Should Plan Sponsors Fear? Is the 401k Merely a Ponzi Scheme?

This may represent the 401k fiduciary’s greatest fear. Recently, a small-market radio talk show host (Bob Lonsberry, WHAM, Rochester, New York), while railing against questionable public pension practices in New York State, called the 401k plan a mere Ponzi scheme that, at most, will benefit only the older of baby boomers. The moderator vehemently decried the nation’s most popular retirement plan as the root cause of the stock market crash – and future crashes – and the ultimate false siren to millions of unsuspecting workers. Could it be true? And, if so, will the albatross of liability ultimately hang upon the 401k plan sponsor?

The 401k Ponzi scheme claim seems to pop up whenever the market suffers an extended decline. The earliest instance, as revealed by a Google search, occurred during the depths of the post 9/11 recession with the article “Your 401k Is Making a Statement” (Fast Company, October 31, 2002). This article, while alluding to the prospect of a 401k “pyramid” scheme, ends up squashing the notion.

The nadir of the recession of 2009, however, proved less forgiving. Then, with class warfare waging, a slew of articles and blogs pointedly alleged the 401k idea is a scam. The worst of these accuse brokers and plan sponsors of profiting from the 401k plan (“How Big a Slice of Your 401k Pie Does Wall Street Get?” ABC News, June 16, 2010). Perhaps the greatest affront to the 401k concept occurred when the October 7, 2009 issue of Time Magazine declared the death of the 401k (see “Time Magazine is Wrong!” Fiduciary News, October 8, 2009). The most sober-minded arguments can best be summed up by an excert from Robert Kiyosaki’s article “Why the Rich Get Richer” (Yahoo, August 24, 2009):

The 401k Ponzi scheme. A Ponzi scheme, like the scheme Madoff ran, depends upon young money to pay off old money. In other words, a Ponzi scheme needs tadpoles to finance old frogs. The same is true for the 401k and other retirement plans to work. If young money does not come into the stock market, the old money cannot retire. One reason so many people my age are worried, not only about Social Security and Medicare, is because they’re concerned about getting their money out of the stock market before the other old frogs decide to drain the swamp.

The facts are that the 401k plan has a trigger that requires old frogs to begin withdrawing their money at a certain age. In other words, as baby boomers grow older, more and more will be required, by law, to begin withdrawing their money from the market. You do not have to be a rocket scientist to know that it is hard for a market to keep going up when more and more people are getting out.

The Rochester radio host said only people in the financial business don’t believe in the 401k Ponzi scheme, so he probably didn’t respect The Motley Fool’s rebuttal to this assertion (“Is Your 401k a Ponzi Scheme?” Motley Fool, February 23, 2009). Of course, it doesn’t help when the Fool’s counterpoint was “you can’t blame investment losses in your 401k account on a grand conspiracy.” Mr. Lonsberry would be correct to ask “Why not?”

Let’s take a look at the numbers and determine if the conspiracy theory holds. First, according to some, the current stock market bull began because the 401k Section became effective in 1980. In fact, as Rich McSheehy pointed out (“401k Plans Are Just a Ponzi Scheme,” Rich McSheehy’s Weblog, March 5, 2009) “The market skyrocketed from about 800 in 1982 to almost 14,000 in 2007, a gain of almost 1650%!!! Compare that with the period 1960 to 1980. The Dow went from about 700 to about 800 in twenty years, a gain of only 14%.” OK, so maybe the recession of 2009 brought the market down, but the point is still valid. The market did rise dramatically over the last 30 years. Did the 401k plan cause a stagnant market to explode – or was it a vibrant economy? Or, was McSheehy comparing 20 years of data with 30 years of data? (Yes.) Ibbotson’s annual data book suggests the market grew a little over 17 times in the 30 years ending 1980 and a little under 17 times in the 30 years ending 2009. By this measure it appears 401k plans have had no impact.

How about the economy in those time frames? GDP grew 7 times in the 30 years ending in 1980, but only 4 times in the 30 years ending 2009. This might suggest either: a) the market’s growth in the latter 30 year period was too high; or b) the market was extremely undervalued at the end of the first 30 year period. If we look at one popular metric – the P/E ratio – we see the early 1980’s did have a historically low P/E. Likewise, today’s market P/E ranks about average. (see “Is the Stock Market Cheap?” dshort.com, February 1, 2011). Perhaps it was these low valuations prior to the introduction of Reaganomics that caused the inordinate market growth over the past three decades.

Let’s take a look at another factor used to “prove” the 401k is a legal Ponzi scheme. By definition, Ponzi schemes require the use of “new” money to replace “old” money. In the argument posed by Kiyosaki, and voiced by Lonsberry, the “new” money runs out when the baby boomers retire. This assumes the boomers represent a tremendous bulge in the American population demographic. In fact, the U.S. Census shows the boomers (those born between 1945 and 1960) represent about 18% of the population. Surprisingly, the two younger cohorts have more. Those born between 1960 and 1975 represent 22% of the population and those born between 1975 and 1990 represent 20% of the population. More importantly, these younger groups are poised to earn more over time; thus, saving a higher dollar amount in their 401ks. Rather than remove the demand for stocks, it appears that demand will only increase.

Finally, implicit in the Ponzi scheme assertion lies the assumption baby boomers will sell their stock upon retirement. In fact, most financial planners would suggest retirees plan on funding a 30 year retirement. This requires a continued reliance on equities; thus, negating the need to sell stocks as some conspiracists believe. Even as they take money out of their retirement plans, they are likely to move any excessive funds into taxable accounts invested (at least some portion) into equities.

Unfortunately, urban myths die hard. While it’s easier to show how a pension plan can become a Ponzi scheme (through the real numbers of actuarial assumptions, funding rates and investment returns), it’s in fact much more difficult to demonstrate how the 401k can become a Ponzi scheme. In fact, if anything, the freedom to invest as individuals as opposed to a group is what separates the Ponzi scheme risk for employees. In a 401k plan, any worried investor can leave the market at any time. Employees relying on pension plans, however, have no such luxury.