As featured in The Wall Street Journal, Money Magazine, and more!
     

5 Reasons to Beware 401(k) Retirement Plans

This article was written by in Investing. 24 comments.


Financial planners just love promoting 401(k) retirement plans. They have quite a few benefits, notably a tax deduction for contributions as well as a tax deferral for contributions and earnings. They’re also one of the most popular vehicles for introducing the working middle class to the stock market, something that might not have been accessible to this group in the decades before the 401(k) plan was established.

In addition to financial planners, fund management firms and plan administrators love 401(k) plans, and their love knows no bounds. Companies pay significant fees to other companies that operate and manage 401(k) plans. More fees are embedded in the funds within the plans, benefiting each fund’s management team.

CubicleThe tax advantages, as well as a potential matching contribution if an employer offers one, offset some of the drawbacks of 401(k) plans.

1. Fees.

As already mentioned, most 401(k) plans are subject to fees, many of which are not immediately apparent to the investor. If you bother to read the prospectus associated with each fund you choose to invest in, you may find an expense ratio listed. If you do, there’s a good chance it’s higher than a comparable index fund. My former employer included investment choices that were annuity products disguised as mutual funds, and these didn’t have expense ratios listed. It was nearly impossible to determine how much of my investment I was losing to funds each year.

While fees are higher with 401(k) plans than with pensions, pensions offer a stable, predictable return. 401(k) performance depends on the investment choices and the associated markets. Pensions, when they are fully funded, tend to be more stable.

2. Employers are hands-off.

As the popularity of 401(k) plans grew, pension plans disappeared. A 401(k) is considered a “defined contribution” plan, while pensions are considered a “defined benefit” plan. That comes from the idea that the 401(k) balance is affected each payroll period by a contribution from the employee, while the pension balance increases at regular intervals by a contribution from the employer — a benefit of working at the company.

The value of a pension also tends to increase as the length of service at one company increases. As the popularity of pensions and other loyalty benefits decreased over the last couple of decades, employees had a decreasing incentive to stay at one company for their entire career. With pensions being a smaller part of most employers’ benefits, they do not need to worry as much about the solvency of these accounts. At the same time, it is up to the employee to make the right investment choices in a 401(k).

3. Automatic enrollment.

The advent of 401(k) programs brought on an increase of the nation’s wealth tied up in the stock market. That’s more income for money managers. It also creates a higher demand for investments, raising prices somewhat artificially. But there has also been a more recent increasing trend of employers automatically enrolling new employees into 401(k) plans once they are eligible. It’s a great idea to stimulate a better possible retirement outcome, considering many employees might not bother to elect to invest in a 401(k) immediately, even if they intend to.

Usually, any mechanism that automates your finances is a good thing. But too much automation can create complacency. It’s important to be aware and know what’s going on with your finances rather than blindly accepting what someone creates for you. You might be better off with an increased deferral rate than the default, or you may need to cancel your 401(k) contribution before it begins to improve your cash flow for necessary expenses.

4. Automatic allocation.

Like automatic investment, automatic allocation can be a trap. Some plans will, if the employee doesn’t elect specific investments, direct all contributions to a money market fund. Any investor could probably be better off in a high-yield savings account than a money market fund managed by a large investment house, even taking into the tax benefit of a 401(k) plan.

Furthermore, some plans will automatically invest your funds in a mix of stocks and bonds, with the percentages based on your age or your expected retirement date. This may or may not be appropriate for your situation, and importantly, it doesn’t take your outside investments into account. For example, if you plan on retiring 35 years from now, your 401(k) plan might recommend an investment of 90 percent stock funds and 10 percent bond funds, but if you already have a significant investment in stocks, your overall portfolio may be closer to 95 percent stocks and 5 percent bonds.

5. Loans.

With a 401(k) plan, you can loan yourself money. This sounds like it should be a benefit. In some cases it is, but often 401(k) loans end up being detrimental to someone’s finances. If there is an emergency and you cannot pay back the loan either on time or at all, you can face fees and penalties. If you lose your job with a loan outstanding, the entire remaining loan balance could become due immediately.

