Over the past quarter of a century, 401(k) plans have evolved into the dominant retirement plan scheme for most U.S. workers. While many improvements have been made to the structure and features of 401(k) plans since their creation, they're not perfect.
There are issues with the current 401(k) structure that make such vehicles less than ideal. But there are also ways to mitigate the impact of these problems, making 401(k)s ultimately worth your time and money.
Here's a look at six issues that have the current 401(k) plan structure, as well as ways to temper the effects.
- While 401(k) plans are a valuable part of retirement planning for most U.S. workers, they're not perfect.
- The value of 401(k) plans is based on the concept of dollar-cost averaging, but that's not always a reliable theory.
- Many 401(k) plans are expensive because of high administrative and record-keeping costs.
- Nonetheless, 401(k) plans are ultimately worth it for most people, depending on your retirement goals.
You may have bought into the concept of dollar-cost averaging because it was explained to you as a prudent investment methodology. Unfortunately, dollar-cost averaging is simply a convenient solution to justify the contributions channeled from your employer to your 401(k) plan.
To explain, defined contribution plans, like your 401(k) plan, require periodic contributions to be made to your retirement account with each paycheck. For this reason, without a theory such as dollar-cost averaging, funneling money on a periodic basis from your paycheck to your investment options would not make sense. Your investment options may be fully valued or, even worse, overvalued at the time the contributions are made.
Fortunately, you can take control of your investment process by directing all of your contributions into a conservative investment option that is offered in your retirement plan. Then, when the time is right, you can make a strategic investment allocation to one or more of the less conservative funds offered in your 401(k) plan.
Of course, you'll have to determine when the switch looks attractive from an investment standpoint. Nevertheless, you should expect this type of responsibility if you participate in a defined contribution plan.
Long Investment Time Horizons
You have probably been told that your employer established a 401(k) plan on your behalf in order to provide you with a long-term savings plan for retirement. Given this premise, you may believe that you should develop a long-term strategic asset allocation based on a time horizon that exceeds a decade.
Unfortunately, it's highly unlikely that the portfolio managers who are currently managing your investment options will be managing them 10 or more years from now. So for strategic allocation with a long-term focus, index funds can mitigate the likely mismatch between the shorter-term tenure of your fund managers and your longer-term investment holding period.
Most active mutual funds do not outperform their index or benchmark, and you are better off putting your money into an index fund. A 1% saving can mean tens of thousands of extra dollars at retirement.
If index funds aren't offered in your 401(k) plan, your current fund managers will be managing your money for many years to come. However, there is another option.
First, you can develop a tactical asset allocation contingency plan in the event that one of your portfolio managers relinquishes responsibility. Next, you could open a traditional IRA or Roth IRA and contribute up to your legal limit through various index funds not available in your 401(k) plan.
A qualified 401(k) plan is an expensive employee benefit. 401(k) plans entail many compliance issues that have to be monitored and constant service and administration. What's more, a number of education and communication services must be offered to plan participants.
Given these mandates, it's highly likely that you are paying for them through things like:
- Participant fees
- Supplemental asset-based charges
- Itemized costs for services such as loans, hardship withdrawals, and qualified domestic relations orders
- Higher fund expenses
Costs are particularly steep for smaller employers and plans where a lack of economies of scale fosters higher expenses.
Fortunately, you can mitigate the negative costs of your 401(k) plan by developing a tailored retirement plan strategy. First, you should always invest in your 401(k) plan up to the point where you receive 100% of your employer's matching contribution.
Then, you should open a traditional IRA or Roth IRA and contribute up to your legal limit. The investment options available to you through an IRA will be much greater and less expensive than the investment options available to you through an employer-sponsored 401(k) plan. One warning, though—if you or your spouse is covered by an employer-sponsored retirement plan, and your income exceeds certain levels, you may not be able to deduct your entire contribution.
After you have maxed out the money that you can contribute to an IRA, you should then increase your contribution rate in your 401(k) plan to reach your desired level of savings.
Recordkeeping for assets in your 401(k) plan is complex and time-consuming, even with today's technology. Therefore, few retirement plan providers distribute investor-friendly statements. Instead, they generate only what the law requires, which is not sufficient for you to make a useful financial assessment of your investment strategy.
To successfully plan for retirement, you need to know on a monthly basis your beginning account balance, how much you and your employer contributed, the number of transfers or withdrawals you made, the amount of any gains or losses, and your ending balance.
Unfortunately, your record-keeper probably doesn't provide this information in a user-friendly way. To get the data, you may have to extract the information from your monthly or quarterly statements and build a spreadsheet to track the details.
Once you have properly compiled the information, you should manually calculate your annualized rate of return. It's worthwhile seeking outside advice to get an accurate view of how your investments are performing.
"Often, it is difficult to go through your quarterly statement and decipher how well your investment strategy is working," says Carlos Dias Jr., founder and managing partner of Dias Wealth LLC in Lake Mary, FL.
"By consulting with an outside fee-only advisor," Dias adds, "you can see how your 401(k) investments are really performing and what modifications can be made without having to transfer to an IRA."
Most active mutual funds, on which 401(k) plans are based, don't outperform their index or benchmark. You're better off putting your money into an index fund.
