Saturday, December 7, 2013

No, the "401(k) revolution" was not a "failure"; it was a spectacular success

Image: Wall Street watches out for senior citizens. They can make an awful lot of money off them. (source)

I recommend reading this piece by Lynn Stuart Parramore, as it is among the most clear and concise descriptions of how the "401(k) revolution" (her words) is in the process of upending the retirement security of the vast majority of Americans, but also how it is a major driver of inequality. As she explains, the rise of the 401(k) added a tremendous amount of fuel to the inequality fire (for more, here's a useful Wonkblog summary of a much longer EPI report).

But Parramore makes a mistake very common to many liberals lamenting the rise of the 401(k). I'm not implying that she is in any way unique--this mistake is extremely common across the political spectrum, including liberals. That mistake occurs from beginning to end in the tale of the 401(k). Act one: 401(k)'s are born:
Thirty years ago, as laissez-faire fanaticism took hold of America, misguided policy-makers decided that do-it-yourself retirement plans, otherwise known as 401(k)s, would magically secure our financial future in the face of gyrating markets, economic crises, unpredictable life events, stagnant wages and rampant job insecurity.
Note how the rise of the 401(k) is described as a mistake. Some "misguided" people made a mistake, and we're about to feel the very serious effects of that poor decision. The "misguided policy-makers" honestly thought this was a good idea--but good intentions do not make good policy, and their plan is about to backfire:
Instead of having predictable streams of income from traditional pensions, ordinary people with little financial expertise would suddenly transform themselves into financial gurus, putting money aside and managing complicated investments in tax-deferred accounts.
Note how Parramore explains that "ordinary people" were expected to benefit from 401(k)'s. It's not that 401(k)'s were expected to help only the wealthy or only the investor class. They were designed to--and expected to--help everyone, including "ordinary people."

(By "traditional pensions," Parramore means defined benefit pensions. For those unacquainted, a defined benefit pension is an agreement that an employer will pay an employee a specific dollar amount each month from the date the employee retires to the date the employee dies. 401(k)'s are defined contribution, meaning the employer agrees to contribute a specific percentage (the "employer match") to a bizarre financial instrument, which is invested in the stock market and will pay out money to the employee once she retires. Of course, some employers don't actually offer an employer contribution--in other words, the "employer match" or "defined contribution" is zero.)

She succinctly describes how the entire scheme has already violently backfired:
Reality check: In 2007, the financial crisis destroyed America’s retirement fantasy. Jobs evaporated or were downsized. The stock market took a nosedive. Millions of Americans who had worked hard, straining to sock away a portion of their salary for 401(k)s, watched helplessly as a black cloud formed over their golden years. In October 2008, the Congressional Budget Office revealed that Americans had lost $2 trillion in just 15 months — money that will likely never be recovered.
And, she gets close to the crux of the issue in concisely describing how 401(k)'s have enabled a further rise in inequality--
The report reveals that median retirement savings today stand at a paltry $44,000. But if you start looking at affluent America, the picture changes dramatically. A household at the 90 percentile of the retirement savings distribution had nearly 100 times more socked away for retirement than the median household. And the top 1 percent? Households at that lofty level had stashed more than $1.3 million in retirement account savings.

In a nutshell, the 401(k) revolution created a few big winners and turned most of us into losers.
--but ultimately misses the point. Liberals have the what and the how of 401(k)'s nailed down, but usually miss the why.

Augmenting this understanding with the why of 401(k)'s is of utmost importance, because many liberals assume that pointing out the disastrous results of the 401(k) revolution is a key first step in changing policy. In their minds, if we could only prove that the policies that enabled the rise of 401(k)'s resulted in bad policy outcomes, our political system would be convinced that it's time to reverse course.

The problem is, the movement towards 401(k)'s has not been a mistake, and it certainly has not been a failure. It is going exactly according to plan. 401(k)'s indeed are a vastly inferior system for the vast majority of Americans, but 401(k)'s were not created to help ordinary people save for retirement. They were created and expanded for very different reasons. To the people who ushered in the 401(k) revolution, the retirement "nightmare" beginning to swallow recent American retirees has not been a nightmare at all. It has been an especially enriching and welcome development.

