Wednesday, June 10, 2015

The Case Against 401k

The timeless James Altucher did a 30 second video with Business Insider hating on 401k and he got completely destroyed by the blogosphere afterwards.  Everyone came to 401k's defense like it was a Middle Eastern country with gobs of oil, which meant the help came with strings attached.  Here are the strings for a 401k:

The longest and thickest string is a 401k's illiquidity until you are old and decrepit.  Sure with medical advances, 55 is the new 45, but even the current 45 is not pretty.  Particularly as I look around and a lot of these rotund 45 year olds can no longer see their genitals.  Even 55 comes with plenty of asterisks.  First, you have to be employed until you turn 55 as if you quit when you are 54, you cannot withdraw penalty-free until age 59.  But it's not even 59; it's 59.5.  This makes perfect sense the same way joining the Marine Corps made sense when I was 17.

The illiquidity is incredibly paramount to discuss and understand.  In general, any investment that is not easily bought/sold requires a higher rate of return, ceteris paribus.  You deserve to be paid for the inability to get out of the investment.  A 401k is the ultimate illiquid asset where you immediately take a 10% haircut if taken out early, and this is not including taxes.  But you say, of course you are being compensated for it with the deferred taxes, but even this point is wishy-washy.  Your current income tax are lowered, but you will pay it when you want to spend the money.  This also means that you will pay the future tax rate when you wish to withdrawal, but nobody knows what that will be.  The current deficit and America's relatively low tax rates with the rest of the developed world portends to much higher tax rates in the future.

The 401k also presents a disturbing psychological nudge to most people as well.  Since they are saving in a 401k, they neglect to save otherwise, believing that combined with Social Security will be enough. To make things worse, most people don't understand investing and believe the 401k as a magical retirement vehicle with no input needed.  These two factors contribute to a strong economy where people spend over 90% of their paycheck, but leaves them vulnerable to any shock to the economy.  No wonder there are more payday lending businesses than McDonalds stores.

So if they are so shitty, why do they exist?  Like many things that don't make sense, they benefit the people who wield more power than you do.  Before 401k (defined contribution plans), most retirement plans were pension plans (defined benefit plans).  Your employer would set money aside and invest it on your behalf.  When you retire, you get a steady monthly check no matter what.  Soon, many pension plans had problems because people (professionals and amateurs alike) suck at investing.  Either they were too optimistic or simply incompetent, many pension plans became underfunded and ran into problems paying these retirees who refused to die.  Thus the shift to put the risk of underperforming investments onto the employees rather than the employer.  Now, aside from certain non-profits and the government, rarely does any business deal with pension plans.  Remember the old saying: risk never disappears, it just goes somewhere else.  Only problem is that it went to a place where most people do not comprehend it.

Here are some final caveats: if your employer matches, definitely contribute up to the match.  They are part of your benefits and not contributing up to that point is literally leaving money on the table.  Many plans allow you to borrow money against it, typically for a home and this is probably t the greatest benefit of a 401k as the interest goes back into your account.

Ultimately, deciding how much to contribute to a 401k boils down to calculating your innate discount rate of enjoying your money now versus many years down the line.  Unfortunately, most people never consciously make this choice and are shepherded to the default option to contribute which may or may not make sense in your situation.