Why retirement plans are falling short

By now, it is no secret: Many American workers don't save adequately for retirement.

And in most cases, the ever-popular 401(k) plans offered by private businesses will not make up for the inadequacy of a Social Security pension.

In short, 401(k)s are failing many workers, especially younger ones - not because these plans are themselves inadequate, but because Americans are not taking full advantage of them. Consider:

• In 2000, half of working families (51 percent) did not own a private retirement savings account - no 401(k), no 403(b) offered by nonprofits, no Individual Retirement Account, and no Keogh account for the self-employed.

• A quarter of eligible workers do not join such plans, in effect giving up free money their employers would contribute.

• When changing jobs, nearly 60 percent of 401(k) participants cash out their accounts rather than leave it in the plan for retirement use. Such moves incur heavy tax penalties.

These behaviors fall disproportionately on younger workers. Older people about to retire with a standard corporate pension are "pretty much OK," says Alicia Munnell, director of Boston College's Center for Retirement Research and coauthor of a new book, "Coming Up Short; The Challenges of 401(k) Plans." But baby boomers and younger workers may be "ill- prepared," she adds.

Most workers in the United States - 96 percent - are covered by Social Security. But the average retired worker gets $900 a month, a spouse half of that. It is hardly lavish.

And only 25 percent of working families include at least one worker covered by a "defined benefit" corporate pension plan. Like Social Security, these plans guarantee a fixed monthly payment for life.

The proportion of workers with defined-benefit plans has been shrinking as more and more businesses offer 401(k)s to their employees instead. These are termed "defined-contribution" plans because companies and their workers put defined amounts of tax-free money into them. Employers have no responsibility other than to provide a fair contribution. So the level of benefits a worker receives at retirement hangs on the performance of stock and bond funds, or of other investments within a 401(k) portfolio.

In other words, employees assume the risk of poor investment performance, whereas an employer takes that risk under a defined-benefit plan.

So if you are counting on a 401(k) as your financial salvation at retirement, beware! warns Mrs. Munnell. For middle-class families, the 401(k) system may be an inadequate substitute for old-fashioned pensions. Here are some reasons:

• Participants do not diversify their portfolios. Many employees at Enron put most of their 401(k) money into Enron stock - a bad decision since the company went bankrupt. Beyond such unusual circumstances, almost 60 percent of participants are either virtually all in stocks or all in fixed-income investments, such as bonds or money- market funds.

• Hardly any participants rebalance their portfolios as they age or in response to market returns. In theory, good investment practices call on older workers to put more of their portfolio into conservative investments, such as bonds.

• Upon retirement, nearly all participants fail to buy an annuity that would guarantee them income through retirement, even if longer than usual.

Most people, Munnell says, hate buying annuities because they dislike the insurance companies that usually sell them. "People do not understand the risk of outliving their resources," she adds.

The upshot of such bad decisions is that, as of 2001, families headed by a worker 55 to 64 years old had a median retirement account balance of just $55,000. Converted to an annuity at age 65, this sum would provide a monthly payment of $408 a month, notes a new study by the Congressional Research Service.

What makes this picture especially serious is that even without Congress tinkering with Social Security, this system is destined under current law to become a less important source of retirement income.

At present, note Munnell and Annika Sundén, her coauthor, Social Security provides benefits equal to 41.3 percent of preretirement earnings for the average worker retiring at age 65. That replacement rate will decline to 36.3 percent in 2030 for the 65-year-old. That's because normal retirement age will have risen to 67 by that point, which amounts to a benefit cut.

With increased productivity, US living standards should rise at least 30 percent by 2030. So Social Security pensions, which increase when worker pay goes up, may buy more in the future in an absolute sense. But economic research suggests people's sense of well-being hangs considerably on how they're faring relative to others in society.

"Greater personal saving will be needed for the current generation of workers to maintain their desired standard of living in retirement," the congressional study concludes.

Munnell calls for strengthening the 401(k) system by having workers opt out of plans, rather than opt in as they do today. In other words, plans would automatically enroll all workers, set the contribution level to maximize the employer match, allocate assets to an age-appropriate mix of stocks and bonds, restrict investments in company stock, roll over any cash distributions to another retirement account, and pay retirement benefits as an annuity.

Employees could opt out of those defaults, if they wanted. But more workers might end up saving more money for their future.

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