Why Your Retirement Account Underperforms Most Pensions

There’s a retirement crisis brewing in America. We all know it is coming, but it is unclear what to do about it. In 2008, employees were complaining, “My 401(k) is now a 201(k).” Many unemployed baby boomers over 50 are having a hard time finding work, and if they do, they aren’t paid what they had been paid. But what does a retirement crisis mean to the individual investor?

Let’s look at three big trends that have created the “perfect storm.” First, in 1975, the stock market was in the middle of a 10-year period slump—much like today. The S&P 500 began the ’70s around 90, ended at 100, and bounced around between 65 and 120 throughout the decade. In those days, 27 million workers had corporate pension plans, and they were guaranteed a fixed amount at retirement. The corporations had to manage the pension funds properly to meet these obligations. But with a flat stock market, these obligations became greater than what pension plans could support. New accounting laws mandated that these “unfunded liabilities” be shown in public financial statements. Corporations had dramatic decreases in their values because of these pension obligations.

During this time, Congress also approved new laws that created the 401(k) and the IRA. These plans made the worker responsible for his own investing. Corporations effectively said, “Hey, employee—we’re not going to guarantee you a fixed pension each year, but we’ll guarantee you an amount we will contribute. You then have to manage your own money, and whatever you end up with is your problem!” But there was another problem. While employees were given responsibility, the securities laws didn’t protect them from the financial services industry. The financial advisers were not held to a high standard.

In 1975, about 72 percent of retirement funds were professionally managed by corporations. Today that has dropped to 23 percent, while the rest are managed by employees in 401(k) plans and IRAs. With less protection from advisers and brokers and less expertise, employees started paying more in fees with subpar advice.

Returns have suffered. Corporate pensions between 1998 and 2007 generated average returns in excess of 7 percent, while 401(k)s returned 5.4 percent, and IRAs only 4.5 percent. Over a working life, these differences can mean that two workers making the same contributions will end up with very different nest eggs. That 2 or 3 percent can mean that the corporate worker can end up with twice as much as a worker managing his own 401(k).

Second, baby boomers will increase the over-65-years-old population in the next 20 years from 35 million to 70 million. But that is only half of the story because this creates a double whammy. The baby boomers between the ages of 45 and 65 who are working today are paying Social Security and Medicare into the system through payroll deductions. When they retire, there will be fewer individuals collecting a paycheck that the government can tax. And baby boomers are going to live longer, so there will be more years that the government will have to take care of the aging.

The third trend, of course, is that the U.S. government is going into increasing amounts of debt, and cutting that debt is hardest when your population is aging. This means that the government will be forced to manipulate inflation rates, add a year or two to the retirement age, and reduce Medicare benefits.

Retirement investors must understand that a harsh new world is in front of us. You are responsible for managing your retirement. The sooner you prepare for the new realities, the better. Here are three ways to positively impact your nest egg at retirement:

Overall asset allocation. Add up your retirement accounts, 401(k)s, IRAs, and pensions for you and your spouse and look at them as one portfolio. Are the allocations right for you? If not, make some changes.

Orphan IRAs. Do you have multiple IRAs that came from 401(k) rollovers from past employers? Consider combining them so that the dollar amount becomes more meaningful. It helps focus attention. Brokers like Schwab and Fidelity like having more assets and they make it easy to combine IRAs. See if you can continue making yearly contributions. Even if they aren’t tax deductible, they will grow tax deferred.

Fees. Blindly choosing the recommended funds in a 401(k) plan without looking at the fees is a big mistake. Look for an index fund (usually the one with the lowest fee) in each category and you’ll never go wrong.