If you are in your 20s or 30s, I have a tip for you: Learn about IRA accounts. They are the retirement vehicles for your future.
Few have figured this out. Individual Retirement Accounts get little attention because our personal and media focus is on 401(k) and 403(b) accounts sponsored by employers. Worse, IRA accounts have much lower contribution limits. This year, the maximum contribution to an IRA account is $5,500 if you are under age 50, $6,500 if you are over age 50. The maximum contribution to a 401(k) or 403(b) plan is $17,500. This doesn’t count any matching funds contributed by your employer.
But here’s the reality: If you’re young, the high limits of defined-contribution plans are probably irrelevant. Odds are you can’t save $5,500 a year, let alone $17,500. So you won’t be hitting the contribution limit if you focus on IRAs. An IRA also gives you something an employer can’t: complete freedom in choosing where you establish your account and how you invest it.
Another reason to focus on Individual Retirement Accounts: They aren’t part of the ongoing disappointment (or failure) of employer-sponsored retirement plans. Here’s a thumbnail history of the last 70 years:
The first generation of employer-sponsored retirement plans was defined-benefit pensions. These plans grew during World War II as employers took responsibility for saving enough money — and getting a high-enough return on that money — to guarantee a lifetime monthly income. Employees didn’t have to lift a finger.
Unfortunately, errant employers failed to fund the plans adequately. Some unions misused the money. Worse, as job changing increased, fewer and fewer workers had the long years of pension participation necessary for a good retirement income. Basically, defined-benefit pensions were a good idea for a workplace world that no longer existed.
Problems with a few plans became an all-out crisis after the stock market crash of 1973-74 crushed plan assets. Since then, pension plans have been closed every year as employers tried to get out from under the high and uncertain cost of funding them.
The pension crisis led to the defined-contribution alternative — plans where the employee has the responsibility for saving and making investment decisions. The biggest problem with these plans is their expense and low level of employee contribution. Basically, workers contributed too little and earned too small an after-expense return. Today, most workers approaching retirement are retiring to a very reduced income.
Are 401(k) and 403(b) plans improving? Yes. Recent legislation forces full disclosure of fees and expenses. Fund costs are falling, even for small plans. But not fast enough.
Today, unless your employer offers a very low-cost plan combined with a substantial matching contribution, there is a good chance that you’ll do better on your own.
How can that be? Easy. While costs in 401(k) and 403(b) plans are coming down slowly, costs in highly competitive IRA plans have plummeted. Today, you can have an IRA account with costs that are a small fraction of the cost of many employer-provided plans.
Skeptical? I don’t blame you. But here’s an example. Suppose we have three 25-year-olds who save equal amounts that are invested in the same assets until they are 67 years old. The only difference is plan expenses. One has nominal expenses. Another has expenses of 1 percent a year. The third has expenses of 2 percent a year. How will their accumulations compare?
If we assume a monthly investment of $100 and a pre-expense return of 8 percent, the nominal-cost employee will accumulate $412,049; the 1 percent-expense employee will accumulate $304,371; and the 2 percent-expense employee will accumulate only $227,016. If the basic return is lower, the comparison will be still worse.
Viewed another way, the employee in the 1 percent-expense plan would have to contribute $135 a month to accumulate the same amount as the nominal-expense employee. The 2 percent-expense plan employee would have to contribute about $181 a month to accumulate the same amount as the nominal-expense employee.
Bottom line: A low-cost IRA beats any expensive plan without an employer contribution. An employer contribution has to be quite large to compensate for high costs.
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