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, check out mutual fund expense ratios for example, 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 (Update: 401k limit 2011, 401k limit 2013). 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.
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.
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, figuring out how to invest with little money is not easy. 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.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
I had a terrible 401k plan for my company. I never really understood how it worked and the gentleman that originally set it up seemed to disappear once the plan was created. A few years ago I was forced to find a new firm to handle the plan after getting inquiries in the mail from the IRS that I had no idea how to handle. I found Steidle Pension Solutions and they have handled the plan ever since. There make the plan easy to deal with, they are friendly and happy to answer questions on the plan and are always available for advice.
I'm 60 years old and some of my colleagues told me that I could increase my contribution for my 401k plan and my company should match whatever contribution I additionally pay. Please advise if this is legal.
Several good points you've made. I am an advisor, and I have done 401(k) reviews for companies. You are right, there are a lot of bad plans out there. What is really bad is when the employer has someone who doesn't care at all about their plan and doesn't take the fiduciary role seriously.
That is why to get plan reform, you may need several employees to get the message across. Penelope Wang says the same thing in her article. The biggest problem with 401(k)s to me is that employees need a much better understanding of how it works. They need to realize that the 401(k) is their retirement savings plan. Pensions are gone. For the 401(k) to work, employees need more professional advice on how much to save, how to diversify, etc.
Interesting that you mention how several funds DO beat the index. In my book, "Help! My 401(k) Has Fallen - And Must Get Up!" I devote a chapter to the S&P 500. It consists of 500 large cap companies in the US, so it is NOT diversified as we are led to believe. I also show illustrations of some common funds which have outperformed the S&P for the past 10 years. The book should be available by late April/early May.
A free report "The 5 Biggest Problems With 401(k) Plans - And How To Fix Them" is also available through my website.
Thanks Dave and all repliers for some thoughtful comments.
I read the Penelope Wang article and gto a little fired up. A few things were correct and good advice and others were way off the mark. Again its good to atleast have an index fund in the line up for large cap, like and S&P 500 Index fund but long term many funds do....yes I said DO beat the indexes. I always include a SMall cap index because small cap funds can easily go from top performer to bottm performer (James Small cap) as an example. One huge mistake she made, and that employees need to know, is that it doesn't take a BILLION dollars to get institutional shares. I provide institutional shares for plans with a Million dollars or more. She was only off by about 900 million.
Yes, and thanks Dean, Gettinga group together to bring it to the benefits team would be a good approach. Even putting up an annonomous sign up poster saying "who wants a better 401k?" would be very powerful...of course you need to promote it a little so it doesn't backfire when the HR, benefits and owners see it. if it has no signatures you'll be in for several more years of getting the shaft.
Why do companies end up with poor 401ks to begin with?
1. 401k salesmen are like used cars salesmen. They use the typical selling techniques like creating urgency by tellign the owner he only has ten days for this super special once in a life time price. False! normaly a price is good for 60 days.
2. No one at the company has the expertise to compare the plans. I've run into CFO's who didn't make a single logical statement when I was explaining the different plans.
3. Salesmen over sell their benefits and services to an extreme and then leave the company and participants with a fraction of what they promised. And the bigger the 401k provider selling the bigger the story. They hire and pay their salemen well, and in my opinion thye higher those who have sold their soles to the devil for profitts, but hey its the financial world and we should expect that after what we've learned over the years.
It also helps to get several people together when you approach the 401(k) rep for your employer. there is strength in numbers. No company wants a bunch of unhappy employees.
WOW! lots of confusing advice. The point is you want the best investments NET any fees. And you can change your plan if you have a bad one.
1. First fund expenses need to be taken in context. Sure you can get the Vanguard index fund for .18 or known in the business as 18 bases points or 18 beeps. But if your ten year avrg is -.39....OUCH! Wouldn't it be nice to have earned an average of 7.8% for ten years...Oakmark I fund did in the same category (Large Blend) but you can't get that in a Fidelity plan or a Principle plan.
The point is you want the best retunr on your money and to get that you need low fees and an Open architecture plan. This way you can choose the best funds in each category and not have to pick from a list of average or poor performing Fidelity funds or annuity funds. Do you think Fidelity hands over their good funds to a captive audiance...does concert or sports venues have $1 beer night...NOOOOO.
Get a clue and demand that your company find and open architecture plan (if it has a total of a million dollars or more) with low fees. Then just pick the best funds in the best funds inteh categories. Remember the performance should be net fund expenses so focsu more on fund performance.
You bring up some great points. One of the biggest things wrong with today's 401(k) plan is the lack of education given to employees on how to use the plan. Penelope Wang of Money Magazine has an article from the March 2010 issue "What To Do With A Bad 401(k)". She mentions that all plans have some flaws, with funds and fund management fees.
There are new regulations but many employers haven't learned them yet.
As an advisor, one question I ask on 401(k) reviews is "What process are you using to frequently review the funds in your plan for performance and fees as they compare to their peers?" There has to be a monitoring system in place.
I compare this to 'bananas'. What happens if you let bananas sit too long? Well, in a 401(k) plan, you always want the 'freshest' and least costly bananas.
I have a book coming out, "Help! My 401(k) Has Fallen - And Must Get Up!" This book is written in layman's terms to help people just like you to get more out of their long term savings. You can visit my website also for a free report, "The 5 Biggest Problems With 401(k) Plans". I hope I may be able to help.
Although my employer has a match and offers a selection of funds, the vesting schedule for their plan doesn't reflect reality. These articles ignore the fact that all of these plans have very long vesting schedules. If it takes 6 years to get your money, and in the meantime the majority of employees no longer stay with a company for more than 2 or three years on average, isn't this all just a big fat phoney shell game designed to delude employees into thinking they're getting something they're not? In addition, employers don't fulfill their responsibilities when it comes to offering investing classes. They pre-select the funds for YOU and assume we're all dummies that need to be led by our noses. They determine how your money is invested without any input from YOU. This infuriates me. Currently my employer offers few funds, and all funds which have underperformed the market for 6 years! I have a better track record of investing my own money but my employer also doesn't offer a self-directed option.
Time to get rid of the entire 401K model and let people defer 15% of their own income themselves and receive a yearly contribution from the employer. The 401K plan is obsolete and does a disservice to most employees. It needs major legislative overhaul or needs to be chucked.
hello,our company sold out to a privet owner they then reinvested my 401k with their investers ??. then layed us off indeffently.. how should i handle this?? what are my opptions
I was terminated from my job Oct.2008 I was contributing
to a company 401 k but only had done so for 2 years/
I am 63 years old. I contacted the 401k principle group
to do a direct rollover of my entire acct. to a IRA/CD
all of the funds were transferred except $1500.which
princple group said belonged to an acct that was frozen
until funds could be released. does this sound legal.
Am I able to apply for this balance under the harship
rule since I lost my job? please advise. Art Howle
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.
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.
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.
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.
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 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!
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.
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.