Retirement Options: Social Security, 401(k) Plans, and IRAs

Introduction and Statement of the Problem

Almost one-third of American workers are failing to prepare themselves for a comfortable retirement, according to a survey conducted by American Express. The national telephone survey of working adult men and women who had recently left or lost their jobs revealed that 30% did not invest for retirement in their company's 401(k) plan. The survey also revealed that 16% of participants rolled their money into an IRA, and the majority of those who did so said they would make the same decision again. Eleven percent of those surveyed reported cashing out of their retirement plan because they needed the money to pay off debt or cover everyday living expenses.

While these participants may have felt that their decisions were best for their situations, financial experts would have advised against them. Money invested in a 401(k) plan grows tax-deferred until withdrawn, which over time allows an investor to accumulate more savings for retirement. By law, individuals who withdraw a lump-sum distribution from their 401(k) before age 55 are assessed a 10% early withdrawal penalty, as well as federal and state income taxes. This means that early withdrawals cause serious harm to retirement funds. Nevertheless, a lack of knowledge and expertise causes many Americans to make poor choices regarding their retirement options.

Saving for retirement is a major challenge for millions of Americans today. With an abundance of retirement options—including tax-deferred retirement plans, 401(k)s, and IRAs—investors are often confused about which option will make the most of their savings dollars. This paper aims to provide a review of the fundamentals of these powerful retirement vehicles in order to give future retirees the information they need to start investing in their futures.

Saving enough money for retirement is one of the greatest financial challenges faced by individuals today. It requires careful planning, a commitment to regular investing, and an understanding of which retirement options are best suited to different needs.

According to experts, human beings are distinguished from other species by a unique ability to think ahead and plan for the future (The Motley Fool, 2003). While this is true, many people have a hard time thinking about the long-term future and adequately preparing for it. Many people are too busy living in the moment to realize that things have a way of changing quickly. In this regard, human beings share the immediacy found in many other species, which causes many to shrug off the tedious task of saving for retirement. However, understanding one's retirement options and planning ahead are keys to being ready for the future when it arrives. As The Motley Fool (2003) notes: "The younger you are, the more distant is retirement—and the more power you have at your fingertips in the form of compound returns over time. It's a paradox that you can work to your advantage."

David Braze, a specialist in retirement planning, suggests asking the following questions before evaluating retirement options (The Motley Fool, 2003):

How much will I need for my retirement in order to live comfortably? What are my goals? When should I start? What should I do? How much can I count on from Social Security? What costs might I run into once I've actually retired?

According to Braze, "These are the questions that we all need to ask; questions that we often wait too long to ask; questions that surface dimly on occasion, in a remote and dusty corner of the mind, a mind that is otherwise occupied with this minute's conversation, today's project, tonight's movie, and tomorrow's meeting" (The Motley Fool, 2003).

To understand which retirement options are best suited for various needs, it is important to first examine the major retirement plans available. Each of these options has positive and negative aspects, so investors must understand the advantages and drawbacks of all major retirement options in order to maximize their savings potential.

Government, employer, and individually sponsored retirement plans are all good ways to save for retirement. In today's society, relying solely on Social Security appears to be a poor choice, as these programs are not likely to provide the same income level in the next decade. However, there are so many complex retirement options that investors often do not know where to begin. For this reason, this paper examines major retirement options that can help investors plan an enjoyable retirement. This research study aims to describe three major retirement options—Social Security, 401(k) plans, and IRAs—analyzing how each can be advantageous or disadvantageous, and ultimately determining which option offers the best solution for retirement investment.

As all types of retirement options appear to have flaws and many investors lack the knowledge to determine which options are best for their individual needs, existing research suggests a strong need for a clear and concise report on retirement options. This research paper examines the history of retirement options, existing research on various vehicles, the behavior patterns of investors, and the flaws and benefits of each option in order to determine which choices are best for individuals today.

Most people dream of retiring while they are still young and healthy enough to enjoy the rewards of years of hard work (Starchild, 2002). However, these dreams usually require maintaining a standard of living at least as good as their current one. Fortunately, a variety of retirement options are available to help people meet their goals.

