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Your 401(k) Plan May Provide a False Sense of Security

Daniel Solin

The 401(k) landscape is definitely improving. But with this improvement comes a new danger: Your plan may be giving giving you a false sense of security.

According to a report on 2013 defined contribution plan data, "How America Saves 2014," recently published by Vanguard, more than 88 million Americans participate in defined contribution plans. The total assets held in these plans are in excess of $5.5 trillion. The data summarized in this report is both encouraging and depressing.

On the depressing side, the median participant account balance in 2013 was only $31,396. The average balance was $101,650. If you are a participant in a 401(k) plan with an average balance, and are depending primarily on your defined contribution investment to fund your retirement, you had better be prepared to live on $5,000 a year or less.

On a more encouraging note, median and average participant account balances rose by approximately 80 percent from 2008 to 2013. This growth reflects significant increases in the stock market during the same 5-year period. For those who continuously participated in their defined contribution plans from 2008 through 2013, the median account balance rose by a whopping 182 percent. Vanguard attributes this stellar performance to both ongoing contributions and excellent market returns.

Another positive trend noted by Vanguard is the increased use of professionally managed portfolios. At the end of 2013, 40 percent of participants enrolled in Vanguard plans had their entire balance invested in a single target-date fund, balanced fund or managed account advisory service. Vanguard projects that 58 percent of all plan participants and 80 percent of new plan participants will be fully invested in some form of a professionally managed portfolio by 2018.

If one thing is obvious from the sordid history of 401(k) plans, it's that most participants are incapable of putting together a globally diversified portfolio in a suitable asset allocation on their own, using low management fee index funds. Of course, this assumes that low management fee index funds are even an option. Although they are available in Vanguard plans, these funds are more the exception than the rule in 401(k) plans "advised" by brokers and insurance companies.

Vanguard found that, taking into consideration both employee and employer contributions, the average total participant contribution rate in 2013 was 10.2 percent. Unfortunately, if you want to retire with dignity, you'll have to significantly increase that number.

In "The Smartest 401(k) Book You'll Ever Read," I discuss a 2007 study by M. Barton Waring, CIO for investment policies and strategies at Barclays Global Advisors and Laurence B. Siegel, director of policy research at The Ford Foundation, "Wake up and smell the coffee, DC plans aren't working. Here's how to fix them." The study found that the typical 401(k) savings rate was then in the range of 8 percent to 9 percent, including the employer's match. It calculated what would happen if an employee saved 9 percent for 40 years and earned 3 percent yearly salary increases. The study concluded that after all expenses were deducted, the employee would enjoy a 6 percent annual return.

The study found that if the employee faithfully kept this up for 40 years, she would be able to replace only 41 percent of her preretirement income. With Social Security benefits, it's possible you could retire on that amount. However the study assumed no unemployment, no borrowing from the plan assets and no taxable distributions during the life of the plan and a decent rate of return. The calculations also did not take inflation into account.

The study concluded that to replace 75 percent of preretirement income, which many believe is a desirable goal, a 15 percent savings rate is required. The assumptions underlying this second calculation are also very rosy. They assume the employee would earn a "decent realized return," defined as the market rate of return on a medium risk portfolio with low, index fund fees.

Because of poor investment choices, conflicts of interest, kickbacks (euphemistically known as "revenue-sharing payments") and the historical underperformance of actively managed funds, it's unlikely most participants will earn that decent rate of return.

If you are serious about saving for retirement, you will need to put aside a minimum of 15 percent of your income each year, including the employer match. Realistically, that number should be closer to 20 percent.

Other encouraging developments noted by Vanguard include growth in the use of target-date funds, an increase in plan participation rates, growth of automatic savings features, an increase in plans offering a Roth 401(k) option and an increased focus on lowering plan fees, resulting in greater interest in offering a wider range of low-cost passive or index funds.

Notwithstanding these positive trends, 401(k) plans will continue to fall short of their stated goal to provide American employees with a secure retirement, absent meaningful legislative changes, which are unlikely. The current system benefits brokerage firms, brokers, pension consultants, insurance companies, insurance agents, the mutual fund industry and employers.

American employees deserve a much better retirement plan.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book, "The Smartest Sales Book You'll Ever Read," has just been published.