Asymmetrical Information

Taking advantage of human behavior to get better results is one way to achieve safe retirement. Wouldn't better education in markets and economies (especially as we all grow weathier) give us a broader benefit that can be used outside of retirement?

Questions:

Are employer matching contributions counted as part of the savings rate for 401(k) participants, if not why not?

I've mentioned this before, but is anyone else worried that more opt-out rather than opt-in plans (especially if mandated by the government) will reduce the size and generosity of employer matching which could yield more participants, but less benefit to each individual? For instance: If the number of participants in the plan at my employer suddenly doubled and they cut the (generous) match from 1-to-1 up to 6% of salary to 1-to-1 up to 3% of salary as a result to keep costs down, I'd be getting screwed pretty badly eventhough more folks are saving properly. Do you think this concern is legitimate, or am I being paranoid?

Timothy: One anecdotal data point. My (large) employer is implementing some of these new standards, including automatic sign-up for the 401K, and at the same time is increasing the match by one percent.

Plainly employers must have some incentive to encourage employees to participate in these plans; otherwise they wouldn't so often match employee contributions. But what is that incentive? Something in the tax code?

I'd guess that the reason companies offer the match has to do with how much employees value the match vs. an increment to salary and how many take advantage of it.

The company probably doesn't pay payroll taxes on the 401(k) match, employees will see it as tax-free money so their bottom line number is larger, and if only some percentage of employees actually take the match but all consider it when picking a job, why not? It's just like any other benefit that way.

One question: is there a "tipping point" at which investors in stock market index funds will cause said funds to rise by the sheer force of their repeated investments? I understand that index funds usually outperform managed funds. It just seems to me that if you have tons of people pouring money into the S&P 500 by way of index funds, the companies in those funds are going to grow regardless of whether they are well or poorly run. Does anyone know what percentage of the market as a whole is owned by index investors, and perhaps how that has grown since Vanguard's advent in the 1970s?

They need to start hammering pay yourself first in kindergarten, emphasizing that it's not put and take. Starting young may get the point across, minimize the effects of bad/less than optimum investments and even encourage young people to become sophisticated investors. I tell my grandkids to put away 10% of everything they make and they'll never have to worry. Do they do it? No. LOL.

Joe Magarac, stock price does not directly equate to company growth, a hard-learned lesson for many in the '90's bubble. Yahoo stock went $500+ in '99 or '00. The company had never made money at that point. It's $40+ today.

stock price does not directly equate to company growth, a hard-learned lesson for many in the '90's bubble.

A lesson some companies still haven't learned, really...

The reason that employers make matches is to encourage participation among "non-highly compensated" employees.

The tax code has what are called "non-discrimination" tests (ADP/ACP tests) that measure the average deferral each group makes into the plan (what percent of pay you save against the percent your bosses save).

The quick end result is that highly compensated (your bosses) can only contribute two percent more of their pay into the plan that the average NHCE (common joe) puts into the plan.

So, if the average worker contributes 5 percent of pay, the bosses are limited to 7 percent.

To answer Tim ... if the average worker is maxing out the plan, then there is no reason to offer a match, unless the match is a competitive advantage in hiring.

I personally believe that the testing is the primary reason for matches, followed by hiring needs.

Many companies also make a match as part of a profit sharing strategy. So these would presumably not be affected by "auto" plans.

If you're so risk-adverse you don't like betting on the stock market through even passively managed index funds, there's an alternative vastly superior to a money-market account, bank CDs, or the like. Type I savings bonds have a guaranteed positive real rate of return over time, since they pay annualized-inlfation-rate-plus-fixed with a no-decrease floor in case of deflation of more than the fixed rate. You only lose if the Federal Government defaults. (Sure, you can only buy a total of $60,000 a year, half paper and half electronic. If you're putting away enough in investments that that's a limit, you don't need my advice anyway.)

