Do 401(k) Plans Still Make Sense?

Fading Attributes Last month, Bloomberg.com published an article entitled "401(k) Plans No Longer Make Much Sense for Savers," by one of its regular contributors, Aaron Brown. As you might suspect from an essay so provocatively titled, Brown's column has been widely recirculated, appearing in publications appealing both to financial advisors and to the general public.

Brown argues that the tax advantages associated with 401(k) accounts have greatly diminished since the first 401(k) plan debuted in 1981. This change, he writes, owes to declines in both tax and interest rates.

1) Income tax rates Lower income tax rates not only reduce the benefit of deferring taxes on 401(k) plan contributions, but also the value of deferring taxes on the income generated by the account's investments. According to Brown, the marginal federal income tax rate on a median-wage couple with two dependents has declined sharply, from 43% when 401(k)s were launched to 12% today.

The income tax bracket for the median retiree has also dropped, thereby improving the usefulness of 401(k) plans, but that decline has been only modest, from 15% to 12%. The upshot: Whereas the marginal tax rate was once much higher on the median worker than on the median retiree, the two rates have now converged.

2) Capital gains tax rates Owning a 401(k) account also shelters investors from capital gains taxes. For that same median household, states Brown, the effective capital gains tax rate was 28% four decades ago. Today, it is nothing. (I had trouble believing that, but sure enough, the capital gains tax is zero for incomes of less than $80,000 for married couples filing jointly, and the median income for families with children is slightly less than that amount.)

3) Interest rates The higher the interest rate, the greater the yield on cash (and likely bonds), and thus the larger the benefit for deferring taxes on investment income. Back in the day, interest rates were in the double digits; currently, says Brown, they are 0%.

In addition, Brown maintains that while investment expenses have dropped across the board, 401(k) costs have fallen to a “much smaller degree” than have retail mutual fund expenses. As a result, “We’re nearing the point that [401(k) plans] no longer make sense for workers, except those fortunate enough to be offered the best plans or good employer matches.”

Not So Fast As noted by several investment professionals, Brown's case is imperfect. For example, what applies to married households with two dependents and median earnings may not hold for other taxpayers. Of course, Brown couldn't address other financial situations, not without writing a small book, so one can't castigate him for using a single representative example. (At least I cannot, given my habits.) But the magnitude of the tax effects remains open to question.

Weaker yet are Brown’s claims about mutual fund expenses. Four decades ago, he writes, investors paid an average of 3.5% annually to hold mutual funds, both within 401(k) plans and outside, while today’s averages are 1.5% for 401(k) plans and 0.5% for retail accounts. None of those figures, aside from possibly the charges of early 401(k) plans, is correct.

Counting the effect of front-end loads, the average retail mutual fund account cost investors about 2% per year in 1980, assuming they held their funds for the industry average of seven years and paid the maximum load. That number is somewhat lower today, typically running about 1.5% (roughly 1% in financial-advisory fees, then another 50 basis points for underlying mutual fund expenses).

Meanwhile, 401(k) fees have dropped sharply. Brown's estimate of a current charge of 1.5% applies only to the smallest plans, which per this study have average all-in costs of 1.4%. Such plans are outliers. Three fourths of all 401(k) participants are enrolled in plans that exceed $60 million, and when 401(k) sponsors reach that size, their plans tend to come in well below 1%.

Narrowly Wrong, Broadly Right All that said, Brown's conclusion is roughly accurate, if overstated. Over the decades, the 401(k) structure has become less attractive, due to eroding tax benefits and reduced levels of investment income. Despite Brown's assertion, 401(k) plans do continue to make sense for investors--but will employees continue to view them as valuable? The question leaves Brown justifiably worried.

To restore 401(k) plans’ luster, he advocates: 1) making 401(k) withdrawals tax-free for households that earn below the median income; and 2) sheltering contributions from FICA payroll deductions. Those actions would indeed strengthen the investment incentives, although one wonders whether Congress will enact additional tax breaks, given the size of the federal debt.

I have an alternate suggestion: my immodestly titled New American Retirement Plan. That proposal shares Brown's goal of increasing 401(k) participation, but through behavioral means rather than by enhancing the tax incentives. My scheme treats the nation's finances more gently, which I believe improves its chances of being enacted.

Either way, despite its inaccuracies, Brown’s article merits the attention that it has received. The tax rewards that spurred the growth of 401(k) plans are not static. They change over time, and should be periodically reviewed, to assess whether the terms should be modified.

Cautionary Words Of last Tuesday's column, "Maybe There's Something to the Shiller CAPE Ratio, After All," Ted Durant writes, "I probably won't be the first to point out that there's an overlapping data problem in all of the work that you show comparing [stock-market] returns to CAPE Ratios." Actually, Mr. Durant, you were the first--but I suspect that many others shared your thought.

Such is the difference between practitioners’ research and those of academics. Practitioners seize on the recent past, in the hopes of learning how investments now behave. In the process, they usually concede statistical rigor. In contrast, academics study items that have many data points, but which may no longer be timely. Two versions of sin. As a columnist, l prefer the first vice to the second.

Our intrepid reader also points out that interpreting the column’s charts is trickier than I had acknowledged. “If, in the 10 years following an observation of a very high CAPE Ratio,” he asks, “stock prices immediately drop 33%, then spend 10 years on a bull tear, is the CAPE Ratio invalidated? What if stocks keep rising for 10 years, then drop 50% in year 11?”

Ask no difficult questions, Mr. Durant, and you will receive no inadequate answers.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.