The 401k Fallacy

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Here’s an interesting retirement case study for you.

Let’s take a former active duty veteran who resigns after 7 years of service and  enters the civilian workforce in the year 2000.  This purely hypothetical employee in turn contributes to a Defined Contribution plan (401k or TSP)  during his years as a working stiff.  He or she contributes to the maximum ‘match’ amount of the employer’s plan-  That is, when the employer matches up to 50% of contributions on up to 10% of salary, he contributes 10%.  When he is a Federal Employee, he contributes 5% to get the most of the TSP automatic and matching contributions (5% of salary).  (Stop me if you’ve figured out who the hypothetical employee is by now).

So in other words, this hypothetical employee follows the nearly unanimous advice of financial academics and pundits, contributes to his maximum 401k match amounts, and what does he get for a return for the total contributions (employee plus matching) over 19 years?

3.48 percent:

(You can view/critique the IRR Calculation spreadsheet here)

So what’s to takeaway?

1. That 6-8% ‘historical’ market return is not guaranteed.

Go look at Vanguard Total Stock or Total Bond Market returns over the same time period and you will see the same rate of return result of about 3.5 percent.  ‘Past performance does not indicate future results’ is what you read at the front of every Prospectus for an investment.  In your case, academic studies or backwards-looking returns can be misleading.  Especially studies that indicate you can safely withdraw 4% of your initial portfolio value every year (and increase that withdrawal every year with inflation) over 30 years of retirement.

2. The calendar year you enter the workforce  influences your retirement outlook as much- or more so-  than  historical rates of return.

Most academic studies indicate you can plan for 6-8 percent annual return for stock indexes and 3-5 percent per year for bond markets over long time horizons.  But in our hypothetical case of the years 2000 to 2019, both the stock and bond markets eked out about 3.5 percent.

…”but Gubmints”, You say, “You cherry-picked this time frame, and there were 3 ‘Black Swan’ events over this period:

• The Tech Bubble burst (2000)
• 9/11 (2001)
• The Financial Crisis/Great Recession (2008-2009)

… the likelihood of another Black Swan event like these taking place is low, like off-the-charts low.”

“Ok”, says Gubmints.  “Yeah, I cherry-picked the time frame because it is a real-world example.  And oh, by the way, ever heard of a little thing called COVID-19?  I haven’t even listed that crash in the Calculations shared above since the ramifications are still underway.”

The takeaway is this.  You can’t influence the year in which you were born, which in turn influences the year you enter the workforce, which in turn influences the year in which you will retire.  All you can control along the way are your career moves, investment choices, and amounts you save.   If you bank on 100-year average historical stock and bond rates of return for your planning, your plan may be set up to fail.

3. You may need other sources of income to make it in Retirement

For most working stiffs, there are three legs supporting the ‘retirement stool’

• Defined Contribution Plans (401k or TSP or 403b)
• Social Security (Applies to most of the workforce).
• Pensions/Private Annuites/FERS Annuity.

Pensions/Annuities are a great backstop to have.

The private sector pension has become a dinosaur, but private sector employees may have an annuity option within their 401k, or they always have the option to make their own pension using a Single Payment Immediate Annuity if they need certainty of annual payments.

Feds have the FERS Annuity, and Military Retirees have their Active Duty Pension.   Don’t discount the value of these backstops that Uncle Sugar has made available to you.   For yet another layer of income safety, Feds and Veterans have the TSP Annuity available to them at retirement. (For any annuity decisions, get an independent evaluation from a fee-only financial planner who will act as a Fiduciary on your behalf).

4. Military Retirees:  Beware the BRS Lump Sum Offer at Retirement

Many military retirees are now offered the option to swap their pension payments for a Lump Sum at retirement.  Private sector employees may be offered to convert their 401k balance to an Annuity. Federal Employees have the option to convert some or all of their TSP to a TSP Annuity at retirement.

And finally, military retirees under BRS have the option to swap up to 50% of their future pension payments for a Lump Sum when they retire with 20 or more years of service.

…but here’s the thing.  I just showed you that during 2000-2019, the markets returned about 3.5 percent.  If you retire from Active duty under BRS in 2020, the Lump Sum Discount Rate offered to you is 6.75 percent.

Hey that sounds like a great deal!   6.75 percent is almost DOUBLE the 3.5 percent the stock and bond markets provided during the last 19 years.  6.75% sounds pretty good- I should take that deal, right?

PROBABLY NOT.

The Discount rate means Uncle Sugar is providing you an up-front, lump sum equivalent of future payments  DISCOUNTED by 6.75 percent.  In other words, they are making the assumption that the one time payment they are giving you today is the equivalent of an inflation-adjusted monthly payment from now to age 67 – If YOU you can earn a GUARANTEED return of 6.75% each and every one of those years investing on your own.

I’ve just shown you that the Markets averaged about 3.5% over the last 19 years.   If you cash in your Active Duty Pension for a Lump Sum discounted at 6.75%, you are making a one-time bet  that you will earn  6.75% from your Active Duty Retirement date to age 67.  Not a bet I would take.

Here’s an example for illustration.

A Navy Chief (E-7) retires at age 38 and has the BRS offer to swap a lump sum (at a 6.75% discount rate) for half of his future  monthly payments all the way to age 67.  If the Chief accepts the Lump Sum, he has just placed a bet that he will earn 6.75% or better every year from age 38 to age 67 (29 years).  Again, I’ve just shown you that the market rate of return was 3.5% for the last 19 years… should the Chief take this bet with any amount of his retirement money?  

Ok, What’s the point, Gubmints?  Are you telling me not to participate in the TSP/401k?

No, but keep these points in mind:

1. It’s possible that most of the buildup in your 401k and TSP over the years will be driven by employer matches and not market returns.  In our ‘hypothetical’ employee’s case from 2000-2019, the Market returned about 3.5% and the rate of return on the employee’s contributions counting the 401k employer matches as a ‘return’ was about 9.5%.

There might be better places to put your money other than the 401k/TSP.  By all means, take all the match that your employer offers and don’t leave ‘free money’ on the table.  But once you’ve maxed out the match, there may be better places to put your money – Like paying off any debts you carry that have rates above 3.5% (this can even include mortgage debt).

2. A Defined Contribution Plan like the 401k/TSP is a useful retirement tool, but it is not the only tool in the toolbox.   Think of the 401k/TSP as a wrench that you can move forwards or backwards using as much or as little pressure as you need. The 401k provides flexible savings and withdrawal options, market diversification, tax-deferral, and (most overlooked) protection from lawsuits and creditors. I’m not telling you to liquidate your 401k in exchange for gold IRA or a vacant lot, but recognize that the 401k/TSP does not represent the entire retirement toolbox- it is just one of many  tools available.

3. Don’t ‘discount’ the value of a pension provided by Uncle Sugar.  The payment rises with inflation each year and the value is guaranteed by the Federal Government- who can print as much money as it needs as insurance.   When you have a federal government-sponsored pension, this acts as the solid foundation for your annual income in retirement.  Using the toolbox analogy, think of guaranteed pensions like FERS Annuity, Military Pensions, and TSP Annuity as the ‘workbench’ platform that supports all the other tools in your retirement toolbox.

4. If you don’t have or are not eligible for a Federal Pension there are other pension-like options.  You can ‘roll your own’ pension by purchasing a Single Payment Immediate Annuity or your employer’s 401k provider may offer an annuity payment option in retirement.