I wonder if I could get Public Service Announcement ad time to tell people, "Invest your retirement money in passively-managed index funds and I Bonds for a secure retirement". That'd probably do more people more good than 95% of the PSAs that currently run.

I don’t think he has ever cared about civil liberties – he sees his job as protecting us, not protecting our liberties.

I work for such a terrific company that almost all of my 401K consists of its stock. It's guaranteed to keep rising!

Signed,
Enron employee, 2002

Couldn't resist taking issue with one of Jane's premises:

"Keeping your money in cash, putting it into a stock that had recently gone up, and selling as soon as it goes down, is a terrible investment strategy".

Just because a stock went up yesterday does not mean that it will go down today. If that were so, then we'd have a foolproof investment strategy of simply buying after it went down and selling after it went up.

I agree however that holding cash reduces your ability to fully participate in the longer term gains that you get by sticking with stocks.

Peter;

the Enron employees had a choice of 17 funds (including the Enron Stock Fund) for their 401(k) contributions. Only the Enron match was automatically invested in the stock, the workers own contributions were directed by them into any of the funds they chose. Those who stayed out of the Enron stock fund only lost the employer match.

DCPI: Thanks for the info. With regard to Enron, yes, anybody who picked the Enron Stock Plan was a fool and had it coming (to a certain degree), but it was pretty unethical of Enron's executive management to openly encourage people to invest all of their 401(k) into the Enron Stock Plan. There's this clip from some meeting that was in Smartest Guys In The Room where Skilling, Lay and some PR lady of theirs are answering employee questions about the 401(k) the question, "Should we put all of our 401(k) into Enron stock?" was answered with an emphatic yes.

Sleazy.

Short form: The details of my argument were untrue, but my conclusion is true.

I think you are just seeing the effect of the moral hazzard of two generations of Americans being lulled by the beleif that the government will take care of them when they retire.

For all of man's history, people had to manage their own "retirements". For most, this meant living with family in their own age and working until they were no longer able to. The notion of a very long and independant retirement without work is a very costly proposition.

I think we will eventually (and the transition will be hard) see is that people will come to defer some current expenses and save for their retirement. And, expectations will change as people come to terms with the fact that they may well be working into their 70's and beyond.

"- All details of the plan are opt-out. Including enrollment."

That's all I need to hear! :)

Timothy:

My takeaway from the Enron case is (yet again) never trust someone with authority to look out for your best interests! If something is important, take the time to learn about it (or hire your own expert) or risk the consequences. To me it makes no difference if the authority is the Feds or Ken Lay.

Another thought. Your question about whether matches will be reduced if companies widely adopt auto plans is an interesting one (and one that people in the 401k industry are not currently thinking about).

My suspicion would be that for some employers (those with "in-demand" workforces -- such as Frost Bank, will continue matches (with possible variances based on profits). Those with more captive workforces (retailers such as Wal-Mart), will cut matches as much as possible.

Finally, both types of employers may divert their matching budget into other forms of benefits that are more highly valued by participants (typically, health care plans are the most highly valued).

"expectations will change as people come to terms with the fact that they may well be working into their 70's and beyond"

It will be very difficult for people to come to that realization. The trend for at least a generation has been toward earlier and earlier retirement, often by 60 or even 55. Demographic changes are making it impossible for the early-retirement trend to continue, and one might argue that it *shouldn't* continue because people are living longer and healthier lives. That does not, however, make later retirement any more palatable. We'll surely be seeing many disgruntled people.

DCPI: That's about what I took away from Enron.

Thanks for all the info on the 401(k) and matches, I'm only sort of familiar a lot of the details. I might bounce it off of some of the folks I know up in Corporate Trust to see what they think. I'm not concerned about my employer specifically (as they have a long history of treating their employees quite well), but just sort of as a matter of theory.

I think your point about the type of labor that companies have is a good one. I've some more thoughts about that, but they're not very developed at this point.

So what happens when Boomers start to retire en mass and their contributions to market funds starts to go in the other direction?

