew McCabe, Deputy Director of the FBI, has been in the news recently, and his pension/retirement benefits have gotten some attention. (In a petty and spiteful but not surprising act, Trump terminated McCabe just before his enhanced law-enforcement pension rate would have kicked in.). As a law enforcement official, McCabe would have gotten a pension of roughly $60000/year as well as lifetime medical benefits for himself and his family.

The pension system is simple, at least on the employee’s end: upon retirement, you collect a yearly pension that is a significant fraction of your previous yearly income as an employee. For instance, in FERS, the calculation is: (years of service) * 1% * (average of salary in the top 3 consecutive highest-earning years). If you made $100k/year in the three years just before you retired, and you worked 30 years, you’ll collect 30k/year for the rest of your life. That’s not a huge amount, but combined with Social Security and federal health benefits, it seems adequate to live off of.

The basic difference between a pension plan and a 401(k) is the idea of “defined benefit” vs “defined contribution”. In a 401(k), I contribute a set amount per pay period, but my ultimate benefit, upon retirement, is unknown: it depends on market performance, administrative fees, whether my employer matches, etc. In a pension, the benefit is defined at the outset: if I work for a certain number of years I know exactly how much I will collect after retiring.

The 401(k) shifts all of the hard thinking from the employer to the employee. Previously it was the employer who would have to think about managing investment risk (the vagaries of the market) and longevity risk (the fact that people are living longer). The employer would have to set aside money to safeguard against these risks. Now the employee has to do that. I don’t know how long I’ll live. I don’t know how much money I’ll need for retirement (the loosely quoted rules are “10 to 15 times my annual salary”, which seems like an awful lot). I don’t know how well the market will perform between now and when I’m 65. The Excel calculations I referred to above were reassuringly certain. I assumed a real market return rate of 5% and a real income growth rate of 1% and a fixed tax rate of 35% and so on and so forth. Forecasting is never that easy, though. As Paul Campos at LGM wrote,

When it comes to investment, “history” is a tricky thing.

Suppose you had invested a large sum in an index fund tracking the Japanese stock market in December of 1989, and re-invested all dividends over time. How much money, adjusted for inflation, would you have today, nearly 30 years later?

The answer is slightly more than half of your initial investment.

And you don’t have to go discovering Japan to experience the dubious thrill of genuine long-term negative returns on equities. For instance US stock indexes declined, on average, by about 10% in real terms between the mid-1960s and the early 1980s.

(Contrast that with what Peter Lynch, star mutual fund manager at Fidelity, was saying in the 1980s: “You shouldn’t be intimidated. Everyone can do well in the stock market. You have the skills. You have the intelligence. It doesn’t require any education. All you have to have is patience, do a little research, and you’ve got it.”)

And, arguably, the market return rate is the most certain figure in this entire calculation. It carries with it decades of historical data and the benefit of being able to average over long time horizons (assuming you start investing in your 20s and 30s, which most people don’t). Whether I die before retirement age, or live 30 years beyond it, is highly uncertain. And whether my income remains at its current level depends on whether my startup survives, whether I remain in the private sector, whether I continue to be healthy, whether I stay in New York City, and whether any accident of life befalls me. I’m just myself; I can’t average my life with anyone else’s. Statistics loses its value when applied to a sample size of 1. The actuarial tables help actuaries, not individuals.

Interestingly, the “success” of the 401(k) owes itself to a historical accident. These plans were enabled by a little-noticed change to the tax code (Section 401(k), unsurprisingly) that went into effect in 1980. The man who discovered the loophole, Ted Benna, claims he never intended to “open the door for Wall Street to make even more money than they were already making” and that he “was certainly not anticipating that it would be the primary way people would be accumulating money for retirement 30 plus years later”.

But the other historical accident is that US stock indexes surged in the two decades following the introduction of the 401(k). One dollar invested in 1980 in the S&P 500 would have grown to thirteen (!) dollars in 1999, even after adjusting for inflation. In 2017, that same dollar would be worth nearly twenty-two dollars in real terms. Naturally,

“Two bull-market runs in the 1980s and 1990s pushed 401(k) accounts higher,” The [Wall Street] Journal reports. Then, “two recessions in the 2000s erased those gains and prompted second thoughts from some early 401(k) champions.”