Overall, 401(k) plans can help the working middle class retire somewhat comfortably. And there is the possibility for investors to succeed financially significantly more than they might have with a comparable pension. The burden for performance has shifted from the employer to the employee, and that requires a little bit of financial education that might not have been as necessary (though still beneficial) in the heyday of pensions.

Photo: Yo Spiff

Published or updated January 17, 2012. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

Email Email Print Print
avatar
Points: ♦127,387
Rank: Platinum
About the author

Luke Landes, also known as Flexo, is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about him and follow Luke Landes on Twitter. View all articles by .

{ 24 comments… read them below or add one }

avatar PK

Ahh, the dark side of a good account!

Fees are probably the top thing to look out for – not just fund fees, but account fees when maintenance costs are passed onto employees in the plan. Even a 1% fee can sap a significant amount of money out of an account over time – consider that the 2011 return of the S&P 500 was 2.1% (100% from dividends). With a 1% fee? 1.1%, almost 50% less.

Reply to this comment

avatar MoneyforCollegePro

These are the exact reasons I opted out of my defined pension plan and into an active retirement plan. I was able to control my own investments. Sure, in the defined plan the plan assumes all of the risk, but I just read in the news that the state retirement plan in SC is millions in the hole. Not exactly the wisdom I would like to invest my retirement dollars in. So, I choose to actively allocate my retirement and be responsible for whatever return I can muster.

Reply to this comment

avatar wylerassociate ♦907 (Dime)

thanks for the post flexo. good information.

Reply to this comment

avatar David M

I do not see many drawbacks in the 5 items you listed – call me crazy!

1) Fees – are they much higher than they would be if you invested in the same fund not in a 401K?

2) Employer is hands off – is he going to help you if you invest outside of a 401K?

3) and 4) automatic enrollment and automatic allocation – see both of thoses as pluses!

5) Loan – should not be needed but if it is – could definately be better than from a bank and definately is better than from a credit card company.

Thus as I said, I don’t see that much downside to a 401K!

Reply to this comment

avatar Luke Landes ♦127,387 (Platinum)

Sure! These things can also be positive aspects of an investment. It’s all in the perspective.

Reply to this comment

avatar Evan

David M,

“1) Fees – are they much higher than they would be if you invested in the same fund not in a 401K?”

Yes and No.

If it is the same fund then there could be an additional fee wrapped around the account due imposed on the manager of the money. The more likely situation is that you can’t compare the two funds as often those funds within 401(k)s are propriety to 401(k)s.

Reply to this comment

avatar David M

Thanks for your Evan!

1) With my employer there are no fees that I pay and the costs for for the funds are very low – probably the lowest in the country. As another clue – I can compare all my options to other options very easily and see if the rates I’m paying are higher or lower than others are being charged. Can you guess who my employer is? If you guess, I will tell you who it is.

2) If your employer is using funds that are propriety to 401(k)s and thus sticking you with higher fees – you should complain to your employer and possibly look for another job. Doing this, is not treating your employees as they should be treated.

Reply to this comment

avatar Steve Dupree

Running a 401(k) has real costs. Those costs can be paid either by the employer or by the employees. Many employers pay these on behalf of their employees as a benefit. If employees and potential employees don’t value that benefit (perhaps they don’t participate in the 401k, or don’t know or care what the fees are) then it’s a waste of the company’s money to pay those fees. Instead they could offer higher salaries, free soda, etc – something that the employees and potential employees would respond to.

There is a limit to that though, which is the actual cost of running the plan. If the employer just accepts the first insurance company that waltzes in and offers a free (to the employer) 401k plan, then that’s a company that doesn’t value it’s employees and/or has a lazy benefits department. That’s the kind of company you may not want to work for.

avatar Evan

I get a 100% up to 4% of my salary in a match…I am not complaining to anyone.