I mean as off shoring continues unabated and fewer and fewer workers have jobs that have any kind of retirement plan, defined, undefined or otherwise. Also there will be less workers over all propping up the stock market, what will happen? Will the workers of today be the greater fools of the boomers as they retire? I mean someone has to end up being the greater fool, no? Will it be a generational fool?

I've certainly been quick to complain about previous Winterspeak posts, so I'll be quick to compliment this one.

To hear the pols in Washington describe it, the only two possibilities for improving retirement funding are expanding and fully funding defined benefit plans -- which clearly won't happen -- and raising the ceilings on defined contribution (and individual retirement) plans -- which clearly doesn't solve the new problems cropping up.

This plan makes so much senes, and it works at the site of the problem -- the lower end of the income and/or financial education spectrum.

As for Timothy's point, it's an interesting example of unanticipated consequences (kudos for anticipating them!) but I think, from a societal standpoint, we're better off with the same amount of match $$ spread more widely across the population. If we want a future of DCPs and an"ownership society" and all that, it's important that the system works. And the system works best when the most people participate.

A corporation shifting from a defined benefit plan to a defined contribution plan is a major pay cut for the individual, and anyone who argues otherwise is either a fool or takes you to be a fool.

For all of us self-interested folks, I found a great calculator online to see if your current savings patterns will leave you enough to cover your living expenses after retirement. Check it out at
http://partners.financenter.com/kiplinger/calculate/us-eng/retire02a.fcs

I love how Jane is so smart that she feels she can tell other people how to invest their retirement. After you trick them out of investing in CD's and Money Market Funds, and a nuclear bomb goes off in the Midle East leading to a 45% decline in the world equity markets, Jane will take in all the indigent retired. Poorer folks have less risk tolerance because they should have less risk tollerance.

Spencer,

I see defined benefit plans as a promise to pay me wages in the future instead of today - "if possible". Given the speed of the modern business cycle, I think defined contribution is definitely the best option for the employee. The only question is how good the plan will be.

I don't share Spencer's enthusiasm for paying GM workers' pensions. I'm mean that way.

Look, not every person is going to be interested in tinkering with their investments, just as not every person is interested in tinkering with their personal motor vehicle. Some, possibly many, will prefer to leave that work to people who specialize in it; investment issues to specialists in that field, automotive tuneups/oil changes/etc. to other specialists. Furthermore, a substantial number of people want something as close to a defined-benefit program as they can get; a clearly defined monthly check so long as they are alive, basically. Many will want to go beyond that, and more power to them, but some sort of defined-benefit offering is just going to be needed in any retirement system.

Defined benefit pensions worked just fine for quite a while, so long as the dollar did not depreciate too much, too fast. Note that the defined-benefit pension systems first got into trouble in the 1970's, when the value of the dollar was dropping in the wake of the 1971 end of Bretton-Woods. It is probably impossible to run a defined-benefit program in an inflationary environment, where the "store of value" loses value every danged day, and certainly impossible in a hyperinflationary environment. But it's no easier to run a defined-contribution plan in such an environment, really, although we all are going to get to try.

Now I must return to reading one of Prechter's books...

Andy Freeman writes:
I don't share Spencer's enthusiasm for paying GM workers' pensions. I'm mean that way.

Of course, thanks to the PBGC, we all will get to pay some part of Delphi's and GM"s pension plans eventually, I fear. The socialization of bad decisions once again is seen; because GM managers and the union negotiators decided that there really was pie in the sky forever, the rest of us will get to suffer to provide some fraction of those benefits to the line workers who authorized their unions to negotiate, and we get to pay for years. Maybe not directly, via taxes to the Federal government administrators of PBGC, maybe indirectly via inflation as deficit-funding of the Federal government escalates. But we will pay for their bad decisions, I am very much expecting it.

I love how Jane is so smart that she feels she can tell other people how to invest their retirement. After you trick them out of investing in CD's and Money Market Funds, and a nuclear bomb goes off in the Midle East leading to a 45% decline in the world equity markets, Jane will take in all the indigent retired. Poorer folks have less risk tolerance because they should have less risk tollerance.

