Should You Invest in Your Company Plan?
For most Americans, a company-sponsored retirement plan is their largest nest-egg, but that doesn’t mean it isn’t broken
Janice was a 50-something-year-old client who came to me because her parents had been clients for years. She told me that she had a “small CD that’s an IRA,” a small bank account, and a company plan that was the lion’s share of her retirement nest egg.
When I asked how many options her retirement plan offered and how she was allocated, she grinned sheepishly and told me she didn’t have a clue. The kicker was that she only had a vague idea as to the value of the account, and wasn’t sure whether or not the company had a match.
At a time when about half of all Americans aged 50 and older either rely on or will rely on social security “benefits” to pay their bills in retirement, it is rather incredible to consider how little most workers actually understand their company plans. Unfortunately, even for those who are well versed in how their 401(k) or 403(b) operates, the plan itself is often lacking. For America to become an abundant place for all, that must change.
A brief history of company plans in America
The American Express company established the first private pension plan in the United States in 1875. This was at a time when three-fourths of all males over the age of 65 had to continue working to survive. This was also a time when the average lifespan was 49, but those lucky souls reaching 65 could expect to live about 12 years longer, on average. By the end of the 19th century, a dozen more big companies added plans.
In 1935 the Social Security program was enacted. Created as an absolute stopgap measure, it established 65 as the normal retirement age, with the tacit understanding that those receiving payments wouldn’t be long for the world. The program was initially funded by the federal income tax, which began in 1913. In the 1920s, a series of acts were put in place exempting money put into company plans from taxation. Since a growing percentage of Americans, especially business owners, were paying a federal income tax by that point, protecting money via a pension plan becomes very attractive.
By the 1970s, nearly half of all workers were covered by a pension plan. After spending three or four decades at a mill or a plant, a worker would retire and receive a monthly pension check from their company. That began to change with the Revenue Act of 1978, which allowed individual employees to put money into a company plan pre-tax. Thus began the great migration away from defined benefit plans (pensions) to company-sponsored defined contributions plans such as the 401(k).
Why should the American worker prefer the contribution plan over the benefit plan?
There are a multitude of anecdotal examples highlighting the potential dangers of a defined benefit plan. Let’s take a look at what could happen to a pension plan when a company begins to financially spiral out of control, using Trans World Airlines as an example.
After a long and storied history spanning seven full decades, Trans World Airlines ceased operations in December of 2001, following three bankruptcies and an acquisition by American Airlines (AMR). The purchase may have been a welcome overture for TWA senior executives, but it was the beginning of a nightmare for employees who had placed their trust in the company’s pension plan.
What happened to TWA’s pension is a long and complex tale, but let’s distill it down to the real-life story of one 25-year employee who was a flight attendant, a flight engineer, a first officer, and a captain.
After the company’s 3rd bankruptcy, Carl Icahn (the corporate raider who purchased the airline in 1985) gave formal notice of his plans to terminate TWA’s two pension plans. With the court’s approval, these plans ultimately ended up in the hands of a government-sponsored enterprise (GSE) known as the Pension Benefit Guaranty Corp (PBGC). PBGC was created by an act of Congress in 1974 (ERISA) to ensure continuity in pension plans, regardless of what happens to an underlying company. Unfortunately, the PBGC has a cap on what it will payout, and that amount is nowhere near what would be a “typical” monthly pension. This faithful employee now has an income of $60 per month from her flight attendant years and $120 per month from her role in the right and left seat. Not enough for a used-car payment.
Contribution plans such as the 401(k) are much harder to manipulate from the company’s standpoint, but that doesn’t mean disaster can’t strike. Let’s take a look at some common pitfalls, and consider how much a worker should be contributing.
Funding your retirement accounts
Despite all of the industry lingo, understanding the critical components of a company plan doesn’t take much effort. Unfortunately, dealing with the administrators of the plan can often task even the most patient of employees. We have reviewed literally hundreds of different corporate plans and can, with online access to a client’s account, determine their quality within a matter of minutes. If you don’t have a third-party professional like an investment advisor to perform due diligence, here are some of the key factors to look for.
