I recently received the following in an email from a man named Tom.

“Normally I wouldn’t take the time to write this, but I find your ad and corresponding ‘The Great 401k Rip Off’ website a totally irresponsible attempt to stir up fear and confusion around financial planning. I am certain that you accept that a well-managed, company-matching 401(k) is an excellent vehicle to build wealth for retirement…to suggest that 401(k)s are a rip off comes across as sleazy.”

I wrote Tom back, thanking him for his feedback and asked if he would mind my using his comments in my column. He graciously agreed, and even gave me permission to use his first name. I would like to thank him again, here and now. I always welcome open, respectful, and challenging dialogue.

This is a very serious and quite complex issue, so it’s more than I can really cover in a single column. Therefore, I will split it in two, finishing up next time. If you want to hear more about this, we will feature it on our radio show, The Free to Retire Hour this weekend. It will air on WFEA (AM 1370 or FM 99.9) at 8 a.m. Saturday, and WCAP (AM 980) at noon Sunday.

First, I would like to be clear. My goal was not to stoke fear, but to cause people to take notice and be concerned. We believe there should be concern. A lot of it. To Tom, I would say I am very happy to hear you have a 401(k) that is working for you and with which you are happy. However, in a world where the average 401(k) balance for people aged 60-69 is $167,700, can everyone say that?

From the beginning, the goal of the 401(k) was never to improve our retirement picture. In fact, it began as a tax-dodge for highly compensated executives at Xerox and Kodak in upstate New York. For verification and a lot more good information on this subject, I recommend reading “Who Stole the American Dream,” by Hedrick Smith, and viewing PBS Frontline episode (31-7), “The Retirement Gamble.”

Prior to the 401(k), more than 84 percent of employees who had an employer-sponsored retirement plan had a defined-benefit pension plan, which guaranteed lifetime income. That number has since declined to below 30 percent. Corporate America has saved hundreds of billions of dollars by converting guaranteed pensions people could count on into very risky and expensive self-managed accounts. Defined benefit plans guarantee the outcome. Defined contribution plans guarantee nothing except market risk, high fees, and an unknown future.

To understand the difference, consider the case of a client of mine who was offered a cash buyout of $170,000 in lieu of a monthly payout of $1,750, or $21,000 a year. That’s a 12 percent payout for life. To receive the same $1,700 a month from a 401(k), you would need to accumulate $700,000 to meet the 3 percent guideline financial planners now use.

The reason you get so much more out of pensions is twofold. The first is the mortality credits they provide. Mortality credits leverage life expectancy. This is only possible when a plan is based on a large group of people rather than a single individual or couple.

Think of fire insurance. If you, as an individual, were to prepare to replace your house in the event of a fire, you would have to estimate the cost of rebuilding that house and put that money aside today because it could burn down tomorrow. However, you might consider the probability of your house burning down is one in 1,200. You might then be tempted to divide the cost of rebuilding by the probability it could happen. In the case of a $240,000 home, you might say I can put away $200 a year and be OK. However, that’s absurd, as if it does burn down, you are going to need far more than $200. Even after 20 years, you would only have $20,000. To invest that in the market and have $240,000 after 20 years, you would need a rate of return of 33 percent for 20 years. Even if you put away $1,000 per year, you would still need a 22 percent return, and you would have to wait 20 years to be ready.

However, an insurance company that is covering thousands of houses can make these types of calculations because for every house that burns down, 11,999 others don’t. Now fire insurance does cost more than $200 a year, but it also covers a lot more than just fires. So, you could expect to pay $800 to $1,000 per year for the above situation. But it’s still way less than $240,000, and you are protected the day you sign up.

So, the difference between the two is about pooling the risk. When you pool risk, you offload the majority onto a risk pool. The risk pool shares the risk and reduces the cost to each individual by a substantial margin. In the case of fire insurance, it reduced the risk by 240 times. In the case of retirement income, the pension reduced risk by about 75 percent, but even that’s a skewed number.

The reason I say that is to get $700,000 put away over a 30-year working lifetime, you would need to save around $10,000 per year with a rate of return of 5.3 percent. It is hard to get more than 5.3 percent from a 401(k)over time because of the exorbitant fees, which I will cover next time. However, if you can save $10,000 per year, you could get there. That means a person earning $50,000 a year would need to put away 20 percent per year for 30 years to receive a retirement payout of about 40 percent of earnings. For many, this is unattainable. In the pension, you would have to put away just 5 percent annually, a much more attainable goal. The difference between a goal that is possible versus one that is impossible is 100 percent, not 75 percent.

Next time, we will cover the direct costs associated with 401(k) accounts.

Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, he services Greater Boston and the New England areas. He is author of five books, including “Tell Me When You’re Going to Die,” which deals with the problem unknown lifespans create for retirement planning. It and his other books are available on Amazon.com. He can be heard every weekend on the “Free to Retire” radio show on WCAP and WFEA, and he conducts planning workshops at his New England Adult Learning Center, located in Nashua. Initial consultations are always free. You can reach Steve at 603-881-8811, or at www.FreeToRetireRadio.com.

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