Remember as you're reading: defined contribution pensions are a vastly inferior model to defined benefit pensions. Defined benefit pensions can provide the same retirement security as a defined contribution pension, for 45% less cost. Additionally, research argues that putting money in a 401(k) is generally harmful for low income workers. Whatever the reason to switch from defined benefit to 401(k), it should be a really good reason in order to make up for the enormously higher cost and other weaknesses. You be the judge:

401(k)'s help Wall Street rob you blind
There are two types of funds one can invest in with 401(k) money--actively or passively managed accounts. An example of a passively managed account, also known as an index fund, is the Vanguard 500, which simply purchases an equal amount of stock from all 500 of the 500 biggest American corporations. In investments, diversity is the safest (and usually best-performing) investment, and you can't beat that level of diversification; you also don't need financial whiz kids to figure out how to properly diversify.

By contrast, an actively managed account is one where a Wall Street "expert" manages the stock holdings of the account, buying and selling shares of stock as she sees fit. You shouldn't use actively manged funds: a recent study compared the performance of 5000 actively managed funds to passively managed funds over a 16-year period and found that passively managed funds beat actively managed funds 80% to 90% of the time. And, when passively managed funds beat actively managed funds, it was usually by a significant amount; when actively managed funds beat passively managed funds, it was usually by an insignificant amount.

You shouldn't like actively managed funds, but Wall Street sure does. The sheer dollar value of fees paid to Wall Street for active management "services" is staggering. This windfall slips in under the radar for most people, because the fees sound extremely small. But because the fees are compounded annually, it adds up to an extraordinary pay day to Wall Street at your expense. For example, 2% doesn't sound like much, but (emphasis added):
MARTIN SMITH: Bogle gave me an example. Assume you’re invested in a fund that is earning a gross annual return of 7 percent. They charge you a 2 percent annual fee. Over 50 years, the difference between your net of 5 percent — the red line — and what you would have made without fees — the green line — is staggering.
Bogle says you’ve lost almost two thirds of what you would have had.
JOHN BOGLE: What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding costs. It’s a mathematical fact. There’s no getting around it. The fact that we don’t look at it— too bad for us.
MARTIN SMITH: [on camera] What I have a hard time understanding is that 2 percent fee that I might pay to an actively managed mutual fund is going to really have a great impact on my future retirement savings.
JOHN BOGLE: Well, you have to rely on somebody to get out a compound interest table and look at the impact over an investment lifetime. Do you really want to invest in a system where you put up 100 percent of the capital, you the mutual fund shareholder, you take 100 percent of the risk and you get 30 percent of the return?
Neither does 1%:*
“Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.”
Just how much is this worth to Wall Street? There is no way of knowing, and Wall Street has obvious reasons for declining to make that information public. Nevertheless, it is probably a lot:
In 2008, Bloomberg magazine polled a group of pension consultants and came to the conclusion that 401(k) fees alone totaled $89.1 billion annually. Ghilarducci, who recently took a more all-encompassing look at American retirement assets, and included IRAs and pensions in her total, pegged the number at $500 billion.
This is worse than rent seeking, since Wall Street isn't just grafting off of mutually beneficial transactions that would have occurred without their interference. They're actually making money by tricking people into buying an inferior product.

There's really no way of knowing the average 401(k) fee, since it's legal to conceal that information from fund participants. Nevertheless, the typical 401(k) fee is certainly not 0.17%, the annual fee for the Vanguard500 index fund.

Another amazing feature of 401(k)'s is that Wall Street collects its fees whether or not the account actually makes money. Wall Street quietly collected their fees from the 401(k) accounts that lost half their value when the stock market tanked at the end of 2008. And they quietly collect their fees even when their actively managed funds get beaten by passively managed funds. It's heads Wall Street wins, tails you lose.

Wall Street doesn't just rob retirement benefits through 401(k)'s. For example, Wall Street has arranged a spectacular corporate welfare deal to actively manage Rhode Island's public pensions for an extraordinary 4% annual fee! They arranged this sweetheart deal using the same smokescreen--promising higher returns through active management. This was a broader part of Rhode Island's "pension reform" plan, in which a Democratic administration slashed retiree benefits in the name of saving money. However, the additional fees Rhode Island's public pension fund owes Wall Street exceeds the money saved by cutting retiree benefits. Not only does the Democrat who arranged this appear to have a personal financial stake in this decision (otherwise known as bribery), she now certainly has powerful allies in Wall Street for her future political or corporate ambitions. And, to date since its inception, Rhode Island's new actively managed fund is getting far lower returns than passively managed funds. This all sounds like a very bad situation, but from the perspective of Wall Street and career politicians, these are all good things, not bad things.