You should first consider how much of your own contribution your employer is willing to “match.” (This should also be a question you find the answer to before taking a position at a firm.) For example, a company with strong corporate governance might have a match that looks something like this: Dollar for dollar up to the first five percent and then a 50% match up to a max contribution of 10%. In other words, if you put 10% of your pre-tax salary into your plan, the employer will add another 7½% on top of that. Unless the plan is absolutely rot-gut, never leave company money on the table!
But what if your company has a paltry match or none at all? You will still get the tax benefit of putting your hard-earned money to work without the IRS touching it...at least until you begin pulling it out.
As for the amount, we stress to clients that they should be putting the first ten cents of every dollar they earn into their personal “Vault.” After the employer match is hit, we recommend fully funding a personal IRA—either a ROTH or a Traditional. Contributions on the ROTH are never taxed (even when the money is being pulled out in retirement), but they cannot be deducted from taxable income. The Traditional IRA contributions are deductible to a point (typically 5,500 or 6,500, depending on your age and other factors), but all withdrawals will be taxed as the money is pulled out.
But what happens after you exhaust both the company match at work and have put the maximum allowed into an IRA, and still wish to invest more? It is fine to add more of your gross income (to the max allowable $18,000 per year, or $24,000 if over age 50) into your company plan, but be sure and evaluate—with a critical eye—its viability and tenacity before doing so. If it is a weak plan, you are better off putting any excess capital into a taxable account earmarked for retirement.
Allocating among the myriad of investment choices
Let’s tackle the elephant in the room right now: the question of how much of your retirement account should be in company stock, or any one investment for that matter. It is natural that an employee wants to believe in, and support via their retirement plan, the company they work for. That being said, it should be a hard and fast rule to never put more than 10% of your contributions into company stock, and never exceed 25% in any one investment or sector. Let me illustrate this point with a personal story.
Around the year 2003, I found myself playing golf with a fellow stock broker and his two brothers. One of his brothers was a gregarious sort, while the other seemed quite curmudgeonly. I must have been in a mood to “poke the bear,” because when I noticed the second brother sporting a pair of socks with the Lucent symbol on them (Lucent was a once-dynamic spin-off from AT&T that had fallen from about $85 per share to $2 per share), I proclaimed, “those socks are worth about five shares of Lucent stock!” He went from curmudgeonly to outrightly hostile in short order, storming off after finishing the back nine. Over a beer, one of the other brothers explained to me that this guy, who was in his early 60s, had over half of his retirement plan in company stock and had to postpone his planned early retirement because of his unfortunate investment decision. Ouch.
I have reviewed some outstanding company plans, with dozens of solid investment choices across style (value to growth), market cap (small to mega), and asset class (cash and fixed income to aggressive equity). I tell the clients with these plans how lucky they are to work for a company that performed proper due diligence, because most I review are somewhere between mediocre and outrageously bad.
To the largest degree possible (based on the plan’s choices), your current and future contributions should mimic your specific asset allocation strategy, which is based on your risk tolerance level. You can determine your risk number by selecting the Free Portfolio Risk Analysis link about halfway down the homepage of www.penneconomics.com. Once you have your risk number in hand, determine your proper investment strategy by visiting the member page Asset Allocation Strategy. These dynamic allocation strategies are based on your risk level, along with current and anticipated market trends.
So, you might ask, how many sub-funds (the investment vehicles in most company plans) should you be invested in at any one time? Within the five Penn Portfolios, we own approximately 100 positions at any given time. You might only have ten choices or so in your company’s plan, however. An additional factor is whether you have $5,000 invested or $500,000. You don’t want to over-concentrate or spread your money too thin among the sub-funds, so a basic rule for a typical account might be a position in: one or two large-cap US funds (one growth and one value), a good small/mid-cap fund, an international fund, a fixed income fund, and a cash-equivalent position. Allocate the percentages of those four or five funds based on your personal Asset Allocation Strategy as best you can.
Don’t get too caught up in trying to micromanage your company plan. We recommend using a professional money manager (like our sister company, Penn Wealth Management) to help you reallocate and monitor your plan. Remember, this is your financial future we are talking about!
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