Oh, you are a gem. Not only did you target the wrong writer, you assumed the antecedent of a conditional and made a couple other "blithering idiot" errors in basic logic.

In the words of Lewis: What do they teach kids in the schools these days?

"a substantial number of people want something as close to a defined-benefit program as they can get; a clearly defined monthly check so long as they are alive, basically." When you reach 65 or whatever, you can always take your 401K, etc., and find an insurance company that will take that lump sum in exchange for X$ a month as long as you live. They can't tell how long you will live, but they can be pretty sure that the average of a large group of 65 year olds will be less than 20 years - short of some reseacher stumbling over the cure for aging next year, and even then it will be over ten years and half that cohort will be dead by the time the treatment has been developed, tested, and approved by the FDA. They can't tell how the markets where they invest the money will perform, but they can come close enough to be pretty sure they'll make money overall, and 99% sure their reserves will cover any shortfall.

What they won't guarantee is that $X/month will still be enough to live on in 20 years. That depends on whether the government finds some way to handle it's own problems with underfunded defined benefits plans (both SS and employee pensions) other than printing money.

However, defined benefit pensions are telling a 25 year old that Y$ put in now will cover $X per month, starting in 40 years. Market and lifespan uncertainties will have multiplied many times by then. The only way you can promise that is if the government is ready to step in when there's a problem - or to make the promise conditional upon the company staying in business, and then it's quite likely to be the pension costs that finally put it out of business.

Furthermore, the defined benefit plans of the 50's and 60's would be a bad joke by now if they merely paid out what was promised back then. You couldn't even buy dog food for what was enough to live on in 1965.

Alan Greenspan himself has stated that the US Government can guarantee payment of Social Security and other benefits, but cannot guarantee the value of those payments. Yes, a 401K can be rolled into any of seveeral annuities but that's cold comfort to individuals that have put their 401K into GIC's, money market funds, or other very slow-growth investments. Again, many people want that "defined paycheck" and do not want to have to become investment analysts to get it, just as they want their air conditioner to work & do not wish to become refrigeration technicans.

Marm notes:
Furthermore, the defined benefit plans of the 50's and 60's would be a bad joke by now if they merely paid out what was promised back then. You couldn't even buy dog food for what was enough to live on in 1965.

Yes, the destruction of the dollar as a store of value by multiple Congresses, Presidents and Federal Reserve Chairmen has many effects. That doesn't make defined-benefit pensions bad things per se. I agree that longevity issues will become more significant in this century, but the fact that the dollar has lost 95%+ of its value since 1913 cannot be ignored.

"Again, many people want that "defined paycheck" and do not want to have to become investment analysts to get it, ..."

Alas, every free market security has a risk of ruin: the small but finite chance that its entire value will vanish. Poof, everything gone forever. So sorry, better luck next time 'round.

But guaranteeing a defined benefit requires zero risk of ruin. Not one in a thousand, not one in ten thousand, not one in a billion. Exactly, identically zero. No free market investment can provide this, so a defined benefit plan must necessarily be backed by an institution with the power to print money. This is a basic law of economics.

"Yes, a 401K can be rolled into any of seveeral annuities but that's cold comfort to individuals that have put their 401K into GIC's, money market funds, or other very slow-growth investments."

It was a forgone conclusion that such investments would fail in their goals. People who do that are either willfully reckless, or hopeless charity cases.

The solution to inflation is simple: invest in several very broad, passively-managed index funds. For them to fail means that most of the economy has gone down the tubes, in which case even gold will have considerably reduced value.

"Yes, the destruction of the dollar as a store of value by multiple Congresses, Presidents and Federal Reserve Chairmen has many effects. ... but the fact that the dollar has lost 95%+ of its value since 1913 cannot be ignored."