If you want to really see if your 401k is awesome as you think it is check out http://www.brightscope.com/

avatar Moneyman

David M,
I want to give you some very important advice. I am in the financial services business, and I will say no more about that. If you are interested in the information I provide you, you are welcome to respond. I will try to answer any questions you may have. What I have to say is pretty complex, but here goes. When 401k programs became popular there were 27 different tax brackets, therefore the idea was to put away some of the money you earned and pay tax on it and the gain when you retired. Effectively, you could put back enough each year to lower your taxable income and put yourself in a lower tax bracket (or even two or three) each year. Then, the idea was that when you retire you may not need as much income to live on, so you would also be in a lower tax bracket and pay less tax. Then, in the 80s when tax brackets were consolidated, there are now only six. So, the idea does not work as well today. Most people cannot contribute enough of their income today to put themselves into a lower tax bracket, and when retirement comes they will probably not be in a lower tax bracket then either. Today, when we look at the state of our economy and our national debt, we cannot dispute the fact that taxes are going up now and in the future. If you are someone close to retirement, then this will not be a problem for you. However, if you are young enough and have at least 10 years from retirement, then contributing the maximum amount to your 401k each year is a mistake, tax wise. Don’t get me wrong 401k’s are very good, provided there is a match. 100% return on your investment immediately is impossible to beat (or even a 50 cents on the dollar split). My suggestion is to only fund your 401k to the match and have someone professionally manage your account or do it yourself. Next, you should fully fund a ROTH IRA. With a Roth, I am sure you know, it is funded with after tax dollars, and when you retire you pay zero tax on the gain. Just by trying to be tax diversified 50/50 will make a HUGE impact on your retirement funds. There are a few drawbacks to a ROTH as well as your 401k. You may make too much money to qualify for a ROTH, because it is based off of your income. Second, you can only contribute 5,000 a year until after age 50, then you can contribute 6,000 a year. The last major drawback of both a Roth and 401k is that you can’t access the money until 591/2 without paying a penalty. I also want to caution you on taking loans against your 401k. This is a horrible idea, ever. I do not have time to get into why, but please do the research before you make that decision. I hope, if nothing else, this has given you something to think about. One last thing, if you do not qualify for a Roth, there are all kinds of places to put money to get the same benefits as a Roth would give you, and your money would be accessible when ever you need it without having to pay a penalty, and in some cases no tax on the gain. There are probably 1,000 books written on this subject. So, if you are interested just look on the net. My goal in life is to teach. I enjoy learning, and teaching others what I myself have been fought by others. Good luck.

Reply to this comment

avatar David M

Moneyman,

Thanks for your long and detailed response MUCH APPRECIATED!

Regarding loans from a 401K – no worries there is no chance that I’m going to take a loan – lots of downside with very little upside to a 401K loan. I actually believe that the law should be changed and once $ are put into a 401K the person should not be able to take out and/or borrow against them – no if and or buts!! Make it a lockbox as people like to say. The chances of the law being changed as I would like – ABSOLUTELY ZERO!!!!!

Again THANKS!

Reply to this comment

avatar KC @ PsychoMoney

Great points. I love the comment by PK that starts things out, The Dark Side.

It is hard and people need to understand all of this better so they can then make better decisions, gone are the days of just put it in an account and it will grow, or dont worry your employer will take care of you. That is why we need more education on 401K’s and the like.

Reply to this comment

avatar Steve Mertz

Good points, as usual Flexo! For the majority of individuals the 401-k is the best thing that ever happened-to a point. Unfortunately, most participants never really learn about the hands on management of their funds and more importantly, their exit strategy when it’s time to turn this money into cash flow. From the governments perspective-they know where every dime is and if you believe as I do; that taxes will continue to go up-your tax bill will be horrific.
I’m a huge believer in making some after-tax contributions in your 401-k. Food for thought.

Reply to this comment

avatar jim

Personally I think that the #2 item is a positive thing. With a pension the employer has control over the money and can manipulate the finances. Many / most pensions are underfunded which means the company doesn’t have enough money in the pension to meet its obligations. Then when the company goes bankrupt the government has to step in to bail out the pension fund. None of that can happen with a 401k which is handled by a separate financial institution.

Reply to this comment

avatar Steve Dupree

Even if the pension is fully funded when you are working there, it could become underfunded later.

