Investing in 401(k)aos: Highlights from Andy Tanner’s Book
1. 401(k) to the Rescue
To understand why the 401(k) is an agent of chaos, we need to look at its history. Invented in 1978 to help workers fund retirement, the 401(k) plan was meant to supplement other options such as IRAs, pensions, brokerage accounts, and personal savings. Ideally, the average American worker would draw from a diverse financial portfolio in later years. A financial strategy could include commercial investing and active investing in providing retirement income streams.
Fast forward to today, and many people rely on their 401(k) as their primary retirement strategy. They expect this account, along with social security and homeownership, to support them throughout retirement. In reality, most people won’t have nearly enough saved to cover their expenses. According to Andy, relying on the 401(k) has created a tragic and chaotic situation. He echoes the original architect Ted Benna in asserting that it was never intended as a primary retirement account.
Another aspect to consider is whether your financial goals are congruent with the 401(k)’s purpose. These plans build net worth, not provide cash flow. If you are involved in passive investing or commercial properties, you care about cash flow. Placing significant assets in a 401(k) may not be your best option, as withdrawing cash before retirement age could incur steep taxes.
2. The Peril of Mutual Funds
If you are an active investor, consider the lack of agency you have with a 401(k). These plans rely on mutual funds as investment vehicles. Further, they offer limited choices and stratify them according to risk. The conventional advice is that younger workers can tolerate more risk and should invest in riskier but potentially higher-yield funds. Older workers should invest more conservatively. Plans usually guide employees through a friendly online algorithm designed to help them allocate their contributions according to risk tolerance.
The issue here is with applying the same general investing strategy to all people. This approach also assumes that age primarily determines risk tolerance, irrespective of individual goals and circumstances. If you are an active investor, you know this view is shortsighted.
Andy flags historical mutual fund performance as a risk. Mutual funds generally track the stock market. If the S&P and Dow Jones indexes are down, your account probably is too. Reallocating a 401(k) is cumbersome and tied to specific time windows. You cannot react agilely to a volatile market, and you can’t plan to hedge losses.
The fundamental issue is that mutual funds are part of the Wall Street system and tied to its fortunes. Real estate and other assets can hedge against Wall Street, especially if they focus on people’s basic needs for goods, services, and housing. Retail shopping centers often survive market downturns. Other commercial properties, such as well-managed apartment complexes, usually thrive.
When you manage your own brokerage account, you can set a stop loss against sudden stock price drops. You can create other alerts that help you succeed with active investing. If your 401(k) nosedives, you wait for better days.
Retirement Fund Waiting Game
You may wonder if you need that flexibility in a long-term savings plan. After all, isn’t the 401(k) meant to be the ultimate vehicle for long-term passive investing? Don’t you want to let compounding and historical market trends work their magic? After all, many Americans lack the resources or knowledge to pursue commercial investing.
Let’s think back to the Great Recession. In many cases, the value of conventional retirement plans dropped by 50% or more. People lost half their retirement savings overnight. While the losses were unrealized, they quickly became real to the many people who needed to draw on the money within ten years. Employees approaching retirement did not have time to make up for the losses. Younger workers waited five years or more for their accounts to regain pre-recession value. If you were planning on borrowing against your 401(k) for an imminent home purchase, medical bills, or your children’s college expenses, you were out of luck.
If we look at the math behind the drops, the portfolio performance needed to recover is greater than the loss. If your account plummets by 50%, for example, you have to gain 100% to return to the initial value. In other words, you have to double your money to break even. This is an odd calculus for an investor, particularly when applied to mutual funds.
3. Feeding Wall Street
According to Andy, you should realize that the 401(k) was invented to enrich Wall Street. Though it may offer some advantages to individuals, its purpose is to promote mass participation in the stock market. Wall Street reaps fees and other profits from this vast investor base.
This doesn’t mean a 401(k) has no place in your financial strategy. Just keep in mind that the vehicle was not designed to benefit the individual. The tax situation illustrates this fact. If you want to withdraw from your account before retirement age, you face a stiff tax rate and penalties. To avoid this, you need to take a hands-off approach to that money or leverage the few exceptions, which still tax you at ordinary income rates.
Let’s take a mutual fund purchase as an example. If you buy a fund on your own through a broker, you can hold it for over a year and then sell at a long-term capital gains tax rate. This rate is 15% for most people. If you buy the same fund through your 401(k), hold for more than one year, and then cash out at retirement age, you may pay up to 37% in taxes on ordinary earned income.
Andy asks the question we should all ask ourselves: Do you plan on making more or less money in retirement than you do now? People’s answers vary depending on their goals. If you plan on making more, however, you are likely an investor. Does it make sense to take a 401(k) tax advantage now and pay much more tax later on that money in a higher income bracket? You may want to calculate scenarios in light of your investment strategy.
4. Abdicating Investing Responsibility
Andy points out an insidious side effect of mass reliance on the 401(k). If you trust your sponsored retirement vehicles to secure your future, you may forfeit owning your financial destiny. It becomes too easy to remain ignorant of basic investment and economic principles. Many people don’t learn financial literacy at home or in school. Without an incentive to learn fundamentals, they may pay excessive taxes because they don’t understand the system. Over decades of hard work, they may overlook opportunities and even risk life savings because they abdicated responsibility.
Structurally, the 401(k) reinforces dependence by offering limited investment choices. You typically have a small portfolio of mutual funds at various risk ratings, sometimes only one fund at each risk level. Your company may also offer a stock fund, but consider that you already invest in the firm by working there.
If you invest privately, you can choose from thousands of individual stocks, mutual funds, and other vehicles. You can complement real estate investments such as retail shopping centers or other commercial properties. Crucially, you can enter and exit investments as you need to.
5. Artificial Market Demand
Not only does the 401(k) affect individual financial habits, Andy describes its impact on the market. The millions of Americans regularly contributing to these plans create artificial demand for mutual funds, stocks, and the behemoth infrastructure that supports them. It is hard to cast the situation as a traditional bubble because retirement vehicles are funded so predictably and on a mass scale. We don’t yet know the consequences of this systemized influx.
When viewed as an asset among several in your portfolio, the 401(k) offers some advantages. Often you can take out a loan against your vested balance. If your employer matches your contribution up to a certain percentage, you’re receiving free money. Before contributing above the match amount, consider weighing your particular situation’s pros and cons.
Andy’s key takeaway is that investing is a life skill we all need to own. You don’t need a degree in finance or a Wall Street job, but you want to understand tax code and market fundamentals. Know some history for context and be able to soundly evaluate your investment vehicle options. The better you can do this, the better you can invest in your financial future, not just Wall Street.