Smart, informed choices key to 401(k) success

This article was produced by the Financial Planning Association and provided by William O. Woody of Stovall Woody Associates.

The decline of the stock market over the last 2 1/2 years and the devastating bankruptcies of such companies as Enron and WorldCom have prompted critics to call 401(k) plans a failure.

Some have even called the 2-decade-old concept a scam and say employers need to return to the traditional pension plan to ensure that workers will have enough funds for retirement. The 401(k) supporters counter that the problem is not with the plan itself, but the way participants use it.

Whatever the pros and cons of the debate, 401(k) plans are here to stay, and plan participants can do more to make their 401(k) an effective way to build a comfortable nest egg. The following are some of the criticisms of 401(k)s and what participants can do to minimize potential drawbacks.

Participation

Critics contend that all eligible workers benefit from a traditional pension plan, whereas 401(k) participation is voluntary. According to the Profit-Sharing/401(k) Council of America, roughly 75 percent to 80 percent of eligible workers participate in 401(k) plans, with participation rates even lower among younger workers and low-income workers.

Proponents note that more companies are providing automatic enrollments in 401(k) plans, which requires workers to opt out of participation. In these plans, participation rates are around 95 percent, according to the benefits consulting firm of Hewitt Associates.

Proponents also point out that if it weren't for 401(k) plans, many workers wouldn't have any type of retirement plan because 90 percent of 401(k) plans are offered by small companies who typically wouldn't offer a traditional benefit plan.

Contribute as much as possible

The average 401(k) participant contributes less than 7 percent of pretax salary, according to the Employee Benefit Research Institute. Financial advisors recommend contributing at least 10 percent.

Investment decisions

In a traditional pension plan, the company makes the investment decisions. In a 401(k) plan, all workers must be their own investment manager a task many are not up to. Workers typically don't diversify well, either loading up on company stock or investing too much in lower-returning fixed-income options. Proponents concede that the average 401(k) plan offers too few investment options for workers, but workers compound the limited choice by choosing only two to three funds, and often similar or overlapping funds at that. Fortunately, workers can seek professional independent investment advice to help them make smart investment choices.

Market fluctuations

A traditional pension plan promises that you will receive your pension payments at retirement, typically based on your highest salary and years of service, regardless of the ups and downs of the market and the economy. If the company's plan can't meet its obligations, the federal government will step in, though higher-paid workers may not receive all the benefits they are entitled to. There are no guaranteed payments with 401(k) plans.

Proponents argue that workers can better protect themselves against market volatility through greater savings and long-term diversification, instead of trying to hit a home run as many workers attempted in the l990s.

Proponents also point out that pension payouts during retirement typically are not adjusted for inflation your pension will lose purchasing power over time. A well-invested 401(k) can keep up with inflation.

Cashing out 401(k) plans

Another criticism of 401(k) plans is that when workers change jobs which they do every four to five years on average many cash out what they've saved. This is particularly true among younger workers. The money not only can no longer grow tax-deferred, but the withdrawal faces income taxes and usually a 10 percent penalty.

Proponents agree that workers need to roll over their accounts into an individual retirement account or another employer's retirement plan. But they also point out that this portability of 401(k) plans is one of the pluses.

The payout from a pension plan can be excellent if you stay at the same company for 30 years, but who does that anymore?

Traditional pension plans and 401(k)s each will continue to have their pros and cons. The important point is that workers must better educate themselves about their plan options so they can make smart choices, whichever type of plan they use.