At age 65, the average man will live almost 19 more years, while the average woman will live another 22 years. The majority of the population will spend 25% to 30% of their lives in retirement, requiring substantial funds to maintain an enjoyable lifestyle. Social Security and pensions replace only 40% to 60% of the average retiree's pre-retirement income. A recent study indicates that individuals between the ages of 25 and 44 are saving only 34% of the amount needed to support their current lifestyle in retirement. The study suggests that individuals without a pension should have savings equal to approximately four to eight times their peak annual earnings, while those covered by a pension plan need approximately two and a half to six times their pre-retirement annual earnings. Only 57% of those eligible to contribute to 401(k)s do so, fewer than 15% of the 67 million workers eligible to contribute to a fully deductible IRA do so, and only 12% of the self-employed have retirement plans (Starchild, 2002).

According to Adam Starchild (2002), the word "retirement" carries many positive connotations. "Traditionally, retirement has signified a release from the drudgery of work. Retirement has always meant freedom and, with luck, an active, carefree leisure," he says. "It has meant rest, relaxation and the chance to pursue long-postponed dreams and ambitions." However, Starchild is quick to point out that there is another, less pleasant side of retirement, as it means giving up one's career. "Nobody likes to get benched and, on one level, retirement can seem just that. The idea of no longer enjoying a place in the workaday world can be downright disturbing," he adds. "In a society as geared towards work as ours, the place of someone who no longer works is poorly defined."

For the majority of the population, working becomes more and more difficult after the age of 60 (Starchild, 2002). Therefore, age 65 is the commonly accepted retirement age. However, in today's society, as the cost of living increases rapidly and government finances remain in an unstable state, retirement appears to be an uncertain reward for a lifetime of work. Social Security alone is no longer a guarantee of freedom from economic worries.

Individuals who fail to save for retirement may find themselves in a frightening position when the time comes (Starchild, 2002). Even those who have saved adequately often face serious challenges. Still, despite these concerns, most people perceive retirement as something to look forward to, and those who make the most of their retirement options often find it to be a pleasurable experience.

Today, the average man who lives to age 65 will probably live another fifteen years, and the average woman will probably live another twenty. As a result, the retirement phase of a person's life may encompass a third or more of his or her entire lifetime. These facts underscore the importance of saving for retirement and of understanding the options available.

Social Security: History, Benefits, and Limitations

Current tax rate — current marginal income tax rate.

Equity — ownership interest held by shareholders.

Financial planner — a professional who analyzes an investor's general financial situation and develops a plan to meet individual goals.

401(k) plan — a voluntary retirement plan offered to employees of a company that enables a specific percentage of before-tax earnings to be set aside and invested within a retirement plan. The funds and their growth are not taxed until withdrawn. The advantage of this deferral arrangement is that the percentage of money invested is deducted from personal income taxes and grows tax-deferred.

Individual Retirement Account (IRA) — a personal retirement tax shelter for which the government provides favorable tax benefits. An individual can invest up to $3,000 per year into an IRA. Depending on income level and whether they participate in an employer-sponsored retirement plan, investors may deduct the amount contributed. Once inside the IRA, money grows tax-deferred. Investors can use stocks, bonds, mutual funds, or other IRS-permissible investments as the investment vehicle.

Investment — the use of capital, including stocks, bonds, real estate, or limited partnerships, to generate returns.

Investment tax rate — expected marginal tax rate for investments.

Money market fund — a mutual fund that invests in paper-based commodities, including commercial paper, repurchase agreements, banker's acceptances, certificates of deposit, and other low-risk, low-yielding instruments.

Rate of return — expected rate of return on an investment.

Standard & Poor's 500 Index (S&P 500) — a broad-based measurement of 500 large companies from different sectors that trade on the New York Stock Exchange, serving as a benchmark for daily stock market performance.

Stock — ownership of a company represented in shares consisting of the company's earnings and assets.

Stock market — the organized trading of securities on various market exchanges.

Tax rate at retirement — expected marginal income tax rate at retirement.

In modern society, retirement has become a socially accepted and even celebrated phase of life (Marks, 2002). However, it was not always this way. Prior to World War II, even in industrialized countries, many people worked until they died. According to Peter G. Peterson in Gray Dawn, the word "retirement" once carried a negative connotation, implying that one's useful days were over. To avoid this stigma, men often kept working whether or not they could afford to retire.

Fortunately, society's ideas about retirement have changed. After the Great Depression, President Franklin Delano Roosevelt initiated the Social Security Act, signed into law in 1935, which was designed to protect retired persons from poverty (Marks, 2002). The government used Social Security to distribute benefits to all retirees, regardless of income or wealth. However, many people—even today—fail to realize that Social Security was never intended to be the sole method of support for retired workers. The government assumes that individuals will supplement their Social Security income with other financial assets.

