The Danger Of A 401(k) Flameout

It's possible that the 401(k) plan has failed. Don't believe it? Take a look at your latest account statement. Hypothetical investment returns run by your employer probably suggest an 8% return per year is possible as an average for use in planning purposes. The Standard and Poor's 500, a benchmark that closely mirrors the performance of a significant number of mutual funds commonly found in 401(k) plans, was down for the past decade (December 2000 to December 2010), and a sampling of popular funds offered by major mutual fund complexes suggests that even a 6% rate of return over ten years is unlikely. Those 8% projects may have worked on out on paper, but for anyone hoping to retire over the past few years or during the next half a decade, that 8% is likely to prove elusive. How did we get so dependent on a savings vehicle that has failed so many of us? History provides some insight.

TUTORIAL: Introduction To Retirement Plans

History of the 401(k)
It started in 1978, with section 401(k) of the Internal Revenue Code, which permits private-sector employers to offer tax-deferred savings plans similar to those available to government workers. (Learn more in Making Sense Of The Tax Code.)

The 401(k) plan accelerated in 1986, when Congress passed legislation permitting the replacement of the defined-benefit plan offered to government workers with a less attractive defined-benefit plan and an attractive defined-contribution plan. Government workers would get a guaranteed pension and a subsidized savings plan. Private-sector employers jumped on the bandwagon, but took it one step further, eliminating their defined benefit plans.

The conversion to the 401(k) got bumped into overdrive when President George W. Bush signed the Pension Protection Act of 2006. This legislation permitted employers to automatically enroll their employees in employer-sponsored retirement savings plans. It also forced employers to fully fund their defined benefits plans. As a result, taxpayers were forced to ante up more money to make sure government employees would enjoy a financially secure retirement while at the same time, private sector employers closed their defined benefit plans to avoid funding them. In place of the guaranteed checks provide by defined benefit plans, more workers were forced to participate in 401(k) plans if they wanted to save for retirement. (For more, see The Demise Of The Defined-Benefit Plan.)

The Dark Side of 401(k) Plans
The dark side of 401(k) plans is highlighted during bear markets. The down market experienced in 2008 provides a notable example, as the bear market erased a decade's worth of stock market gains. If your portfolio's asset allocation was 100% equities during the Great Recession, you probably would have lost at least 38% of your nest egg. Out of what was once a $100,000 balance, you' would have had just $62,000 left. Unfortunately, a 38% gain in the markets wouldn't make you whole again because that 38% gain is now based on a balance of just $62,000. A market rebound of 38% would have left you with just $85,560 of your original $100,000. Based on that hypothetical average of 8% per year, it would take more than six years just to make back what you lost. If you are nearing retirement, you could be in even more trouble because that 8% growth rate is based on an all-stock portfolio. If your risk tolerance drops within six years and you add bonds to your portfolio, that more conservative asset allocation is likely to grow even more slowly.

The recession drove home the message that 401(k) plans don't come with any guarantees. Because millions of uneducated, unsophisticated investors had been making their own investment decisions, many retirement dreams were left in ruins. The data from the decades of yearly Quantitative Analysis of Investor Behavior surveys by Dalbar paint a clear picture: many investors make poor choices. The study cites cash flows, demonstrating that investors chase performance, buying when markets are high and selling when they are low. It's a reality that holds true year after year in survey after survey. (High-cost, outdated plans can prevent your retirement portfolio from thriving. See How To Cure An Ailing 401(k) and Bear Spray For Your 401(k).)

Bulls and Bears
Investors put their retirement money into the stock market based on the belief that it will deliver positive returns during bull markets. During bear markets, the balance is expected to decline, but the long-term average is supposed to work out fine for the balance in your 401(k) plan. It's all good in theory, but the problem is that theoretical performance and the average returns it should generate are meaningless when a bear market strikes and derails your retirement. If you try to retire during a down year (2002 or 2008, for example), you may be forced to make new plans. You may be in trouble, if you are already retired and living off of the proceeds in your portfolio when the market crashes.

Uncle Sam Messed It Up, Uncle Sam Will Try to Fix It
The 401(k) plan originally flourished as a result of the government. Elected officials were left to clean up the mess on Wall Street after the market meltdown of 2008, and in the aftermath of that clean up, turned their attention to the 401(k) plan. In 2009, legislators began talking about how to fix the system and help guarantee the financially secure retirement that employer-sponsored plans failed to deliver.

Initial leanings indicate that a requirement for clear fee disclosure is a near-certainty. Since fees detract from returns, knowing how much you are paying and how it impacts your results is a critical data point for investors. Looking at how most 401(k) plan participants fared when they followed the advice provide by mutual fund companies, the Bush administration ruling that permitted mutual fund companies to provide advice to 401(k) plan participants may also be scrutinized.

Some industry leaders have even suggested a lifetime income guarantee for plan participants, or at least a limit to the amount of losses in an account. A more likely development is the addition of guaranteed income annuity products in the line up of investments available to plan participants, as this path would provide an opportunity to sell more investments.

The Bottom Line
401(k) plan participants whose savings are decimated by a bear market have no other choice than to watch, wait and hope that the markets recover - and maybe take a second job to save a few more dollars or delay retirement for at least a few more years. The fact is that investors always need to learn from their mistakes and educate themselves about the opportunities and risks involved when investing in the stock market. If your 401(k) has taken a hit, the best you can do now is learn from it and move on. (Professionals choose the options available to you in your plan, making your decisions easier, read Pick 401(k) Assets Like A Pro and Which Retirement Plan Is Best?.)