Why 401k’s are Broken and My Secret to Fixing It

Welcome to the extra post as part of the Investing Crash Course — I wanted to throw in some bonus content! Today’s topic tackles the all-important topic: Why 401k’s Are Broken and My Secret to Fixing 401k’s.

If you haven’t read the first three posts, I highly recommend it as I poured countless hours refining the major takeaways on the journey to creating financial freedom in my life. The first post details the ONE shift we experienced when we went from 20% savings to 60% savings and it builds from there.

Should we place our hopes and trust into the 401k? Is the 401k sufficient to cover all my retirement needs? This post dives into why 401k’s are structurally broken and my “secret” to fixing it.

401k’s Are Broken – Cracks in the Foundation

For millions of Americans, 401k’s are the premier retirement vehicle – and this is a crisis for two reasons.

The first reason we have heard plenty of times: 401k’s are vastly underfunded and under-appreciated. More than TWO THIRDS of Americans DO NOT contribute a single dollar to their 401k’s (when given the option)!

Even for the one third who do participate, more than half are underfunding their retirement needs.

The second reason is 401k’s were NEVER designed to be what they represent today.

The original design of a 401k was to be used as a tool for corporations to shield taxable earnings. You can go more into detail here with a recent podcast interview we did on this subject and more:

When handed a tool that we will rely on for our future, it helps to understand what the tool was originally designed to do.

The overlying problem is that we have made 401k synonymous with retirement. When someone says, “Oh, preparing for retirement? I fund my 401k up to the match, so I’m good for now,” or, “I max out my retirement savings by topping off my 401k,” either of these phrases is cause for alarm.

We should utilize tax-efficient retirement accounts such as a 401k, but we should not let 401k’s be our only means to effective retirement planning or planning for our future.

Let’s run through some numbers and identify potential solutions to this 401k crisis.

My “Secret” to Fixing 401k’s

By investing the maximum amount of $18,000 every year for 40 years, and assuming a 5% return, the total value of your portfolio will rise to just over $2,000,000.

Two million might sound like enough today to retire, but in 40 years, 2,000,000 may appear much closer to $1,000,000 in purchasing power, due to inflation. With a “conservative,” 4% withdrawal rate, income from a 401k alone will not be sufficient.

Even with the 401k FULLY funded, we still fall short of our retirement planning.

These numbers represent our case and my suggestion to you is to take ten minutes to run the numbers on your current setup and then ask yourself:

Are you relying too heavily on your 401k?

Is it possible to fix 401k’s to do what people want them to do? Yes, I believe it is but the effort here (as mentioned in the interview above) is best directed towards lobbying for a federal change… AKA much, much more difficult than the personal solution I proposed above!


17 comments… add one
  • Ryan @ Just Another Dollar Jun 20, 2017, 5:27 am

    Very informative post! Alyssa and I fund Roth 401k’s to our employer match, which should give us a decent mix of taxable and tax-free money in retirement. Our plan once we pay off debt is to invest in income producing real estate in addition to our stock market retirement savings. Neither of us plans to work anywhere near 40 years before retirement, so the traditional 401k has never been very appealing to us.

  • Mrs. Adventure Rich Jun 20, 2017, 5:55 am

    Very interesting! I agree, even though we currently max out my 401K, it will (hopefully!) not be the only stream of income we rely on in retirement. Great additions to you Investing Series!

  • Mrs. Adventure Rich Jun 20, 2017, 5:58 am

    *great addition to your Investing Series

    …apparently I cannot type before 7am.

  • Debbi Jun 20, 2017, 6:44 am

    Nicely done. We have always maxed out our 401’s (employer contributions, tax sheltering current income – what is not to like) but used that as one piece of savings based on the number we believe we will need for an ample retirement. It had not really occurred to me that not everyone starts with the amount they will need to have invested and works backwards from there when they think about retirement, assuming they actually think about retirement. I did realize that many people do not save or think about retirement at all but was assuming that people who did think about it realized what seems obvious to me; start with the end goal. Your post made me realize how much need there is for greater financial literacy is really out there!

  • Matt @ Optimize Your Life Jun 20, 2017, 8:33 am

    Great point. I do tax prep for folks in a wealthy neighborhood during tax season, and the number of people who thought they were “maxing” their 401k because they were getting the match was frightening. We really are at a point where people think that they will be fine in retirement if they are contributing to a 401k, and it is going to cause serious problems down the road.

  • Mrs. Picky Pincher Jun 20, 2017, 8:46 am

    IIIIIInteresting. I didn’t know much about the advent of 401ks, but now I’m interested in delving into this a little bit more. Damned corporations lol.

    • Ryan @ Just Another Dollar Jun 20, 2017, 11:42 am

      Slippery slope digging into all of the ways corporations have influenced policy.. We watched the documentary “Merchants of Doubt” the other day on a recommendation and it sort of blew our minds.

      Like that quote from Zoolander. “Keep pulling the sweater. Eventually the thing will unravel.”