Reply to this comment

avatar Pat S

Also… you can’t touch the money penalty free until 59 1/2…

Reply to this comment

avatar David m

@steve dupree,

I agree with you 100 percent as what you wrote totally agrees with what I wrote.

If a company does not pay 401k fees and/or shafts you with high expense funds – all things being equal, this is not a company to work for.

My employer pays all the cost of running the 401k and the fund fees are rediculously low.

Reply to this comment

avatar Steve Dupree

We are saying two different things on the same spectrum.

Reply to this comment

avatar Tyler S.

Great stuff, not just blasting away at these 5 aspects of the 401k, just giving a warning about some potential downfalls that the average person might not have a clue about, and could lose out because of it.

I would agree with previous comments that automation is a plus, but once again, this is going to benefit someone who knows what they’re getting into the most, and someone who don’t fully understand the setup could be hurting themselves.

Reply to this comment

avatar qixx ♦1,826 (Half-Dollar)

Another thing is that depending on the funds available to you you might get better return elsewhere. If your company matches funds you are probably better taking the match. If they don’t match or you don’t qualify for the match you might get a better return and lower fees taking your money elsewhere. One example would be an Index fund with an IRA might be better than the actively managed funds in your 401(k). My last company’s 403(b) did not offer any Index funds and i did not qualify for the matching they did.

Reply to this comment

avatar David M

What about the 401K/403B allowing you to put $17,000 away tax defferred. If you are eligible to participate in a 401K/403B but do not as the funds are not that good – can you put $17,000 into an IRA or are you still limited to $5,000?

If the answer is still limited to $5,000 then being able to defer $12,000 more $ may be a reason to participate in the 401K/403B even if they have less than optimal funds available to you.

Reply to this comment

avatar qixx ♦1,826 (Half-Dollar)

I should have added a disclaimer that i was not yet hitting the IRA max input for the year. I was only putting away around $4200 a year (12% of around $35,000).

Reply to this comment

avatar David M

Thanks for the reply now I understand why you did what you did.

Reply to this comment

avatar Roger Wohlner

Good article and many good points. As an advisor/consultant to several 401(k) plans I have a few thoughts:

Fees and expenses are critical. As of July 1 plan sponsors (mostly via the recordKeeping firm) will be required to provide employees with disclosures about the expenses charged to their accounts via the plan. In some cases this will be a real eye opener. Low costs are key. I generally use a mix of index funds and active, always with an eye towards the lowest cost share class available.

As far as employers being hands-off I’m not sure that I agree in all cases. My clients hire me to act as an extension of their investment committee. Together we monitor the funds, replace funds when needed, monitor expenses, and the performance of the plan provider. I can say that all of my plan sponsor clients are interested in doing the best they can for their employees. On the flip side I have a few individual clients with 7 figure 401(k) plans. These folks were not excessively high earners, but rather they saved on a regular basis. That all said I have also seen more than my share of high cost plans with lousy investment choices and plan sponsors who aren’t all that concerned about them.

My issue with auto-enrollment is that too often the deferral rate is too low. This lulls participants into thinking the 1% or 2% is sufficient to fund retirement. I think we can all agree this is not generally the case.

You point about auto-allocation is fair. The Pension Protection Act of 2006 created QDIAs (Qualified Default Investment Alternatives ) which offer a safe-harbor for plan sponsors. Target Date funds and balanced funds are acceptable QDIAs. While I’m not a fan of Target Date Funds for many of the reasons you mentioned, plan sponsors do need to have someplace to put participants who refuse to make their own choice.

401(k) plans have their flaws, and there are certainly many plans are in need of an overhaul. On the other hand if used properly these plans offer a great “painless” vehicle for retirement savings.

Reply to this comment

Leave a Comment

Connect with Facebook

Note: Use your name or a unique handle, not the name of a website or business. No deep links or business URLs are allowed. Spam, including promotional linking to a company website, will be deleted. By submitting your comment you are agreeing to these terms and conditions.

Notify me of followup comments via e-mail. You can also subscribe without commenting.

Previous post:

Next post: