10 Flaws of Conventional Retirement Plans

Have a 401(K) with an employer match and think you're all set for your golden years? Think again.

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By Pamela Yellen


Opinions expressed by Entrepreneur contributors are their own.

According to a new survey, 25 percent of Americans are worried about running out of money in retirement. A 2015 Government Accountability Office study found that Americans surveyed who were 55 to 64 years old had saved an average of $104,000 and those 65 to 74, only $148,000. The same study found that 29 percent of Americans 55 and older didn't have any retirement savings.

Related: 4 Questions Entrepreneurs Should Ask Their 401(K) Providers

Among Americans who do have retirement savings, most are invested in conventional government-controlled retirement plans such as 401(k), 403(b), IRA or Roth IRA plans. Yet that's not necessarily the solution, because overwhelming evidence shows that these plans haven't given people the financial security and predictability they deserve and expect.

The top 10 hidden drawbacks to government-sponsored retirement plans

1. Tied to the stock market and all its volatility. Most conventional plans are dependent on the stock market, with its inherent risk and volatility. Over 77 percent of the savings in these plans are invested in volatile equities and mutual funds, dumping risk on uninformed retirement savers. Barry Dyke, author of The Pirates of Manhattan, says "The 401(k), without any guaranteed returns, is a recipe for disaster."

2. Subject to seemingly small fees that take a huge bit out of your savings. According to the Department of Labor, fees of only 1 percent per year can slash the value of your savings by 28 percent over 35 years, assuming a 7 percent annual return. And most plan participants are paying at least 1 percent a year in fees. Even with new laws requiring better fee disclosures, studies show that most employees who trust their savings to these plans have no clue how much they're paying in fees.

3. Administered by unqualified people. In many companies, people with no training or education in this area make the important decisions about 401(k) plans. A study from the Center for Retirement Research at Boston College found that plan administrators choose mutual funds that lag far behind comparable indexes.

4. Conflicts of interest. Many advisors have revenue-sharing arrangements with the funds that pay them. This may restrict your choice of funds and result in your paying higher fees.

5. Subject to change. Once you've put your money into a 401(k) or similar plan, the government and your company can change your plan's rules and participation rates with little or no notice. For example, in 2013, IBM decided to pay its matching contributions as a lump-sum payment on the last day of each year, rather than matching payments throughout the year. Employees lost an entire year's growth on that match money. Your company could make similar or different changes without your consent.

Related: 2 Little-Known Retirement Savings Plans Tailored for Entrepreneurs

6. Restrictive government rules and regulations. The government tells you how much you may put in your plan, what you can and cannot invest in, how much you can borrow, how you must pay it back, how long you must wait before you can access your money and when you must start taking withdrawals. Penalties for running afoul of these regulations are costly.

7. Lack of liquidity. Each year, about 15 percent of participants in employer-sponsored defined-contribution plans make early withdrawals (that is, before age 59-and-a-half), according to Census Bureau surveys. In one recent year alone, the IRS collected $5.7 billion in penalties related to 401(k) withdrawals, meaning Americans took about $57 billion from their retirement funds before they were supposed to.

Early withdrawals are subject to taxes as well as penalties, so you can't access your money in an emergency without taking a big hit.

8. Pitfalls of taking loans. In the last few years, 401(k) loans have become America's new piggy bank, with up to 40 percent of workers taking loans. But the government limits how much you can borrow, how long you can borrow it for and how and when you must make payments on your loan. You also have to sell assets in your plan to take a loan, forfeiting potential growth. Loans are not permitted at all in IRAs.

Because of all the restrictions and penalties, you should consider a government-controlled, tax-deferred retirement fund to be a non-liquid asset that you shouldn't touch until age 59-and-a-half.

9. Potential tax time bomb. Postponing taxes might sound good today, but if you're successful in growing your nest egg and tax rates go up as most of us expect they will, you'll end up paying higher taxes on a bigger number in retirement.

10. Target-date funds (TDFs) common in 401(k)s are risky in spite of the hype. TDFs are funds in which the asset mix is periodically adjusted, based on when you expect to retire. Total investments in TDFs have grown significantly since Congress made them a "default" option for workplace plans in 2006.

However TDFs often have fees that are significantly higher than those of other mutual funds. And, though originally designed to minimize risk, TDFs do not guarantee that you won't suffer losses. According to the Government Accountability Office, between 2005 and 2009, investors in the largest TDFs lost as much as 31 percent of their money while the Dow Jones Industrial Average lost only 1.61 percent during that same period.

Even worse is the fact that some TDFs designed for people retiring in just two years lost up to 40 percent!

So, what can you do if, like most Americans, you are invested in one of these plans? First, take the time to evaluate your plan. If your company automatically invests your contributions into its default mutual fund option, do not assume that that option has your best interests at heart. Do your research, know how much you're paying in fees and keep in mind that investments -- including TDFs -- have no guarantees whatsoever.

Remember, it's your money, and the investment results stemming from your decisions will determine whether or not you have a secure retirement.

Most importantly, investigate alternatives for at least a portion of your retirement nest egg. For instance, more than 500,000 Americans are saving for retirement using specially designed, dividend-paying whole life insurance policies. These plans have none of the 10 drawbacks listed above. Instead they hold numerous advantages, including safety, liquidity, access, control of your money and many tax benefits.

Related: 13 Reasons Why Your 401(k) Is Your Riskiest Investment

And, they allow you to know the guaranteed minimum value of your plan on the day you retire and every step along the way. These are benefits you won't find with any of the conventional investment schemes touted by Washington and Wall Street.

Pamela Yellen

Financial security expert

Pamela Yellen is a financial security expert, a two-time NY Times best-selling author and President of Bank On Yourself. Pamela's latest book is "Rescue Your Retirement: Five Wealth-Killing Traps of 401(k)s, IRAs and Roth Plans – and How to Avoid Them."

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