To conclude this section: 401(k)'s have not been a failure. 401(k)'s have been wildly successful in allowing Wall Street to collect an enormous sum of money from your retirement account in exchange for a service that is worse than useless. This scheme is made possible by the fact that it is legal for financial advisors to lie to you, presenting themselves as a neutral advisor, when they actually have a financial stake in you buying their high fee, actively managed account. They can literally tell you that they are giving you neutral advice so you can decide what's in your best interest; in reality, they're secretly salesmen trying to rip you off by tricking you into buying an expensive, inferior product that enriches them. This is not illegal, and Wall Street will fight tooth and nail to keep it that way. If this sounds too Machiavellian to be true, it's not. Earlier this year, the Department of Labor was considering regulations that would have made it illegal to lie to clients in this way (in legalese, it would have imposed a fiduciary standard on all financial advice). It was aggressively lobbied against by Wall Street and a subservient Congress--including 32 "liberal" representatives--moved to torpedo it.

Billions of dollars in profit? Aggressive lobbying to protect those profits? Sounds like a plan working exactly as intended, not a terrible mistake.

(Note--if you're wondering why both examples calculating compounded fees used 7% returns as the baseline, read this page)

Designed by the wealthy, for the wealthy
Recently, Planet Money broke down how poor, middle class, and rich households spend their money. It's interesting that spending as a percentage of total income does not vary by income level for most things. But scroll down, and you'll see the one major difference--

--in saving for retirement. The rich save a much larger amount of money--proportionately--than anyone else. Keep in mind that 15.9% of the income of a rich family is way bigger than 15.9% of the income of a low- or middle-income family. This is a huge amount of money. By providing a tax break for money saved for retirement, 401(k)'s were ostensibly created to encourage saving for retirement. In reality, 401(k)'s simply provide a way for wealthy families to avoid paying taxes on money they would have saved for retirement with or without a 401(k). Yes, the best research available argues that 401(k)'s don't encourage retirement savings, but rather allow rich people to avoid paying taxes on money they would have saved for retirement with or without a 401(k).

Simply put, there is no better example of a regressive benefit. If you wanted to invent a scheme that helps rich people as much as possible while helping poor people as little as possible, you would invent a 401(k). This is particularly true since marginal tax rates increase as income increases (because more income means moving into higher tax brackets). Obviously, a tax break is more valuable if you have higher taxes; thus, each dollar saved through this form of government welfare benefits the rich more than it benefits the middle class or poor. Thus, not only do rich people use their 401(k)'s more than poor or middle class people--it benefits them more to do so (and few low income jobs actually offer a 401(k)). As we saw above, putting money into a 401(k) tends to be a harmful financial decision for poor people.

Note also how "rich" families include those making over $150,000. Sufficient data do not exist to resolve this any higher, but families making in excess of, say, $1 million per year probably save a greater percentage for retirement.

Planet Money's categories mask reality in another way. The investor class invests most of their income. Any time an investor sells off some stock to purchase a different stock, she has to pay taxes on the income she made from the selling of that stock. But paying taxes is such a drag--wouldn't it be nice if there was a way to invest some of your income in the stock market without first having to pay taxes on it?

That is exactly the role of the 401(k)--a tax-free stock market investment vehicle. Thus, for the very wealthy, the Planet Money category "saving for retirement" is a misnomer. This money would have been invested in the stock market with or without the option of using a 401(k); it's just that now, this money can be invested, tax free.

So--401(k)'s have created a way for the wealthy and ultra wealthy to pay less money in taxes, without having to change their behavior. That doesn't sound like a mistake. That sounds like a plan working exactly as intended. It's no wonder people like Paul Ryan want to increase the amount of money that can be put into a 401(k)--why not get rewarded with more tax breaks for stock market investments or retirement savings you would have made anyway?

Defined benefit pensions are expensive
The Heritage Foundation analyzed General Motors' tax returns for 2007, finding that GM paid out a total of $4.9 billion in defined benefit pensions to 291,000 beneficiaries. That averages to a payout of approximately $16,800 per person. Believe you me, there is no 401(k) that costs an employer $16,800 per person. Even with an unheard of 5% employer match, you would have to be making well in excess of $300,000 per year before your 401(k) cost your employer $16,800.