I agree. It would be so much better if families were still paying their inherited 1920s mortages. Why are they so special to get the mistakes of the past erased?

I wrote:
Again, many people want that "defined paycheck" and do not want to have to become investment analysts to get it, ..."

dn replied:
Alas, every free market security has a risk of ruin: the small but finite chance that its entire value will vanish. Poof, everything gone forever. So sorry, better luck next time 'round.

Diversification is the traditional way to deal with this, along with pooling risk. Defined benefit pensions were managed in such a way as to minimize risk of loss of principal while maintaining a reasonable income. This is also the reason why savings accounts paid less interest than an investment; risk was supposed to be lower in the mortgage market. However, the ongoing depreciation of the dollar, by constantly reducing its value & making it less and less useful as a store of value, drives investors to ever more risk in search of returns that will beat inflation. We see this now, with hedge funds becoming more common (I wonder how many defined-benefit funds are at least partly invested in hedge funds, or funds-of-funds?) and speculation in housing markets.

But guaranteeing a defined benefit requires zero risk of ruin.

No, this claim is false. It requires a very low risk of utter ruin, usually accomplished by diversification among other things. A stable currency is helpful, of course...

Not one in a thousand, not one in ten thousand, not one in a billion. Exactly, identically zero. No free market investment can provide this, so a defined benefit plan must necessarily be backed by an institution with the power to print money. This is a basic law of economics.

Better check that "economic law book", it seems defective. For one thing, it does not match reality...

I wrote:
"Yes, a 401K can be rolled into any of seveeral annuities but that's cold comfort to individuals that have put their 401K into GIC's, money market funds, or other very slow-growth investments."

dn replied:
It was a forgone conclusion that such investments would fail in their goals. People who do that are either willfully reckless, or hopeless charity cases.

Or fiscally conservative and risk averse, but that's reality. This is a reality based discussion, right? So let's deal with reality, not "the way it should be" or "the way I would do it".

The solution to inflation is simple: invest in several very broad, passively-managed index funds. For them to fail means that most of the economy has gone down the tubes, in which case even gold will have considerably reduced value.

The rate of return on such index funds in the inflationary 1970's was well below the rate of inflation; therefore the value of such funds shrank. If one had invested in a Dow or S&P index fund in 2000, how much money would have been made in the last 5 years? Not much, with the market going sideways for most of that time. Inflation makes bonds into a trap, and in time robs enough profit from companies to affect the market and broader indices. In time, people begin to pile into any tangible good, from housing to collectables to precious metals, that show potential of outperforming the inflation that is robbing their savings of value. Gold has doubled in dollar terms over the last few years, for example. Commodity plays are more difficult to time than stock or bond plays, however, making such a market more twitchy. We'd all be better off with a stable currency....well, except for government, which benefits by inflating its debt out of existence.

I wrote:
"Yes, the destruction of the dollar as a store of value by multiple Congresses, Presidents and Federal Reserve Chairmen has many effects. ... but the fact that the dollar has lost 95%+ of its value since 1913 cannot be ignored."

dn replied:
I agree. It would be so much better if families were still paying their inherited 1920s mortages. Why are they so special to get the mistakes of the past erased?

Non sequitur.

However, the ongoing depreciation of the dollar, by constantly reducing its value & making it less and less useful as a store of value, drives investors to ever more risk in search of returns that will beat inflation.

This is only true if the rate of inflation is generally increasing. For the past 25 years, it has not been.

I wrote:
However, the ongoing depreciation of the dollar, by constantly reducing its value & making it less and less useful as a store of value, drives investors to ever more risk in search of returns that will beat inflation.

AT replied:
This is only true if the rate of inflation is generally increasing.

Hmmm...not necessarily. A constant rate that is high enough likely would have the same effect, but it is unlikely that such stability can be achieved; inflation has a feedback cycle. This can be seen in the Assignats, the German hyperinflation, and of course the 1970's inflation.

For the past 25 years, it has not been.

"Past performance is no guarantee of future results".

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