  • Financial Coach Brad Jun 20, 2017, 11:55 am

    Your assumption is a single working person, right? Based on my math two working married people would amass over $4 million in their 401k by retirement. You’re getting a lot closer to a comfortable retirement there.

    Also, just my opinion, but 5% is super-conservative. Even 7% is conservative based on historical performance (no guarantee of future results of course). I’d either use 7% for “today’s dollars” or 5% for “real dollars”. In either of those scenarios retiring on a 401k savings seems much more reasonable.

  • Counting Quarters Jun 22, 2017, 9:17 pm

    While having a 401k is better than no 401k I completely agree that there are much better options out there. Im currently working towards maxing my roth and upping my index funds. While also playing a little bit with mad money.

    One does have to wonder that there are many people out there who would not invest on their own if they did not have a 401k.

  • David @ Zero Day Finance Jun 23, 2017, 12:36 pm

    Why do you use 5% in your calculation for 401(k) growth? The S&P 500 index has averaged 6-7% return per year after inflation, not 5% before inflation.

    In addition, if someone retires with the equivalent of a $1 million nest egg, they almost certainly have a SS benefit near $20,000. Withdrawing 4% ($40,000 per year) plus $20,000 in SS is higher than the average household income in America, which should give the majority of people a very relaxing retirement.

    • Distilled Dollar Jun 23, 2017, 12:57 pm

      5% was a conservative number – you could run the scenario with 6 or 7% and you’ll still fall short of a comfortable retirement. $1,000,000 today + SS today might be enough at 4% – agreed, but I’m not sure $1,000,000 + SS in 40 years will be enough- the $1,000,000 alone will have lost much of its purchasing power due to inflation.

      I agree with your overall point that 401K + other retirement sources should be included as part of “retirement” planning. I just don’t want people to think 401k alone is more than enough.

      • David @ Zero Day Finance Jun 23, 2017, 4:40 pm

        The thing is 6-7% is the return after inflation. So if you want to be conservative, you could use your 5%. But that 5% is after inflation. 5% after inflation means you don’t need to worry about dollars now vs. dollars then.

        With a 5% return after inflation, compounded annually for 40 years, you end up with $2.174 million. But that number is in today’s dollars because the 5% is a conservative estimate of your post inflation investment gain.

        With $2.174 million in today’s dollars, you should be able to generate $87,000 using the 4% rule. Plus social security and you’re over $100,000. The problem is the majority of people can’t even come close to maxing out their 401(k). They’re lucky if they can do $50 a week.

        • Distilled Dollar Jun 23, 2017, 6:55 pm

          Ah I may have mixed up the math from your earlier comment and my post. I agree I could easily use a higher return and still label it “conservative,” but I guess I may be factoring in for a little extra room- like the 10,000 lb truck crossing the 30,000 lb bridge – so to speak.

  • Dave @ Married with Money Jul 11, 2017, 9:31 pm

    I’m curious what your thoughts are on this: I’d wager that many people (most? idk) who go through the trouble maxing their 401(k) are also interested in saving for retirement through other means such as IRA’s, real estate, other taxable accounts, etc.

    Wouldn’t you agree that it’s not inherently an issue with 401(k)’s but rather the approach to retirement a bit more holistically?

    Sure, 401(k)’s may over-simplify the process to a degree in which it does retirement planning a disservice, but I would argue that as a component of one’s retirement planning it is an excellent vehicle through which you can take advantage of tax laws for your benefit.

    I don’t think 401(k)’s are broken. I think our understanding of math and our psychology of saving and spending is the part that’s broken. 401(k)’s are just a scapegoat in this conversation.

    • Distilled Dollar Jul 11, 2017, 9:39 pm

      I agree with much of your premise but we seem to disagree here: I do believe it is inherently an issue with 401(k)’s because of financial literacy.

      I don’t disagree on it being an excellent vehicle to which we can save taxes. I myself optimize my 401k and recommend others to do so.

      The point of the article is that 401k’s are broken because for many they equate 401k=retirement. This is a flaw, and I’m not sure who to blame, but I think its worth pointing out that we need to do more than just the 401k. This gets back into where we both agree again.

      • Dave @ Married with Money Jul 16, 2017, 1:42 pm

        ” for many they equate 401k=retirement”

        Yep definitely true. I was lucky in that when I was young (as soon as I had my first job) my dad started educating me about Roth IRA’s. That’s better than most people get, but I still didn’t REALLY get how big of an impact it had until years later.

        For most, the 401k just is not adequate, especially when you consider how few actually max theirs out…even for those that do, it may not be enough.

        I think 401k’s perhaps falsely simplify the perception of what’s needed to retire. By the time most people realize that putting 5% or 10% of their income toward retirement isn’t going to cut it, it’s frequently too late. Many of us have wised up and can aggressively save, but not everybody’s in the same boat.

        The more the financial community can educate others on money in general, I think the better off we’ll all be.

        • Distilled Dollar Jul 16, 2017, 1:45 pm

          Excellent point on how too many see the issue too late, especially surrounding the 5-10% number/myth.

          Thanks for the follow up!

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