It’s not how educated you are that determines how will you use your 401k. In fact, it is how smart you are. As I was working on step five for the book, I wrote the following:
(Book excerpt from Target2025)
The effect of lower wages for similar work will plague the average worker well into the second decade of this century. This will result in the biggest labor shift in thinking since the Great Depression. Jobs will be created but may not offer the same benefits as they did in the past.
Wages aside, many 401k plans may take much longer than the predicted few years (some suggest that the generosity of the employer match will return by the year 2012 after a reduction or hiatus of almost three years) to return. Even more problematic than having the ranks of those enrolled at a greatly diminished level, those lost years, should they continue beyond that estimated mark, will have a devastating effect on the long range plans of current employees.
Let’s talk about those benefits for a moment. The relative demise of the pension and the rise of the 401k was done with incentives. Some of them were rather straightforward and appealed to those of us who felt as though taking control of our investments meant a better future. We’ll discuss that concept a little further along. The other incentive was the company match. This too was simple in principle.
The employee contributes to the plan and the employer matches their contribution up to a certain percentage. For instance, if the employee socked away 3% of their pre-tax income, the employer would match with a contribution of their own. This is the free money concept used to sell these plans to the suspecting and the unsuspecting. The later group usually failed to take full advantage of the employer’s generosity by enrolling or having the minimum threshold for the match withheld.
The other group, the ones who knew what the match was for did not as a rule exceed the employer’s contribution. For many us, the employer match to our 401(k) plans has gone, or in some cases reduced to a mere shadow of its former generosity.
This presents the person planning for retirement (perhaps predicting a retirement income would be a better description) with a dilemma. They are at first troubled by their own human nature. That human nature has been quite problematic and worthy of extensive study about why and how uses these plans the way they were intended.
David A. Love wondered what the life-cycle model could tell us about plan participation and more importantly, about those contributions. The vast majority break our assets down into liquid (easily turned into cash) and illiquid (not-so-easily transformed). Savings accounts are liquid; 401ks, even though they represent a cash balance, are subject to penalties and taxes if touched too early.
“Liquidity”, he writes, “is important in our model because risk-averse individuals have an incentive to smooth consumption over earnings and employment shocks.” He found this group to be among the lower wage earners and the younger worker.
Depending on your age, the plan that is offered you varies in terms of incentives. Younger workers should be attracted to the matching contribution feature of the plan. Mr. Love discovered that their primary concern was the loan feature. A plan that is offered with vesting (the law requires immediate enrollment in the employer’s plan but the matching contribution incentive may be delayed based on the employer), matching and loans provided attractiveness to all age groups in the study but increased matching contributions were underused by older workers.
Vesting comes in a number of different forms. Cliff vesting allots a certain percentage increase over the course of fixed time frame. For instance, 20% a year over a five year period before the employee is fully vested. Some plans use a graduated method by allowing increased access to the employer match each year. Should either of these employees feel as though their time with their current employer will not see the full vestment, the importance of the plan is diminished.
There are several reasons newly hired workers do not begin contributing immediately to the plan even though they are eligible.
Those that have to wait for the full vesting option, which amounts to about 75% of those with a plan, fear the loss of the employer match should they leave the job before they are fully vested. Their contributions remain intact and are fully portable. Yet a great many delay investing in the plan because of this type of restriction. Mr. Love believes that the life-cycle model, one that assigns decisions on the basis of what stage of a career on might be in, such as a younger worker would rather borrow than save while an older worker might save rather than borrow comes into play. The younger worker simply does not see the advantage of contributing if s/he is not receiving the fully vested amount.
This sort of strategy has long-range effects (not insurmountable but difficult to recoup with each passing year). The tax implications on pay without contributions should be incentive enough. But in the youngest workers, where risk is almost completely absent, this creates a behavior that does not change once they are eligible for full vesting.
Not only has some valuable compounding time been lost, taxes paid when they could have been deferred, a participation habits delayed, the younger worker is not likely to pick-up the plan even when they are vested. Worse, as Mr. Love points out, “a person who delay contributing to the plans will have an increased probability of desiring contributions in excess of either the employer matching limit or the annual contribution in future years.”
The irony: the match actually means more for younger workers (who under use it or have some sort of delayed vesting in place in their plan) while contributions mean more for older workers. What does that mean for workers who have seen their matching contributions drop or be eliminated?
Surprisingly, the role of education has little to do with who takes the matching contribution when it is offered, even in a limited sense. College graduates contribute far less that high school graduates or dropouts do. College grads catch up statistically at age 37 and begin to increase their contributions well above the employer’s match. Sadly, this may be too late to take advantage of what the plan could have offered. Almost half of the dropouts contribute enough to fully maximize the employer’s matching contribution.
Although dropouts and high school graduates tend to have a more linear pay history over the course of their careers, they are mostly unable to make any increases above those matching levels. This is sad considering in many instances, a mere 2-3% more, for a total of 5-6% of the pretax income of these individuals rarely affects the net pay.
This creates another problem for the average worker, college grad, dropout or high school grad: what happens when the match goes away?
If behavioral models tell us anything, and they do when it comes to how we utilize our income, these employees stop as well. And even though statistics also tell us that this type of behavior can begin young and remain as an investment stain for years to come, we have never been faced with a time when we are supposed to direct or retirement when there are no clear incentives (in the present tense) to do so.
The right thing to do would have been fill in the void left by the employer. Lower income workers would find this much harder to do believing that the lack of liquidity in a 401k plan is not suited for emergencies. (Even if an under-funded retirement constitutes the direst of emergencies.)
We now know that many of us miss the chance to contribute when the plan shows no direct matching benefits. And what are the chances we will fly in the face of this behavior when faced with a sudden shortfall? Few of us max out these accounts, instead relying in the employer’s match to give us three, possibly more, percentage points of pre-tax income contribution. If your employer stopped putting 3% (of free money) into your account and those matches never returned, you risk missing even conservative predictions about your account by up to $100,000 over a thirty-year career.
To make up for this shortfall, we will need to increase your contribution by at least as much as the missing match. In the short-term, this may mean taking home less. And while there is no legal obligation for the company to reinstate the matching contribution, waiting for it to return could cost you additional thousands of dollars of potential investments.