Limited Investment Options
In terms of retirement plan design, the conventional wisdom in the 401(k) plan investment industry is that "less is more." For example, a comprehensive retirement plan design offers a group of investment options that cover roughly five asset class categories. These categories, in order of theoretical risk, are as follows:
- Money-market funds or stable value funds
- Core bond funds
- Large-capitalization funds
- Small-capitalization funds
- International funds
The concept behind "less is more" is to streamline your investment decision-making responsibilities to minimize the complexity of your investment choices. You can develop a diversified portfolio by investing in funds that fall into these five asset-class categories.
But it's likely that you'll also need access to Treasury Inflation-Protected Securities (TIPS) funds, high-yield funds, real estate investment trust (REIT) funds, mid-capitalization equity funds, emerging markets funds, and commodity funds to build a comprehensive portfolio for your long-term financial needs.
"When I find a client’s 401(k) has limited (or subpar) investment choices, I always look to see if they have a self-directed brokerage window available to them," says Carol Berger, CFP® with Berger Wealth Management in Peachtree City, GA.
"This allows them to open an account on the 'brokerage window' side and opens up many more investment choices," Berger adds. "The client then has their regular contributions go into this account versus the 'regular' 401(k) choices."
The quality of the investment options offered in your plan may be well below average, particularly if you are a participant in a small retirement plan. You should thus assess how comprehensive your 401(k) retirement plan design is and conduct a thorough due diligence analysis before making any type of investment.
Once this assessment is complete, your best course of action is to notify your human resources department of any enhancements that should be made. In addition, you should offset any of your 401(k) plan deficiencies by investing in a host of index funds through an individual IRA.
Kirk Chisholm, Wealth Manager at Innovative Advisory Group, Lexington, MA
One frequently overlooked option for an investor who has a poor selection of fund choices is to speak to your employer.
Frequently, employers are not deliberately trying to provide you with poor choices. Many times they are given these choices by the advisor on the plan.
If you request different or additional options, it is possible your employer will say yes. Many employers are looking for this type of feedback.
Complex Tax Implications
Arguably the most highly touted 401(k) plan attribute is the pre-tax treatment of invested cash flows. This feature is important because if you have more money to invest upfront, you should have a greater opportunity to enhance your returns down the road.
However, before accepting the premise that pre-tax investing is an investment advantage, keep in mind that when you withdraw your money from your 401(k) plan, the entire amount will be taxed at your personal income tax level.
This may be a disadvantage if your investment strategy achieves substantial long-term gains that could have been taxed at the lower capital gains tax rate level. Since these gains will be taxed as income under a 401(k) plan structure, your perceived pre-tax advantage on the front end will be offset to a certain degree by the tax disadvantage on the back end.
Assessing tax implications is complex because your tax status and tax laws will change over time. In addition, new retirement plan schemes will be developed in the future. Therefore, what looks like a good deal today may very well be a bad deal tomorrow.
What Are the Advantages of a 401(k)?
A 401(k) has many advantages for someone saving for retirement. Among the highlights: contributions are made on a pre-tax basis, lowering your yearly taxable income; some employers will match a portion of your contributions, increasing your savings; 401(k)s are protected from most creditors, due to the Employee Retirement Income Security Act.
Is It Better to Have a 401(k) or an IRA?
Many investors choose to have both as they each offer advantages for saving. An Individual Retirement Account (IRA) will have a greater variety of investment options, but only a 401(k) has the potential for employer matching funds.
A 401(k) also allows for greater contributions than an IRA. For 2022, 401(k) contribution limits are $20,500 (plus a $6,500 catch-up for people aged 50 and older). Employer contributions in 2022 are $61,000 plus the $6,500 catch-up amount. For 2022, IRA contributions are $6,000 (plus a $1,000 catch-up for those aged 50 and older).
Do You Need a 401(k) and a Savings Account?
A 401(k) and a savings account can serve different purposes. A 401(k) has all of the advantages mentioned in the article, including offering pre-tax contributions and employer matching funds. However, the funds in a 401(k) are not easily accessible. In fact, there are usually penalties for withdrawing money early. A savings account can augment a 401(k) by holding funds that are more readily accessible in an emergency.
The Bottom Line
While 401(k) plans are an important part of your employee benefits package, the issues associated with some of their provisions are problematic. Remember that in a defined contribution pension plan like the 401(k), you bear all of the investment risk.
The amount of cash that's in the fund when you retire is what you will receive as a pension. Thus, there is no guarantee that you will receive anything from this defined contribution plan.
The fund may lose all (or a substantial part) of its value in the markets just as you're ready to start taking distributions. While that's true of any financial investment, the risk is compounded by the relative inaccessibility of 401(k) money throughout the account's—and your—lifetime.
"The final problem is that your 401(k) assets are not liquid," says Dan Stewart, CFA®, president of Revere Asset Management, Inc. in Dallas, TX. "Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement. Do not put all of your savings into your 401(k) where you cannot easily access it, if necessary."
Consider these issues and take an active role in preparing for your financial future. With careful planning, you should be able to mitigate the negative features of your 401(k) plan and meet your retirement plan goals.