As I See It: The Salary Reduction Plan

Published: October 26, 2009

by Victor Rozek

Jobless recoveries, working retirees, and President Obama getting the Nobel Peace Prize. We live in a land of contradictions. For fans of the oxymoron, it's a target rich environment. Leaders who don't lead, lenders that don't lend, and health care so expensive it makes you sick. We're heading toward Halloween and there's plenty of things out there to scare us. Haunted houses worth less than their mortgage, skeletal 401(k)s, and a vampire financial system designed to suck every last dollar from your wallet. Oh, and by the way, the ghouls who helped orchestrate the Great Recession are now running the Treasury Department.

That can't be encouraging for the 73 million Americans stuck with shrinking 401(k)s. They've already been plundered and now it looks as if plunder will be backed by the full faith and endless credit of the United States government. In the words of reformed investment banker, Nomi Prins, "It takes a pillage."

But the vulnerability of retirement savings has been problematic since 401(k)s were introduced some 30 years ago. Although they are now widely used as pension substitutes that was not their original purpose. The entire premise, in fact, was based on deception. Before they were drably named after a segment of the tax code, 401(k)s were called "salary reduction plans" and were designed as slight-of-hand perks for overpaid executives. Management compensation had become so inflated that stock holders began complaining. What to do? Companies scrutinized the tax code and discovered they could withhold a chunk of an executive's base compensation, call it something else, and stick it in an account that was tax exempt where it would sit, hopefully unnoticed, until retirement. Corporations could claim their executives were being paid less, while their managers actually pocketed more, albeit after retirement. A win-win for boards of directors and their executives, not so much for the stockholders.

Back then, 401(k)s were not even available to the rank and file, and would never have been had greed not played its familiar part. At the time, there was a womb-to-tomb ethic that many large corporations shared. Employees who put in their time (usually 30 years), were guaranteed a pension for life. And the inflationary 1970s were good for pension funds. Huge amounts of money were being sequestered to support current and future retirees. But, like a bulging bag of Halloween candy, the temptation proved overwhelming. Whenever CEOs looked for cheap money, they invariably glanced longingly at retirement accounts that did not belong to them.

The law was clear, however. Pension funds did not come with debit cards and the money was off limits. But there was a work-around. The company could gain control of the money if they cancelled one fund and started another. It was a simple matter to claim that they had a better plan, shut down the existing fund, skim off hundreds of millions, then reconstitute the fund as a 401(k). (The name was no doubt hastily changed because it was hard to sell a "salary reduction plan" to workers barely making ends meet.) In keeping with the season, think of it as financial Trick or Treat. And the workers just got tricked.

Initially it appeared that 401(k)s offered some advantage. They were tax free until withdrawn, moved with the holder from job to job, were under control of the individual investor, and provided a relatively painless means of saving. However, unlike pensions they were not guaranteed and were vulnerable to the fluctuations of the stock market. When the market was down, as it has been four of the last nine years, investors took a beating.

According to Stephen Gandel, writing for Time, there is a fundamental flaw in the way 401(k) accounts are structured that makes them "most dangerous for those closest to retirement." For a younger worker, a 401(k) grows primarily through contributions. But the longer you hold it, "the more market-exposed it becomes." As a result, during the last meltdown, "the 401(k)s of 55-to-65-year-olds lost a quarter more than those of their 35-to-45-year-old colleagues."

But younger workers lost as well. In the decade ending in 2008, the average 401(k), when adjusted for inflation, lost nearly 27 percent of its value. Gandel concludes, "The ugly truth. . . . is that the 401(k) is a lousy idea, a financial flop, a rotten repository for our retirement reserves."

Defenders of the 401(k) claim that they haven't been around long enough to create the wealth necessary to support retirees. So Gandel looked at workers from a company that was among the first to adopt 401(k)s and whose workers put in a full 30 years or more of contributions. He found that employees forced to migrate to 401(k)s have done much worse than they would have under pension plans.

A 68-year-old retiree, with 36 years of service, gets a whopping $8,000 annual income from his 401(k), but would have received nearly twice that much from his scuttled pension plan. He spends his days on the golf course, but he isn't playing; he's repairing golf carts. Another retiree saw his 401(k) shrink by $200,000, and his annual income reduced to $21,000 from the $37,200 he would have received from his pension. He sells real estate to make ends meet, and if pictures speak louder than words, he doesn't look happy about it.

But whatever the income, the biggest shortcoming of 401(k)s is that they will eventually run out. And as people live longer, that prospect is terrifying. "Forty-four percent of all Americans are in danger of going broke in their post-work years," says Gandel, not a pleasant prospect for a nation without an adequate safety net. But even as the market has proven to be an unsafe repository of the nation's retirement funds, there were those in Congress anxious to toss Social Security into the jaws of the market, where it would no doubt have been invested in rock-solid securities like sub-prime mortgages.

Gandel's solution is insurance--spreading the risk by insuring retirement savings. The problem with that solution is that private insurance companies are all part of the same crooked financial cabal. Who hasn't felt cheated by insurance providers? As workers got older, retirement premiums would no doubt skyrocket, and any claims would be fought tooth and claw. Probably the only affordable retirement insurance would have a $100,000 deductible. Then they'd pay 80 percent up to some amount unless your claim was filed on a Tuesday, or any month with a vowel in it. Then you'd get zilch.

A saner approach would have the government "divert 5 percent of everyone's wages," for which, after retirement, they would receive "a check for 26 percent of [their] final salary. . . until [they] died." Better, but that still substitutes forced savings for pensions. When the Social Security system was originally set up, personal savings were never meant to replace pensions. They were part of a three-pronged strategy that included savings (such as 401(k)s), pensions, and Social Security. Singly, none of them could replace a salary, but in combination they provided a comfortable and secure retirement.

They also provided a system of checks and balances. If your savings were low, you still had a pension and Social Security to fall back on. If you job-hopped in order to crank up your salary and therefore limited the amount of your pension, you probably had more savings or at least more assets. Just as the constitutional system of checks and balances was designed to protect us against making bad choices, so was the three-pronged retirement approach.

But integrity was the first casualty of deregulation. If I were starting over again, I would not trust my future to people I've never met, investing in companies which may or may not be falsifying their financial statements. A much better alternative, if you're thinking long-term, is to invest in rental housing, or a small apartment unit, that can provide income for life. And what better time than now to pick up inexpensive property? Pay it off in 20 years and you have asset which you can rent, or live in rent/mortgage free, or sell. It's tangible. You can see it, touch it. When the next Bernie Madoff perp-walks off to jail, you'll still be able to see it and touch it. When others discover the stock they bought is just worthless paper, you'll still have a tangible, physical, able-to-drive-by-and-admire-it, real, honest-to-goodness asset.

Some will point to the housing bubble and say, "What are you thinking?" But, remember, there was nothing wrong with the houses--the loans were crooked and ill-advised. So when others lose 40 percent of their investments in a market manipulation scheme, your house may temporarily be worth less, but you will still have a whole house, not 60 percent of a house.

That's how the parents of Boomers made their money. They weren't financial geniuses; they simply bought their first home for $15,000 and while they were busy working, that modest tract home inflated in value to $220,000. Then it was refinance, baby, and an entire generation was movin' on up.

The average 401(k) today is worth a little over $45,000. That's a cheap Lexus or a short hospital stay. If that's your retirement strategy, you may want to consider the Ben Franklin plan. Old Ben, the original American party animal, once observed that "in wine there is wisdom, in beer there is freedom, in water there is bacteria."

While the money lasts, keep drinking.

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