Tethering the fortunes of tens of millions of Americans to the stock market sounds great when it’s increasing by 10% year over year. It reminds me of one of my favorite quotes about the 2007 financial crisis, from Citigroup CEO Chuck Prince. When asked to explain why his company invested in subprime mortgages, even when he knew the easy money would eventually dry up, he said, “As long as the music is playing, you’ve got to get up and dance.” Which is the logic behind all bubbles, really: if housing prices are soaring, everyone should become a homeowner; if bitcoin prices are skyrocketing, everyone should become a cryptofanatic; and if the stock market continues to amass wealth, then everyone should have a 401(k). It should be no surprise that Republicans introduced Social Security privatization in 2005, during the peak of the post-1999 bull market. If we had been so stupid as to implement that legislation, god knows how much wealth would have evaporated in 2008.

I’ve talked a lot about uncertainty and risk, and how individuals – even well-educated ones like me! – are poorly suited to coping with it. That’s the whole point of insurance – by pooling risks together, they become easier to mitigate.

These arguments would, even on their own, be enough to cast serious doubt on the wisdom of encouraging Americans to utilize 401(k)s as their primary investment vehicle. But there’s also a bigger problem. And that’s inequality. People simply don’t have enough money to make 401(k)s work. And the 401(k) system is designed to funnel money into the financial industry through an opaque fee structure and minimal regulation thereof. Far from being a general purpose tool for retirement, 401(k)s are good only for upper-middle-class or rich people like me, not to mention the leeches in the financial industry who make money whether you save enough for retirement or not.

There are a couple of incredible studies on this topic, one quantitative and data-driven and coldly rigorous, the other qualitative and anecdotal and heartwrenching. The first is a study by the Economic Policy Institute (EPI), called “The State of American Retirement: How 401(k)s have failed most American workers”. The other is a documentary by Frontline, called “The Retirement Gamble”. I’d encourage to read/watch both of them. Long story short, 401(k)s account for a minimal percentage of retirement savings for the vast majority of Americans, and if we want to help lower-income people save to retirement, there’s no better solution than bolstering Social Security.

Perhaps the saddest part of the Frontline documentary is the reporter (Martin Smith) himself realizing that he’s woefully unprepared for retirement. There is a scene in the first few minutes where he is consulting with his financial advisor about his retirement plan.

MARTIN SMITH: As for me, I’m almost 65. I started saving for my retirement in my late 20s. But along the way, I dipped into my nest egg— not once, but several times.

[on camera] So this is my IRA and 401(k) and—

FINANCIAL ADVISOR: Which will be cleaned out over a certain amount of time.


[voice-over] And now, like millions of other Baby Boomers, I, too, don’t have enough.

FINANCIAL ADVISOR: The key to your retirement working out is having enough return on your assets.

MARTIN SMITH: Most of my savings went to pay for my kids’ educations.

[on camera] Well, this is where fees would really hurt you badly, as well.

FINANCIAL ADVISOR: This is where fees would hurt you badly because—

MARTIN SMITH: [voice-over] A divorce and the crash of 2008 didn’t help, either.

[on camera] It looks like my own personal fiscal cliff.

[voice-over] I’m now planning to work for as long as I possibly can.

[on camera] So this whole plan is predicated on working full-time until 70.


MARTIN SMITH: And at 70?

FINANCIAL ADVISOR: From age 70 to 75, I have you working part-time.

There is no better representation of the two Americas. We have Martin Smith, sitting on one side of the table, contemplating the possibility of working until he is 75 (or more), his face etched with worry. And we have the nameless financial advisor, sitting on the other side of the table, rosy-cheeked and comfortable, explaining in a calm and somewhat detached tone that “fees would hurt you badly” – the same fees that he is charging Martin Smith for his advice.

Rich America gives poor America plenty of advice on how to succeed in life. Don’t do drugs. Don’t commit crime. Play by the rules. Don’t have too many kids. Save for retirement. Invest in the stock market. Don’t live beyond your means. Work hard. Work forever. Don’t fall sick. Meanwhile rich America has rigged the game so that it is successful regardless. A financial advisor makes 1 or 2 or 3% guaranteed, regardless of whether the advice is sound, regardless of whether the investment goes up or down. And, under the new rules, my advice doesn’t even have to be in my client’s interest – I can tell him or her to invest in whatever will make me the most money! This is the truer definition of “defined benefit” and “defined contribution” – the contribution is defined for Martin Smith, and the benefit is defined for his financial advisor.

In the end, I can only echo what Hamilton Nolan said: “You can’t force people to save money if they don’t have enough money to begin with. We don’t need self-help books. We need wealth redistribution.”


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s