Is your 401(k) plan a good deal or a rip-off? How do you know if you have a good 401(k) plan at work? What should you do if you don’t have a good plan? These are important questions. Not everyone has access to a great retirement plan with low costs, diversified investment options and a generous employer match. We will go through some questions you should ask when reviewing your retirement plan at work, and give you some ideas on what to do if you don’t like your options.
Does your 401(k) offer matching employer contributions?
One of the most important questions to ask is whether or not your employer offers a match on your retirement savings. If they do, you generally want to take advantage of the match because it’s essentially free money. When I hear about people who have employer matches but don’t contribute enough to get the full match, it leaves me confused. Don’t you like free money? Even if the match has a pretty strict vesting schedule, you should still participate. Just assume you will still be working there when the match vests. Otherwise you are leaving money on the table. Free money.
Next up, what are the fees on your 401(k) plan?
These include plan administration fees (the cost to actually run the 401(k) plan which some employers pass on to participants) as well as the fees charged on the investment options offered within the plan. The fees charged on the investment options inside the plan could include expense ratios, 12b-1 fees, insurance wrappers and sales loads. Over the last couple of years these fees have been receiving a lot of attention from regulators, employers and employees. If you can’t easily find the answer on your benefits website then send an email to your Human Resources representative. They should be able to get the answer pretty quickly.
In general, I start to get pretty suspicious of mutual fund fees over 1%. If the fees on your investment options are pretty expensive (perhaps they include sales charges or 12b-1 fees) ask your HR rep about this as well. What do I mean by “pretty expensive?” Again, that 1% number comes up but don’t just look at expense ratios. You may find that a Large Cap Value fund in your plan has an expense ratio (the fee the mutual fund company charges to manage the fund) of 0.9%. BUT on top of that there is a 12b-1 fee of 0.25% which brings the total cost of investing in that fund to 1.15%. The expense ratio is charged on the money you have invested in that fund.
By law your plan administrator has to share with you the fees you are charged on your retirement plan. Most plans make these available on the website you sign into to check your balance or change contributions. If you can’t easily find it reach out to Human Resources and ask for the fee disclosure.
What kind of investment options do you have in your 401(k)?
Hopefully you have access to some index funds or other low cost investments available to you in your plan in a variety of asset classes. Why do I like index funds? Three reasons:
1) Traditional index funds tend to outperform active funds on an after-tax and after-fee basis1
2) They are cheap
3) Index funds can help you easily manage your asset allocation
Most people don’t realize that the bulk of your investment returns are determined by your asset allocation (how much of your portfolio is held in stocks, bonds and cash). When you hold a plain vanilla index fund (i.e. something that tracks the S&P 500, Russell 2000, MSCI EAFE, etc.) it’s much easier to understand what you own and when to rebalance your portfolio. Asset allocation doesn’t mean simply holding an all stock portfolio and trying to earn as much as possible. Instead it means having a properly diversified portfolio that includes stocks, bonds and cash that can (hopefully) help even out your portfolio returns over time.
Let’s dig in a little deeper here. When it comes down to it, two of the most important things you can control in your retirement plan portfolio are your allocation and your costs. Index funds and other passive investments tend to be very inexpensive, costing less than 0.25% a year. Those savings on your investment choices go directly into your pocket. Keeping more money in your retirement account increases the effect of compound interest (check out this video on compound interest). Putting compound interest to work ultimately means you could have more money to spend in retirement.
Does your 401(k) have a Roth option?
One final consideration that is coming up more and more often - does your employer offer a Roth option in your 401(k) plan? This can be a really attractive feature, particularly for younger or early career employees who anticipate that they will earn more money as they get older. A Roth feature in your 401(k) is set up like a Roth IRA. You don’t get an income tax deduction now on your contributions, but your savings do grow in a tax sheltered account and, under current law, can be withdrawn after age 59 ½ tax free.
Should you contribute to a Roth 401(k)? This really depends on your situation. Some things to consider - if you think you will earn more money in retirement or income tax rates will be higher when you are retired, you may want to participate in the Roth option. Alternatively, a traditional 401(k) may be better if you are in your peak earning years and you think your income bracket will be lower in retirement. Again, a CERTIFIED FINANCIAL PLANNERTM practitioner can help you make these decisions depending on your personal situation.
Great, now what?
OK, so now you know what things you need to think about when it comes to evaluating your retirement plan options. So, what happens if it turns out your retirement plan stinks? First, ask your HR department to improve it using some of the ideas I have gone over above (offering a match, lowering fees, getting better investment options).
Work for a small business? This can be a bit tricky - you don't want to insult your boss. However, if high fees are a concern for your 401(k) plan then those fees are affecting your boss as well! At the end of this article from Time Magazine they list some great ideas on how to frame this conversation with your boss - check it out. Then I would go through the following questions:
→ does your plan offer a match? If so, contribute at least up to your match.
→ are you in your peak earning years and really need the tax deduction? If so, It may be worthwhile to save in your 401(k) and lobby your HR department for better options. (Ask your tax planner for advice)
→ does your plan offer a Roth option? This can be very appealing to some people.
→ are you saving regularly on your own now? There is a behavioral benefit to saving in the 401(k). It’s easy and automatic. Most people greatly benefit from the automatic savings an employer provided retirement plan offers. I know I benefit from automated savings.
→ If your 401(k) has lots of fees and does not offer a match you should explore contributing to a Traditional IRA or Roth IRA instead. For most people, even maxing out an IRA won’t be enough retirement savings. They will also need to open a taxable account.
Now you know how to evaluate your company retirement plan and when you should approach your HR department about improving your plan if it’s not great. Remember that contributing enough to get an employer match is usually a good way to go. Try to keep your fees and expenses low and don’t be shy about asking your plan provider about the fees in your 401k.
Wondering why fees matter so much? Read this for an example on how excessive fees can eat into your savings and slow you down on the path to building wealth.