How to Tell if You Have a Bad 401k Plan
Posted on
Tue, 29th July, 2008 by
Jeremy
Wondering if Your 401k Sucks? A Few Tips to Help You Spot a Bad Plan
CNN Money recently featured another piece by ‘The Mole’ that discusses what to do if you have a bad 401k plan, and this was followed up by J.D. at Get Rich Slowly with a few more tips. There is a lot of good suggestions in terms of what action to take if you’re in a bad plan, but as the comments illustrate, people are asking how you can actually tell if you’re in a bad 401k plan. So, I wanted to take a few minutes to give you some tips on how you can analyze your own plan and determine whether or not it is worth sticking with.
Beware of the Annuity
While not as common in 401k plans compared to 403b plans, one of the first signs of a bad plan is typically if it is wrapped up into an annuity. This is bad for a number of reasons. First, annuities are primarily used because they offer tax-deferred growth. Well, guess what? Your retirement plan is already a tax-deferred account, so that aspect of the annuity does nothing for you. The second thing is that annuities come with fees. While we all know that investments come with fees, annuities really stick it to you. If you’re investing in some sort of mutual or index fund that’s in an annuity, you’ll still be paying those fund’s expenses. But on top of that, the annuity also has a fee, sometimes 1-2% or more.
So, if your plan consists of an annuity inside of your 401k or 403b plan, you should seriously consider if it’s worth it. Unless the company is offering a really high match, or the fees are somehow extremely low, it might be worth sticking to it, but chances are this isn’t the case, and you could be throwing money away.
The Company Match
One of the greatest benefits to employer-sponsored plans such as a 401k comes in the form of a company match. Unfortunately, not all employers offer this. If your plan doesn’t have any match program, there is probably little incentive to contribute to it. Chances are you can find better investment alternatives with fewer restrictions by investing in an IRA. If your company does provide a match, you should contribute enough to get the match before diverting contributions elsewhere. Remember, match money is free money, and it is hard to beat a 50% or 100% return on your money, even with fees and lousy investment choices.
If your plan doesn’t offer a match, before jumping ship you also want to determine how much money you plan on saving. Remember, in 2008, IRAs have a $5,000 annual contribution limit (not including age 50 catch-up) and most 401ks will allow you to contribute up to $15,500. So, if you want to take advantage of more than $5,000 a year in pre-tax savings, your 401k is going to be one of the few places to do that after you’ve exhausted the IRA contribution.
Fund Families
Some of the comments I see regarding bad 401k plans come in the form of someone saying that unless your plan is a Vanguard or Fidelity plan, then it sucks and you shouldn’t contribute. While there is no doubt that Vanguard and Fidelity are two great fund companies that offer low-cost funds, the chances of your employer using them is relatively small considering the vast number of plan providers and fund companies out there. If you have access to these fund families in your account, that’s fantastic. If not, don’t be quick to dismiss your plan without further examination.
There are plenty of great fund companies out there, and you may be surprised to find that your plan has some good funds with reasonable expenses. One of the reasons is that 401k plans for many employers can qualify for institutional class shares of funds. Institutional funds are typically only available to investors with $1, $5, or even $10 million or more. Because of the high minimum and because they target pension and retirement funds, the operating costs are usually lower, and this means a lower cost to you. So, you might not have a traditional low-cost fund family, but if it is an institutional class of the fund, the expenses may be relatively low.
The Almighty Fees
This is what seems to get a lot of people riled up, and for good reason. Fees can have quite an impact on your performance over time. And unfortunately, some retirement plans pass the fees on to you. But what you can’t do is pull a number out of the air and say that if your fund options have fees of X%, it’s a bad plan. I’ve heard people throw around all sorts of numbers, some as high as 1%, others as low as 0.2%. Fees alone don’t determine a bad plan. High fees certainly don’t help, but you have to factor in everything from the match money, to contribution limits, to relative expense for the type of fund you’re looking at.
For example, let’s say your employer matches dollar for dollar on the first 3% of your salary, and you make $50,000 a year. Let’s also assume that your plan has an index fund, but it charges 0.5%, which is relatively high for an index fund when you could pick up VFINX for 0.15%. Just because your plan has a fee that is more than double what you could get elsewhere, does that mean you should skip your plan? Let’s take a look
Assuming you defer 3% of your pay, you will save $1,500, and your company will match another $1,500. Because of fees going forward, your annual expense on $3,000 would be $15. If you invested that same $1,500 into an IRA and with VFINX, the annual fee on that would be $2.25. Seems like a savings, but you actually threw $1,500 away for the sake of saving a couple dollars on fees. Probably not a smart move.
This isn’t to diminish the impact of fees, but you do need to put things into context before dismissing your plan altogether. Weighing the fees with respect to any potential match should be done before assuming that any plan with X% fees is a bad one. If there is no match to be concerned with, then it really is more or less an apples to apples comparison, and the low fees win.
