Why the 401(k) Was Invented and What You Need to Know about It

Do you have any idea how expensive it is for an employer to establish a pension plan for a policeman today?  Let’s say you are a policeman aged 25, and your salary is $40,000 a year.  Your employment contract says that after 25 years of service you are entitled to 75 percent of your pay the rest of your life, including your spouse.  Today, if your average length of life is age 85, that means you and your spouse will live 35 years in retirement, while you only worked 25 years.  Now many police officers, emergency responders, ambulance service technicians and the like will retire at 25 years, but then go into private employment and work for another 15 years, to supplement retirement income.  But the point is, they worked for only 25 years and are expecting a pension for another 35 years. This gets expensive for their employer.
If you are age 25 and will retire at age 50, you will need $811,000 in an investment account to provide $30,000 a year for the remaining 35 years of life.  These are estimated numbers, but that means the city you work for must pay $15,000 a year into your retirement account.  And why shouldn’t these public servants have these wonderful benefits? Police officers put their lives in constant danger to keep communities safe.  Of course offering such benefits is to induce people to become public servants, which can be a very thankless and dangerous job.  But again, what about the cost employers must bear in offering such benefits?
Back in the day, say in the 1940’s, 50’s and 60’s for example, offering such benefits was not as big of a deal for employers. People retired around age 65, then men died at age 69 and women at 72, on average. People worked their whole life only to retire and die four years later! That meant that the employer only had to provide a pension for around four years and maybe pay the surviving spouse for another three years. The employer only had to pay into a pension $1,200 a year, from age 25 to age 65, or 40 years.  You can see from the numbers that offering a pension was more doable then.
But because people today are living 20 and 25 years longer than they did 50 and 60 years ago the option to provide a pension becomes almost impossible. Living longer presents and exacerbates a whole new set of problems.  First, the contrast of only paying $1,200 a year, rather than $15,000 is a lot less money for the employer to come up with!   Second, retirement income must be provided 30 more years than it once was in the good old days. Also, back in the 40’s and 50’s people would never change employment; they worked for 40 years at the same place.  But from 1970 until today, innovations have come on the scene rapidly and technology has improved at almost an exponential rate.  Gigantic industries have been born and then died.  How many industries can you think of over the last 30 years that have cropped up and then suddenly become obsolete? Because technology is so rapidly moving, people and industries have had to move with it, becoming much more mobile and flexible in the workforce than they once were. Many private-sector companies that promised pensions are now defunct!
Thus the 401(k) was born. When employers got squeezed for more profits in the 1970’s, they switched to offering only a match or no match “retirement” plan and no pension, or in other words the 401(k) program.  These tax-deferred plans must invest funds in the stock market where there are real risks the average employee has no clue about. The chance of losing most or all of your retirement funds if they are all sitting in a 401(k) is very possible — just ask all those who lost everything in the crash of 2008. The days of pensions that an employee did not have to contribute to, ever, are long gone!  Now days, pensions are mainly for school teachers, nurses, police officers and emergency responders.  They have very good benefits because their salary is not as attractive in the private workplace.  Pensions for the average worker are good to have, but not likely now that 401(k)’s have been around for 35 years and cost employers little to nothing to offer. 
My point in giving you a history on pensions and how 401(k)s came about is to help educate people who have ignorantly bought into the notion that these tax-deferred contribution plans are the only way to save for retirement. Nobody thinks about what they really are — a poor substitute for the now-extinct pension plan.  The 401(k) and IRA are not the be-all, end-all of retirement planning. They should be considered only one of many ways you could be funding your retirement, but only if you don’t have a ton of debt. If you are in debt, the amount of interest you earn on usually conservative investments of your 401(k) cannot keep up with debt interest expense, and therefore are probably not doing you a whole lot of good.
If you want to get serious about real options for funding retirement call me to discuss the Money Mastery system at no cost to you: peter@moneymastery.com, 801-292-1099.