Another factor that made retirement universally embraced was the increase of pension plans during World War II (Marks, 2002). At a time when there were more jobs than workers, many employers used fringe benefits, including pension plans, to attract and retain employees without violating wartime wage freeze rules. The most common type of pension was a defined benefit plan, which workers preferred because it provided a specific benefit at retirement. Since the 1950s, workers began retiring at younger ages.

Today, however, many factors threaten the viability of early retirement. The government lacks the fiscal resources to pay a growing number of retirees their benefits (Marks, 2002). In the early 1900s, life expectancy was 47.3 years; today it has reached an unprecedented 76.9 years. In 1950 there were 16 productive workers for each retiree, but today there are just 3.3. These numbers suggest that a decreasing number of workers will be unable to adequately support aging generations as they reach old age.

Many companies have also switched from defined benefit plans to defined contribution plans, which distribute funds according to the size and success of investments made within them. The stock market's volatility has resulted in many people losing more than half of their self-managed pension investments, and many companies are scaling back retiree health benefits as well.

In a recent study by The American Savings Education Council, 70% of workers aged 40 to 59 expressed confidence that they would be able to have a comfortable retirement (Marks, 2002). However, only 25% had saved at least $100,000. Half of all workers reported saving less than $50,000, and 15% had saved nothing at all.

Over the past sixty years, Social Security has become the most successful domestic government program in American history (Social Security Administration, 2001). The Great Depression of the 1930s revealed that American workers were financially dependent on factors beyond their own control, making a federal safety net necessary. In the years following its creation, Social Security expanded to include survivor's benefits, disability benefits, and health care benefits.

According to the 2003 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance Trust Funds (National Center for Policy Analysis, 2003), Social Security provides retirement and disability insurance benefits for qualified workers and their dependents, as well as survivors' benefits. In 2002, Social Security paid retirement and survivor benefits to 39.1 million people and disability benefits to 7 million, while 152.7 million workers contributed to the program. Social Security is a pay-as-you-go program, meaning the government pays today's beneficiaries using payroll taxes collected from today's workers. When Social Security began in 1935, the payroll tax was 1% on the first $3,000 of income; today it is financed by a 12.4% payroll tax—split equally between employee and employer—on the first $87,000 of earnings. The average Social Security benefit in 2003 was $895 per month, or $9,204 per year. Sixty-four percent of retirees depend on Social Security for half or more of their income, 29% rely on it for 90% or more, and 18% rely on it for all of their retirement income.

Understanding 401(k) Plans

Because Social Security provides benefits to millions of Americans, it is often perceived as a simple retirement savings account (National Center for Policy Analysis, 2003). Many believe that if they simply contribute through payroll deductions, they will get that money back at retirement. However, Social Security is a complex social program rather than a retirement plan. By design, it involves massive subsidies across income levels, family structures, and lifespans. A mandated personal-investment plan cannot redistribute benefits in the same socially conscious ways that Social Security does; instead, it raises or lowers benefits based on investment ability, timing, and luck. Thus, Social Security is perceived as a more reliable option than many alternatives—but it faces serious long-term challenges.

Social Security pays monthly retirement benefits to millions of retired workers and their families (Social Security Administration, 2001). Approximately 90% of Americans age 65 or older receive Social Security benefits. Full retirement benefits are payable at age 65 for those born before 1938, with reduced benefits available at age 62. The age for full benefits is slowly rising and will reach age 67 in 2027 for those born after 1960.

Financial advisers estimate that most individuals need about 70% of pre-retirement income to live comfortably after they retire. Social Security replaces about 40% of the average earner's salary (Social Security Administration, 2001). Almost all American workers pay Social Security taxes; the tax rate of 7.65% covers both Social Security and Medicare. Of every dollar paid in Social Security and Medicare taxes, approximately 69 cents goes to a trust fund for retirement and survivors' benefits, 19 cents goes to Medicare, and 12 cents goes to disability benefits.

The long-term outlook for Social Security is a significant concern. According to the 2003 Annual Report of the Board of Trustees (National Center for Policy Analysis, 2003), the number of Social Security beneficiaries is growing faster than the number of workers paying taxes to support them. The number of elderly Americans between now and 2050 is expected to increase by 100%, while the number of workers will increase by only 22%. People are living longer—by 2050, life expectancy is projected to be 79.2 years for men and 83.4 years for women—while birth rates are declining. In 1940, there were 42 workers per retiree; today the ratio is 3-to-1, and by 2050 it will be 2-to-1. By 2018, Social Security will spend more in benefits than it collects in taxes, and by 2041, the program will have exhausted its trust fund assets, requiring either a significant tax increase or a benefit cut of approximately one-third. Between 2018 and 2075, Social Security's unfunded liability totals an estimated $24.2 trillion—approximately 12 times the size of the 2002 federal budget.

Saving money for retirement is not an easy process, and many people do not know where to place their funds given the sheer number of available options. Understanding the 401(k) is an excellent first step toward a financially secure retirement.

A 401(k) plan is a voluntary retirement plan offered to employees that enables a specific percentage of their before-tax earnings to be set aside and invested within a retirement fund. The funds and their growth are not taxed until withdrawn. The percentage of pretax pay that may be contributed differs from company to company and often grows with each year of employment. The employer may also choose to contribute funds to employees' accounts as an incentive. In most cases, when an employer matches employee contributions, it is advisable to invest as much as possible, as the matching portion represents essentially free money.

While most people have heard of 401(k) plans, many have not opened an account, even though most companies offer one. Today, more than 25 million Americans are investing over a trillion dollars in 401(k) accounts nationwide (Salisbury, 2003, p. 48). This retirement program allows workers to invest their own money before turning it over to the government, but many fail to take advantage of it—often because they do not know where to start or feel intimidated by the range of investment choices.

The name "401(k)" is derived from section 401(k) of the Internal Revenue Code, which enables employees to take out a certain amount of tax-deferred funds each pay period (BuyerZone, 2003). The employer's role is to offer and set up the plan; the employee determines what percentage of his or her paycheck to contribute and how to invest that money. For the most part, 401(k) plans offer a good deal of flexibility, as employees can change their contribution amounts periodically and choose among multiple investment options. Unlike a traditional pension, a 401(k) plan cannot accurately predict how much money an employee will receive at retirement, since that depends entirely on contributions and investment performance.

Contributions to a 401(k) are deducted before taxes, which means the employer deducts the amount from the employee's salary prior to calculating income taxes (BuyerZone, 2003). The IRS limits employee contributions to 15% of annual earnings, not to exceed $10,000, in order to prevent abuse of the system. While the investments grow within the account, employees are not required to pay taxes on the gains.

There are many advantages to 401(k) plans (Salisbury, 2003). Any business entity—C Corporation, S Corporation, partnership, sole proprietorship, or self-employed individual—may establish a plan, providing an excellent means for all Americans to save for retirement. Typical plans offer a wide range of investment options, including stock and bond mutual funds; balanced funds focused on both stocks and bonds; "lifestyle" or asset allocation funds combining investments based on age and risk tolerance; and fixed-interest investments such as money-market accounts. An increasing number of plans also allow participants to manage their own accounts by purchasing individual stocks and bonds.

Many plan members appreciate that employee contributions are not subject to federal income taxes until a distribution is made, and that investment gains and earnings are similarly deferred. In addition, plan members may borrow against the plan if they need a loan or face financial hardship. For employers, 401(k) plans provide a competitive hiring edge, a flexible means of offering retirement benefits, and a significant tax deduction.

According to Halverson (2001), the following factors summarize the value of a 401(k) plan: funds are not reported on W-2 forms, lowering taxable income; earnings accumulate tax-free until withdrawal; employers often match a portion of employee contributions; contributions are made automatically through payroll deduction; and the funds are portable, meaning employees can keep their accumulated savings if they change jobs.

When an employer offers 401(k) matching, a percentage of the employee's contributions is matched—for example, 50 cents for every dollar contributed (Woodward, 2002). This amounts to an immediate 50% return on investment, making it critical to contribute at least enough to capture the full employer match. Many investors make the mistake of pulling or reducing their 401(k) contributions when the market declines, overlooking the fact that every contribution still earns a guaranteed return in the form of employer matching.

It is important to note that many companies provide vesting schedules for employer contributions, meaning employees may need to work for a certain period before keeping the company's contributions (Woodward, 2003). For example, an employee might receive 25% vesting after one year, 50% after two years, and so on. Employees always retain their own contributions, however. A high employer match may therefore be less valuable than it appears if an employee plans to leave the company before being fully vested.

The best way to maximize returns through a 401(k) plan is to contribute enough to receive all available employer matching funds. A 1998 Money Magazine study compared putting $5,000 in 401(k) stocks (averaging 12% returns) and $5,000 in taxable bonds (averaging 7% returns) over 20 years. The study found that by switching bonds into the 401(k) and holding stocks in a taxable account—where they would face only capital gains tax—investors came out ahead: $45,600 compared to $40,600 under the original allocation.