Your employer retirement plan may be Frankenstein. When Mary Shelley penned her novel in the early 1800s, she had no idea about the need for workers to save money to fund retirement. But the premise of the book is that a scientist creates life and is horrified by what he has made.
In the case of retirement savings, it’s our legislators playing the role of scientists creating the tax code.
One iteration of the code came in 1978 when section 401(k) was created allowing tax-deferred retirement savings. Of course, this also paved the way for more employers to stop offering pension plans and start shifting responsibility for retirement income to the individual. Deeper scrutiny of 401(k) plans over time has caused many people to be horrified at how poorly they’ve helped the average worker build financial security. Maybe horrified is a stretch, but it’s true that the 401(k) is an experiment that has been pieced together with many adaptations over the years, most of which have not done enough to help people replace their income in retirement.
Since the Pension Protection Act of 2006, the 401(k) monster has been modified with the addition of automatic enrollment, improved default investment vehicles, after-tax Roth options and most recently, fee transparency.
These changes have made Frankenstein more human, but the monster still lives.
UNCLEAR COSTS ADD UP
The effect of fees – especially in small employer plans – is certainly one of the horrifying features. A private research firm, Demos, published research in 2012 suggesting that two-earner families, earning median income could lose nearly $155,000 to 401(k) costs over a 40-year working career.
The results are worst for employers with 100 participants or less in their retirement plans. The median expense ratio (annual management fee) for mutual funds in 401(k) plans in 2010 was 1.27 percent. It was 1.29 percent for small plans and just 0.43 percent for plans with 10,000 or more participants.
Add trading costs of an estimated 1.2 percent per year and fees could consume a quarter of the investment returns over time. All 401(k) statements are now required to document fees. This visibility may bring more attention to the matter but seeing an estimate of fees for one year may not drive someone to action. Understanding the magnitude of the drag from fees over time is much more influential when the impact is demonstrated with six figures.
THE PERSONAL DISCONNECT
Excessive expenses are hideous. But there is an even bigger problem with most 401(k) plans. Rarely is there access to guidance that is relevant to your personal financial situation and retirement goals.
Participants mostly receive educational materials or online tools to steer them toward suitable investments. But few plans offer advice about how the 401(k) fits with all the other pieces of your financial life. How can you integrate investment management across multiple accounts (spouse’s retirement plan, IRAs, taxable accounts, etc.)? How can you invest in the best of the limited 401(k) investment offerings and use other accounts to further diversify or gain access to investment options with better performance history and less cost? How can you determine the future value of your 401(k) and other retirement income sources given different contribution rates or different investment strategies? How do you know if your savings rate will accommodate a comfortable retirement?
These are the points that need to be addressed in planning for retirement, and not enough people are thinking about it this way.
WHAT TO DO WITH YOUR 401(K)
If you don’t have low-cost investment options in your plan, you and your coworkers should request that the plan administrator add index fund choices. That request may be somewhat out of your control. But there are other factors that you can control.
First, invest the time – or hire an independent adviser – to determine your retirement income goal and get a sense of how retirement plan savings will supplement Social Security and other income sources.
This bit of planning will make it obvious that you shouldn’t pass up any free money. If your plan offers any level of matching contribution, make sure you contribute enough to receive every dollar of it. Even excessive fees can’t offset free money.
After you obtain all matching funds, decide whether it would be more advantageous to fund a Roth IRA (if you are eligible) or continue funding your 401(k). Either way, until you’re saving at least 10 percent of your income, you’re likely not saving enough for retirement.
If you’re retired, there is not much reason to keep your money in the employer plan. Expand your investment options and take control of your costs by moving these assets over into a Rollover IRA. An IRA also provides more useful options for beneficiaries and flexibility for stretching the account beyond your life.
Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones in Old Town Tacoma. Read his blog at themoneyarchitects.com.
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