Millennials Remain Skeptical of 401(k) Plans
September 15, 2015
I know quite a few millennials—some are nieces and nephews and others are children of friends and acquaintances. I love and admire them all. For the most part they are all smart "kids" who are decent and kind. But I must confess: I don't find them as interesting and awesome as their grandparents, parents and friends do. That’s probably because I can still remember being their age and thinking I was smarter and more interesting than my current self would find. Make sense?
Anyway, despite my aloofness towards millennials, I do enjoy having a "serious" conversation with them. Especially when the conversation is about some of my favorite subjects to talk about. In this case: workplace retirement savings plans; specifically 401(k) plans.
The Conversation
Recently I had dinner with two millennials. They are recent college graduates who are smart and focused. To their immense credit they are researching various retirement savings options. So, naturally, the conversation turned to workplace 401(k) plans. And my excitement barometer went way up when one of these millennials called the 401(k) plan a scam.
Don’t get me wrong, I’m not offended by those words at all, I just never met a millennial that expressed their wariness of financial markets so abruptly. Personally, I think they have many reasons to be cautious.
- They were in college during the worst recession of their and their parents’ lives
- They know how difficult it is to find a job, let alone a good paying one
- They also know about the government’s bailout of Wall Street
They understand the risks of participating in a 401(k) plan but they don’t understand what it is and how it works. Which means they don’t understand the potential rewards and are, therefore, unable to truly evaluate the 401(k) plan as an option.
Their Concerns/My Responses:
1) No one knows how the funds will perform.
True, but investing is a long-term game. You will have ups and downs; however, the data shows that over time most investors will come out ahead. Of course, there are no guarantees, which is the risk you take when investing. But with risks, there may also be rewards. Also, because the market has been in play for such a long time, there is a lot of company and investment fund level data available to knowledgeable investment fund managers to minimize investment risk. Lastly and partly due to the last recession, government regulators have stepped up their scrutiny of 401(k) and similar plans. Since 2012 plan administrators must disclose the fees they charge for their services. These fees are deducted from 401(k) accounts, which means they lower an investor’s overall account balance. Regulation has resulted in many service providers and funds lowering their fees. There is also a pending rule to ensure that financial advisors of 401(k) and IRA (Individual Retirement Account) participants act in the best interest of their clients. This level of government scrutiny is unlikely to decrease due to the ever-growing popularity of workplace 401(k) plans.
2) Workers whose accounts perform poorly are forced to work past normal retirement age.
The 2008-9 recession saw many near retirees lose up to 50% or more of the value of their 401(k) accounts. This was a tragedy, but it’s a well-documented risk of investing. However, there are steps you can take to mitigate this type of risk. One option is to work with a financial advisor, especially if your employer offers free financial or retirement plan advice. A good, fee-only financial advisor can help you design a long-term plan that includes moving your account balance into less risky funds 5-10 years before your scheduled retirement date. Also, retirement saving should not be done in a vacuum. Make sure you pay off debt and choose the right time for you AND your partner to start collecting Social Security benefits.
3) 401(k) account balance: “they are taxed after you withdraw them which seems like a huge problem to me because I feel as though they should be taxed when you are still making the most of your money.”
This is a tougher one to tackle than I originally thought. So let me try to interpret what I think my millennials are trying to say:
You can afford to be taxed on 401(k) contributions and earnings while you are still making money versus when you are retired and not making a steady income…
Here goes…
There is more than one type of 401(k) plan; however, the two most often offered in the workplace include the traditional and the Roth.
The traditional 401(k) works just like my millennials think: you contribute a set percentage to an account that goes into one or more investment funds (money market funds, stocks, bonds, combination of stocks and bonds, ETFs, index funds, company stock, etc.). Not all of the funds you can invest in have the same level of risk. For example, money market funds are very low risk and international stock funds have a higher comparative risk. The amount you put into the account is not taxed (called pre-tax or tax-deferred). The money you contribute along with the money you earn on your investments grows tax-free. Once you begin taking money out of the account, the amount you withdraw is subject to taxation.
The Roth 401(k) works differently but has the same funds available as the traditional 401(k) plan. The difference is that the money you contribute to a Roth 401(k) plan is taxed immediately. When money is withdrawn from the account, the withdrawal is tax-free. Earnings from the Roth are tax-free.
My millennials may want to contribute to both a traditional and Roth 401(k) plans if their employers offer one. But we still need to address the issue of not seeing the huge benefits of contributing pre-tax money to a retirement plan that grows tax-free. This is one of the best features of the 401(k) plan and why it is so popular.
Benefits of the Traditional 401(k) Plan
- When you contribute to a traditional 401(k) plan, you have less taxable income for that year (basically you pay fewer taxes than you would if you did not contribute). That means you have more money to invest and more take home pay that you can use to pay down debt.
- You benefit from compound interests. This means that you not only earn money off the principal amount you contribute, you earn money off of the interest earned on the principal. Here’s a great explanation of how it works. (In my opinion this is the greatest benefit of investing in the market and why average earners are accumulating multi-six figure retirement accounts.)
- Your income tax rate in retirement is typically lower than it is when you are working, which means you will pay a small amount of taxes on your retirement plan withdrawal. Also, if you live in a state with no or low income tax, you will pay no or low state taxes on the withdrawal. You will still have to pay federal income taxes…
I have issues with 401(k) retirement plans just like my millennials do, including fees, complexity and investment risk. But I don't think they are a scam. Sure, the financial services industry is making millions upon millions off of others' retirement savings without any "product guarantees,” yet the 401(k) plan remains one of the best ways to accumulate a meaningful retirement balance. My message to millennials is to remember that preparing for retirement is about more than saving and investing. Plan to enter retirement physically healthy and debt-free. Also, forego receiving Social Security benefits until you or your spouse is eligible to receive the maximum benefit, which for now is age 70. And, lastly start saving or investing now, in anything, while you are still young.
My message to the financial services industry is that you are going to have to up your value game for this new generation of savers and investors.
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Denise Perkins