Simply put, employers wanted to stop offering defined benefit pensions, and 401(k)'s were something they could offer instead. 401(k)'s were a face-saving exit at best, a bait-and-switch at worst: We're offering you the opportunity to participate in an exciting new retirement plan that will take advantage of the sky-high rates of return of the stock market, which cannot be matched by traditional defined benefit pension plans!

By offering the bait for the bait-and-switch away from defined benefit pensions, 401(k)'s have been extremely successful at limiting corporate America's exposure to employee retirement plan obligations. It's also important to note that the wealthy investor class that the 401(k) was designed by (and for) has no personal interest in maintaining defined benefit pensions, but they certainly have an interest in limiting corporations' exposure to employee retirement plan obligations. A dollar not spent on employee retirement is a dollar in profits. That sounds like a plan working smoothly, not a terrible mistake.

Justifications for cutting Social Security
The last goal of the "401(k) revolution," to replace Social Security, has not been a failure; it is still a work in progress.

For the Social Security retirement program, income is only taxed and benefits are only paid out for the first $117,000 of annual income (this is adjusted every year; $117,000 is the amount for 2014). In other words, the more money you make in a year, the more Social Security taxes you must pay, but the higher your Social Security benefits will be once you retire--but the calculation for both taxes and benefits stop at exactly $117,000 in annual income. Thus, if Bob earns $117,001 ($117,000+1) in a year and Bill earns $10,117,000 ($117,000+10 million) in a year, they will both pay the same amount of Social Security taxes and will receive the exact same benefit payment each month when they retire. If Frank makes less than Bob or Bill, he will pay less in taxes and receive less in benefits once he retires.

However, this situation only applies if you're earning wages. If you're ultra wealthy, your income probably comes from capital gains, which are not taxed by Social Security. Thus, the ultra rich have zero interest in Social Security whatsoever: they don't earn wages, so they don't pay taxes to support it--and thus aren't eligible to receive benefits. Even if they were eligible, the benefits (to them) would not be worth the trouble.

Simply put, very wealthy individuals have no need for Social Security and have no personal interest in its continued existence. What's more, the Social Security Trust Fund has a surplus of $2.7 trillion (first paragraph in page numbered 2 in the bottom corner). Wall Street would love to start taking 1, 2, 3, or 4% annual, compounded interest out of that enormous fund. If that huge amount of money was converted to some sort of 401(k)-style retirement investment accounts, Wall Street would stand to gain hundreds of billions of dollars. That is the goal of Social Security privatization.

401(k)'s fit into this plan by making it possible to insist that there is a viable alternative to Social Security. As President, George W. Bush's Social Security semiprivatization plan (still, unsurprisingly, supported by Paul Ryan) would have allowed workers to divert some of their Social Security taxes into personal, portable, retirement savings accounts that would be invested in the stock market--in other words, 401(k)'s by another name.

It's key to realize that Bush's semiprivatization plan is the essential next step in privatizing Social Security. Because low income jobs typically don't offer 401(k)'s, Social Security can't just be eliminated outright; that would leave the poor without any retirement plan whatsoever. But once--as Bush's plan would have done--some 401(k)-like plan is made universal, conservatives can claim that Social Security is no longer needed, and privatization can proceed. That is the long game.

Of course, this sounds to Machiavellian to be true. Unfortunately, this has been the Right's strategy for decades. Here (h/t), for example, is a Cato Institute publication from the 1980's arguing for this exact strategy:
Privatization, in other words, means seeking to transfer programs into the private sector using the carrot of incentives, not the stick of aggregate cutbacks. Rather than trying to frustrate political demands for spending, it means deflecting that demand into the nongovernment sector.
This is exactly the strategy of George W. Bush's semiprivatization strategy: Movement to private accounts would be optional, but encouraged by tax incentives--carrots, not sticks. An "aggregate cutback"--something Cato strongly recommends avoiding--means cutting or eliminating Social Security outright. Because of its effectiveness and popularity, Cato argues, Social Security can't be cut outright. Instead, there needs to be a way to replace Social Security while making it look like Social Security is not actually being replaced. Carrots, not sticks. I sound like a conspiracy theorist, but this is actually the Right's plan, and has been for decades. The Cato publication continues by documenting the spread of Individual Retirement Accounts (IRA's):
To appreciate how the politics of privatization works in practice, consider Individual Retirement Accounts (IRAs) and Social Security...[a] minor provision in the 1981 tax act may eventually break up that coalition, if the White House seizes the opportunity it has been given. By allowing all working Americans to open tax-deductible IRAs, Congress planted the seeds of a private alternative to Social Security. The $2000 annual deduction now available is a concentrated benefit only available to those choosing to open these accounts, while the "cost" (again, assuming that there is a corresponding cost) is spread over all taxpayers, ensuring that the political advantage is with the supporters of the IRAs.

