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.

The 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

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I used to work for a company in the financial services industry. Another branch of the corporation I worked for is involved with institutional money management. This department manages institutional investments like company retirement plans and pensions. This is a service they provided to other companies of various types, much like Fidelity and Schwab offer 401(k) management and administration to companies. This could be considered an in-house service, so as an employee of the company, my 401(k) plan was managed by this branch of the same company.

You would think that given the company’s standing within the financial industry, the 401(k) plan would include smart investment choices. Unfortunately, most of the funds available are high-priced, actively-managed mutual funds and annuity funds. There is one stock market index fund available, but its expense ratio is significantly higher than those of the low cost index funds found elsewhere. Nevertheless, I wanted to take advantage of the company’s matching contribution — after all, that’s free money — as well as the tax savings, so I relented and participated in the plan.

401(k) plans — and 403(b) plans available to non-profit and educational organizations — suffer from poor investment choices. They are often significantly more expensive than the index funds you can find for IRAs. A fund’s expenses play a significant role in an investor’s ability to grow wealth over time. A low-cost fund could save an investor over a hundred thousand dollars over the course of a career when compared to a similar fund with above-average expenses. Even taking inflation into account, this will be a significant amount of money.

Schwab has announced that they are now offering a selection of new 401(k) investment choices designed to cater to investors who are keen on keeping more of their money in a program called Schwab Index Advantage. It isn’t clear from the announcement whether the available funds will match what’s currently available to retail investors, but if they aren’t the same funds, they should be similar in cost. The Schwab S&P 500 Index Fund has an expense ratio of 0.09%, lower than even Vanguard’s competing retail S&P 500 Index Fund with 0.17%.

The brokerage also offers companies the ability to provide employees with investment advice and planning tools for an unspecified low cost. The GuidedChoice system will help employees make ongoing decisions regarding their retirement investing, and this should help employees save more for retirement. It’s individualized advice, which isn’t common with retirement plans. Most employees are lucky if their retirement plan comes with a web application that helps them determine an asset allocation strategy; individualized advice could, if the advice is good, help investors grow their nest eggs in a way that’s most appropriate for their goals.

Are you satisfied with your 401(k) retirement plan, its choices, and its included advice?

Charles Schwab

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