Retirement Savings: Why The Reluctance?

There are many reasons why people don't invest enough into their retirement. Some of the main ones include: a lack of access to a 401(k) plan at work, especially for younger workers; a lack of financial education; fear of investing due to market meltdowns; debt; and the cost of living.

Fear of the market

Firstly, emotional decisions often lead to poor investment choices. As Warren Buffett famously said, "If you cannot control your emotions, you cannot control your money." When the market drops, fear can trigger a panic response, causing people to pull their money out of the market to avoid perceived big losses. However, this reaction often results in losing more money than if they had remained invested.

Secondly, fear has a domino effect on the market. As more people withdraw their investments due to short-term market dips, it can create a chain reaction that drives the market down even further. This fear becomes a self-fulfilling prophecy, as the very act of exiting the market contributes to its decline.

Additionally, fear can cause investors to shift their money to "safer" investments, such as gold and silver, which are often seen as fear trades. While these commodities may provide a sense of security, they may not offer the same growth potential as other investments.

Furthermore, the fear of market volatility can be especially concerning for those nearing retirement. People close to retirement are more sensitive to short-term market fluctuations and may miss out on the benefits of long-term investing. They worry about losing money before they retire and not having the opportunity to recoup their losses.

Lastly, a volatile market can also impact retirement income expectations. Many individuals rely on investment accounts, such as 401(k)s or IRAs, as a significant source of retirement income. When the market underperforms, it can create uncertainty and worry about having enough funds to sustain them through retirement.

To overcome the fear of the market, it is essential to understand that short-term fluctuations are common and that the market has historically recovered from downturns. Instead of reacting emotionally, investors should focus on their long-term investment strategy and avoid making impulsive decisions based on fear.

Debt burden

Debt can affect an individual's ability to save for retirement. The interest rate paid on debt is often higher than the return on retirement savings. For example, an individual with $20,000 in credit card debt, paying an average of 18% interest, would lose 11% by investing their money at a 7% rate of return, rather than paying off their debt.

It is recommended that individuals first ensure they are meeting the minimum payment requirements on their debts. Any debts with double-digit interest rates, such as credit card balances, should be prioritized. Credit card debt is particularly detrimental as it is often accompanied by revolving credit, which can be very damaging to consumers.

However, there are differing opinions on whether individuals should focus on paying off debt or saving for retirement. Some believe that all debt is bad and should be paid off as soon as possible. Others argue that not all debt is created equal, and that individuals should invest their money where they will get the greatest returns. For example, if an individual can invest their money and get a greater return than the cost of the debt they are paying, it may be more beneficial to save for retirement first.

There are also other factors to consider when deciding whether to prioritize debt repayment or retirement savings. An individual's age, income, spending trends, and total debt will influence their ability to save or pay off debt. Additionally, if an individual's employer matches their 401(k) contributions, it may be beneficial to take this opportunity to get "free money", even if they have debt.

Overall, debt burden is a significant factor that prevents people from investing enough in their retirement. The decision of whether to prioritize debt repayment or retirement savings depends on an individual's financial situation and their emotional relationship with money.

Lack of access to 401(k) plans

A significant number of people do not invest enough in their retirement due to a lack of access to 401(k) plans. In 2018, 35% of private sector workers over the age of 22 were not offered a 401(k) plan by their employers. This is a critical issue as 401(k) plans are an excellent way to save for retirement, offering tax advantages and, in some cases, employer-matching contributions.

The 401(k) system is still relatively new, having been introduced in the early 1980s, and was never intended to be a primary source of retirement income. As a result, many workers in their 60s missed out on the benefits of 401(k)s during their earliest working years.

For those who do have access to a 401(k) plan, it is important to maximise this opportunity by contributing as much as possible, especially if your employer offers matching contributions. This will ensure you do not miss out on any free boosts to your retirement savings.

If you do not have access to a 401(k) plan, there are alternative options to save for retirement, such as opening a traditional or Roth IRA, or a brokerage account. These accounts also offer tax advantages and can be a great way to build wealth over time.

Early withdrawals

There are some exceptions to the 10% additional tax and the age 59 ½ minimum. The IRS does not charge the extra 10% on early withdrawals from IRAs, SEPs, SIMPLE IRAs, and SARSEPs after the account holder reaches age 59 ½. Other exceptions include:

• Permissive withdrawals from a plan with auto-enrolment features
• Up to $5,000 per child for qualified birth or adoption expenses
• Corrective distributions of excess contributions
• Total and permanent disability of the account holder
• Up to $22,000 for individuals who suffer an economic loss due to a federally declared disaster
• Up to $10,000 for victims of domestic abuse by a spouse or domestic partner
• Qualified higher education expenses
• One distribution per calendar year for emergency personal or family expenses, up to the lesser of $1,000 or the vested account balance over $1,000
• Distributions from a pension-linked emergency savings account
• Dividend pass-through from an ESOP
• Qualified first-time home purchases, up to $10,000
• Amount of unreimbursed medical expenses that exceed 10% of adjusted gross income (7.5% if the account holder or their spouse is over 65)
• Health insurance premiums paid while unemployed
• Distributions to qualified military reservists called to active duty
• Returned IRA contributions, without earnings, if withdrawn by the extended due date of return
• In-plan Roth rollovers or eligible distributions contributed to another retirement plan or IRA within 60 days

If you are between the ages of 55 and 59 ½ and lose your job, the IRS will allow you to withdraw from your 401(k) plan without penalty under the Rule of 55. Additionally, the Substantially Equal Periodic Payment (SEPP) exemption allows individuals to take substantially equal payments from their 401(k) based on life expectancy.

While the 10% early withdrawal penalty is a clear pitfall, there are other long-term and immediate risks to consider. One of the greatest issues is the loss of compounding returns, where your earnings accumulate to generate even more earnings over time. An early withdrawal can result in a significant opportunity cost, as demonstrated by the example of withdrawing $10,000 about 30 years from retirement, which could result in a loss of approximately $263,000 in total returns. Another immediate risk is the potential increase in your current tax burden, as the distribution may be considered part of your taxable income and bump you into a higher tax bracket.

High fees

There are two types of fees associated with 401(k) plans: those charged by the plan provider, and those charged by the mutual funds or exchange-traded funds (ETFs) in the account. Plan provider fees are outside of an individual's control, but investors can choose funds within the plan with lower expense ratios. Fees for 401(k) plans can range from 0.5% to 2% or higher, depending on the size of the employer's plan, the number of participants, and the provider. The average annual fee is 1%.

A 401(k) typically has more than a dozen undisclosed fees, such as trustee fees, bookkeeping fees, finder's fees, and legal fees. These fees can have a significant impact on an individual's savings. For example, if an individual has $103,700 invested in a 401(k), the average balance among Americans, they will pay about $467 a year in fees. While fees are generally on the decline, overpaying on fees can still significantly reduce an investor's total assets.

Mutual funds within a 401(k) took a 0.36% fee on average in 2021. If a fund is up 7% for the year but takes a 1% fee, an individual is left with only 6%. While this may not seem like a significant amount, over time, a mutual fund may take a large portion of an individual's gains, especially when considering the lost opportunity of long-term compounding.

There are steps that individuals can take to keep their fees as low as possible. They can look into low-cost mutual funds and ETFs offered by companies like Vanguard and Fidelity, which charge less than a tenth of a percentage point. Individuals can also talk to their HR department about switching plan managers or adding more low-cost index funds to their investment options.

Frequently asked questions