It was not long after the passage of the 1981 act that banks and other financial institutions (the administrators and service providers of IRAs) began a massive campaign to encourage Americans to open retirement accounts.
Sound familiar? Make a private retirement account universal in order to eventually replace Social Security. Later, this publication gives a step-by-step process for replacing government programs with private ones; step #5 is "Advocate Vouchers for Low-Income Americans" in order to neutralize the objection that privatization results in incomplete coverage of poor people. The Right astutely realizes that until some form of private retirement plan is universal, Social Security cannot be eliminated outright.

In other words, this is exactly the strategy George W. Bush's semiprivatization scheme followed, and exactly the strategy still endorsed by Republicans like Paul Ryan. By greatly expanding use of private retirement accounts, 401(k)'s quite obviously advance this strategy. (In fairness, Barack Obama is also very much in favor of cutting Social Security.)

The carrots are already in place; you'd be a fool (or just impoverished) not to take advantage of the tax incentives of 401(k)'s. In this way, Social Security privatization is going according to plan, just not as quickly as its architects would like.

It's important to remember that--if you are wealthy and/or concerned for maximizing corporate profits--the move to 401(k)'s has been a fantastic development. It has been a failure for 90-99% of the country, but for the people who actually rule our country, the "401(k) revolution" has been going according to plan. Wall Street has grafted billions of dollars in fees; the wealthy get to pay less in taxes; corporations get less exposure to employee retirement plan obligations (and a dollar not spent on employee retirement is a dollar in profit, further enriching the investor class); and an appearance has been created that Social Security can be replaced by a private alternative. Nothing about this has been a mistake. Nothing about this was not planned in advance. Nothing about this is unwelcome to the people making the policy decisions. Absent fantastic grassroots efforts, the move towards retirement insecurity for the vast majority of Americans will continue its slow but steady advance.

UPDATE (11/20/2014): David Sirota continues to do excellent work, almost single-handedly exposing Wall Street's looting of public pensions in several different states. For instance, Rhode Island's pension fiasco has cost the state hundreds of millions of dollars since its implementation in 2011 as it continues to underperform compared to the stock market average. Much of this money has gone directly to paying exorbitant management fees (I did not mention above that the architect of this plan, Gina Raidondo, then treasury secretary, now governor, was a former executive of the financial managers enriching themselves on these enormous fees); the rest to poor management choices by the firm now in charge of the pension. Murtaza Hussain summarizes much of Sirota's recent investigation into this issue.

UPDATE (11/22/2014): Another Cato publication outlining strategy to use 401(k)'s and IRA's as a means to slowly undermine and eventually privatize Social Security.

*I'm expecting someone to object that Social Security's administrative costs are comparable. Social Security retirement funds (the OASI column), has a 0.5% administrative cost. That means that 99.5% of all Social Security retirement money spent in a year goes directly to beneficiaries (administrative costs for the disability program are a little higher--that's because it's expensive for the government to figure out how disabled you are; it's very easy to figure out how old you are). 0.5% sounds close to Wall Street's 1% or 2% fees, but Wall Street's 401(k) fees are taken compounded every year. Social Security administrative costs are calculated as a percentage of total expenditures. In other words, that 0.5% isn't taken out every year until you retire and are actually receiving benefits. That 0.5% is taken out only once, not every year like in a 401(k). For example, if you pay $100,000 in Social Security retirement taxes before you retire, a 0.5% administrative cost translates to a $500 "fee" on the $100,000 you paid into the program (0.5% of $100,000 is $500). In this case, 0.5% actually means 0.5%, unlike the examples above, which, because of compound interest, 2% actually means 60% and 1% actually means 28%.

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