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Why 401(k)s and Mutual Funds Are the Path to Retirement Disaster

Ask yourself honestly, “Are you an investor or a gambler?”

Many people who have a 401(k) plan consider themselves to be investing for retirement. Yet, they often have no idea what they are investing in, have no idea how those “investments” are performing, and don’t understand the ramifications of what living off a 401(k) for retirement will be.

My question is, if you don’t know what you’re investing in and you don’t really know how your investment is performing, how can you really consider yourself an investor? And even more, how can you know if you are secure for retirement?

The short answer is: you can’t and you don’t.

The 401k was built for non-investors

"We weren't social visionaries."

Those are the words of Herbert Whitehouse, a former human resources executive at Johnson & Johnson who was one of the first to usher in the 401(k).

"It was oversold."

Those are the words of Gerald Facciani, the former head of the American Society of Pension Actuaries. He helped defeat an effort by the Reagan administration to kill the 401(k) in 1986.

The misgivings of the early proponents of the 401(k) are chronicled in the 2017 bombshell article from the "Wall Street Journal", "The Champions of the 401(k) Lament the Revolution They Started."

According to the article:

Many early backers of the 401(k) now say they have regrets about how their creation turned out despite its emergence as the dominant way most Americans save. Some say it wasn't designed to be a primary retirement tool and acknowledge they used forecasts that were too optimistic to sell the plan in its early days.

Others say the proliferation of 401(k) plans has exposed workers to big drops in the stock market and high fees from Wall Street money managers while making it easier for companies to shed guaranteed retiree payouts.

As they say, hindsight is 20/20. And it's now clear that the 401(k) has helped usher in a retirement crisis in America. As the WSJ reports, "Fifty-two percent of U.S. households are at risk of running low on money during retirement, based on projections of assets, home prices, debt levels and Social Security income," and "Roughly 45% of all households currently have zero saved for retirement…"

Still, there are defenders of the plan. If only people would actually save money at a healthy rate in the 401(k), it would provide all that was needed for retirement. A healthy rate was considered 3% of your income with an assumed 7% annual increase.

Vanguard doesn’t buy into 7% annual increases…and neither should you

There are two problems with the 7% annual-increase pseudo-wisdom.

1. Past performance doesn’t predict future performance

2. If you look at the historical data, you can see that averages lie. The market has wild ups and downs that average to 7% gain. For instance, from 1965 to 1983, there was very little growth. In the 1950s, 80s, and 90s, there was double-digit growth, and in the 2000’s there was negative growth. Depending on where you are in the cycles, you could get bit hard by the market when it comes to retirement.

And we’re possibly in one of those cooling off periods. As CNBC reported in 2018, Vanguard predicted that over the next ten years, the market will return less than 3% on average when adjusted for inflation:

The economists at investing giant Vanguard predict that, over the next 10 years, annual U.S. stock market returns will likely average between 3 percent and 5 percent. When you factor in inflation—which, luckily, Vanguard predicts will be below 2 percent—the real rate of return is expected to be under 3 percent.

This was, of course, before a global pandemic, record inflation, and global tensions as Russia invades Ukraine.

Personally, I think we may see more than just a cooling. We might see a large crash like in 2000 and 2008— and so does my advisor, Andy Tanner.

Investing in a 401k means investing in inflated assets

In the world of stocks, many investors keep an eye on the Shiller PE index, a price earnings ratio based on average inflation-adjusted earnings from the previous 10 years. The median Shiller PE Ratio has historically been around 16 - 17. It’s a good barometer of what value we should be targeting. Again, a PE of 16 means that it costs us about $16 for every $1 of earnings we receive from that stock.

Looking back in time, we can see that there have only been a few times that the PE Ratio for the S&P 500 has been above this level. Before the crash of 1929, prices almost doubled and people were paying up to $30 for every dollar of earnings from the S&P 500. And during the dot-com boom people were paying hundreds of dollars for companies that had zero earnings.

When the price of stocks gets really high, we’re forced to answer these questions: Are these high-priced companies cranking out enough dollar bills to still be valuable investments to buy? Are the profits worth the expensive price tag? The moment investors see that the PE ratios are too high, they will only continue to buy if they see growth. And if the outlook for growth becomes pessimistic, selling can ensue.

Of course, this doesn’t mean that the market is going to crash immediately. But as we look back historically, there have only been a couple of times in the past I mentioned before when investors have been willing to pay this much for stocks. As the dot-com bubble showed, when investors were paying $44 for $1 of earnings, they eventually said it wasn’t worth it anymore. That’s when the big crash occurred.

Andy wrote that analysis back in 2018, and since then things have only gotten worse in terms of the PE index. In 2021, the 37.41. What drove that valuation? It wasn’t profits. As Shawn Tully writes for “Fortune,” “ The new era of Fed-engineered, super-low ‘real’ interest rates justifies multiples far above their former norms.”