Fund Minimums
One fact that is often overlooked when comparing the benefits of contributing to a 401k versus an IRA is the minimum investment needed. If you look at the minimum investment required for most funds, you need to have between $1,000 and $3,000 just to open an account. For someone just starting out, it can take a while to build up that initial purchase. This also hurts in terms of diversification. If it takes you $3,000 before you can open another fund, it might take someone quite a few months, or even a few years just to be able to buy one stock fund and one bond fund, and when they do, they now have roughly a 50/50 mix of stocks and bonds, which may certainly not be appropriate.
On the other hand, with 401k plans you can begin diversifying immediately, possibly with as little as $5. In these plans, you can buy fractions of funds that might otherwise require you to save a few thousand to invest in. This means you can keep your investment allocation true regardless of how much or how little your contributions are.
After All Said and Done, You May Not Have a Choice
Even after analyzing your plan for all the pros and cons, there is one thing that might put a snag in your plan, and that is IRA eligibility. For most people, in order to save money for retirement on a pre-tax basis, the only two options are through your employer-sponsored plan, or a traditional IRA. The bad news is that the IRS wants you to contribute to your 401k before an IRA. They can do this by placing limits on what contributions are deductible.
If you are eligible to participate in, whether you decide to or not, the IRS says that your income must fall below a certain level if you want to deduct your IRA contributions. For 2008, a married couple that have employer-sponsored options (401ks and pensions count), your MAGI must fall below $83,000. It phases out above that limit, and deductibility is gone completely over $103,000. Single filers need to have income under $52,000 for full deductibility, and phases out completely at $62,000.
Ouch! If you make a modest amount of money and have a retirement plan available to you, even if you don’t contribute to it, the IRS is going to tell you that you can’t receive any tax deductions for traditional IRA contributions. In this case, your only option is to participate in your employer’s plan if you want an up-front tax break. Of course, this doesn’t apply to Roth IRAs, but then again, those aren’t pre-tax accounts, and aren’t the same as a 401k anyway.
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Two comments:
1. Vanguard - as someone who was on his company’s 401K committee, and who has looked into a possible Vanguard 401K, I can tell you that the services that they offer are not adequate for many companies - which is unfortunate. All of my personal money is in Vanguard funds, and I was really hoping we could use them for the company, but the deal they offer is simply not good enough.
2. Expenses - the real trick is finding out the real cost of your 401K plan. Again, as someone who was on the aministration side of a plan, even we couldn’t get straight answers on the true cost of the plan. It’s really tough.
Good point shadox. A lot of people simply don’t understand how companies select plan providers, what it really costs to run them, and the services that are provided between companies. Most people think all an employer has to do is call up a fund company and join a plan, but it doesn’t quite work that way.
Plan pricing will depend on a lot of factors such as what administrative tasks the provider will do, what has to be outsourced, what has to be picked up by human resources, book keeping, and so on.
So, I agree that if someone finds themselves in what seems to be a poor plan they should bring it up to their employer. But people have to realize that just because their company didn’t go with a provider such as Vanguard, it doesn’t mean they are sticking it to the employees on purpose, since it really may not be a viable option.
And yes, getting to the bottom of all costs associated with the plan can be tricky, although I believe some changes regarding disclosure are coming down the pike (if they haven’t already. For employees, the expenses are fairly easy to identify, but if you want to see exactly who’s getting what part of the fee and what the employer is paying/passing along, that is not readily available.
Here’s another one…Limited choices. I work for the government and our 401k, the Thrift Savings Plan (TSP), has 10 choices–5 lifecycle funds, and one each of bond, international, fixed income, small cap, and S&P Index. It drives me crazy!
James, thanks for bringing that up. That was actually one of the items I was going to add, but I completely forgot. Granted, you don’t need dozens of funds to pick from, but you should at least have a few options across the major asset classes.
Here’s another thing regarding company match. Don’t ever use the excuse that you probably won’t be with the company long enough to become vested. I can’t tell you how many of my friends have said that. Before they know it, they’re with the company long enough to have been fully vested and gave up a bunch of free money, not to mention the foregone capital appreciation on top of it.
WealthBoy, that is a great example. I actually stress this fact when I’m presenting our plan to the new employees coming in here. I always tell the young people especially that nobody knows what the future holds, and even if you don’t plan on being with the company forever. A few years go by pretty fast.
That is a common thing I hear in my meetings as well. I get people who come in and who have been with the company for maybe 4 or 5 years and finally enroll, and they always say they regret not signing up right from the beginning.
What’s the worst that can happen if you do leave before you vest? You still put money away, you still reduced your taxes, and you can just roll that money into an IRA. No harm, no foul.
Jeremy: Don’t 401(k) plans have more legal protection (in the case of lawsuits) than IRAs?
James: The TSP is a really nice plan compared to a lot of 401(k)s I have seen. The fund expenses are super low.
Chris, that is another good point. All of these comments are telling me I should do a comprehensive compare and contrast of different retirement plans.
But in 2005 the laws were changed to provide added protection to IRAs, so they are a bit safer, but as you mentioned, a standard qualified plan is still going to be a bit safer for most people as there are some state exemptions and limitations that can be placed on IRAs.
So, that is another valid reason to consider the 401k if you’re eligible for one. It is also a good reminder that having an umbrella policy in place is always a good idea if you have assets to protect as well.