In other words, cheap capital is driving high P/E valuations. And guess what, the era of cheap capital is going to come to a close sooner than later.

At this writing (March 7, 2022) the S&P 500 PE ratio is 34.38. One wonders how much higher it will go before investors decide to pull out into “safer” investments. When that happens, the poor suckers who blindly put their money into a 401(k) plan, will be left footing the metaphorical bill.

Today, we have a large portion of Americans with next-to-no retirement savings and an even larger portion in 401(k)s stuffed with mutual funds that could all go down together with another stock market crash like the one in 2000 and 2008. That is what you call the recipe for a retirement crisis.

The 401k ushered in an American retirement crisis

Why is this so important? Because America is facing a retirement crisis of epic proportions. A 2018 article from CNBC entitled “Americans are more stressed about money than work or relationships—here’s why,” details the precarious state of most Americans financially.

…Americans are behind on prepping for retirement. Over 20 percent have nothing at all saved for the future, and another 10 percent have less than $5,000 socked away, Northwestern Mutual found. The cost of health care continues to rise faster than incomes as well: Annual costs came out to more than $10,000 per person in 2016.

Of all Americans who have savings for retirement, most are invested in 401(k) plans stuffed with mutual funds, which are exposed to systemic risks, e.g., if the market falls they fall.

In my book, “Who Stole My Pension?: How You Can Stop the Looting”, my co-author Edward Siedle, a former attorney with the United States Securities and Exchange Commission and is America’s leading expert in pension looting, writes about the precariousness of the shifting of retirement burden from employers (pension plans) to employees (401(k) plans).

Shifting responsibility for retirement planning onto workers has been disastrous for workers but great for corporate bottom lines.

The 401(k) defined contribution plans which employers and Wall Street sold to workers as providing comparable retirement benefits to pensions have failed dismally. With median 401(k) balances for 65-year-olds at $70,000 or less, it’s no secret that the great 401(k) “experiment” has failed in the United States. And, as deeply flawed as they are, approximately a third of America’s workers do not have any employer-sponsored retirement plans at all.

According to a 2018 study by Northwestern Mutual, 21% of Americans have no retirement savings and an additional 10% have less than $5,000 in savings. A third of Baby Boomers currently in, or approaching, retirement age have between nothing and $25,000 set aside.

The Economic Policy Institute paints an even bleaker picture. Their data from 2013 reports that, “nearly half of families have no retirement account savings at all.”

The failure of 401(k) innovation was foreseen decades ago by experts—including me—and was avoidable had legislators and regulators acted in the best interest of investors and had the financial services industry curbed its greed.

Edward goes on to conclude: “The solution to the retirement crisis, I assure you, is not costly 401(k)-type defined contribution plans that put all of the responsibility for selection of investments onto individuals.”

Yet, that is exactly the reality most Americans live with today. And their blind faith both in 401(k) plans and the continued rise of the stock market could be their downfall come retirement.

401(k) plans are a tax hit

Finally, while many people think they are playing it safe by investing for retirement in 401(k) plans, perhaps maybe worse than lower than expected returns is that you’re setting yourself up for the possibility of being taxed at the highest rate—currently at 37%.

In the face of this, many financial advisors say the key is to diversify. But the problem is that for them diversification usually just means investing in a variety of post-tax paper asset vehicles such as mutual funds, which may provide diversification of different stocks but aren't really diversified.

The problem is that many think that by investing in mutual funds that they are diversifying, but they are not. As Rich Dad Advisor Andy Tanner shared a while back, “Diversification is stupid,” and it doesn’t work.

And diversification without knowledge of how or why you’re diversifying is really stupid.

So, what’s the answer?

Digging deep to avoid retirement crisis

Rather than “diversify” in paper assets, you must increase your financial knowledge through financial education. Pick an asset class you’re interested in—real estate, business, commodities, paper assets—and dig deep. Learn all you can and play the game of real investing, not just gambling on your 401(k) plan.

For many, this means getting more educated on paper assets, as they are the easiest to get into, more liquid, and can be done in your spare time (to begin with).

Personally, I prefer real estate, business, and commodities, but if you want to know more about the technical side of paper assets, look no further than Andy. He’s the expert I turn to when I’m investing in stocks, and he’s the expert you should turn to as well.

Additionally, as you learn more about each asset class, I invite you to consider a Rich Dad coach, where you can build your financial knowledge and become an expert in whatever asset class you choose.

With the world stock markets taking the average investor for a whiplash roller coaster ride, now is an excellent time to change the way you approach your retirement. It will be the smartest investment decision you’ve made all year.