I have a confession to make: I have a crappy 401(k) plan.
As a long-time employee of a small business with a bad 401(k), I’ve suffered from diminished returns due to excessive mutual fund fees.
Recently I learned that when the plan was set up years ago, the company hired a third party that didn’t have the employee’s best interests in mind. At the time, there were few options for a company of our size.
Fast forward to today, the 401(k) plan is often an afterthought because our HR person in charge of the plan also keeps the office running. He takes care of payroll, billing, health benefits, recruiting, scheduling… you name it.
Historically, small businesses have lacked affordable options in 401(k) administration because the top plan providers tailor their services to larger companies. Yet small businesses make up 99.7% of U.S employer firms, accounting for nearly 50% of private sector employment according to a 2014 study by the SBA.
Today, with modern technology and a strong demand for transparency, low fees and a simple user experience, small businesses have excellent 401(k) plans available to them, narrowing the disparity between large and small employers.
But that doesn’t mean your employer is offering you the best plan out there. Like mine, your HR person could have inherited a bad 401(k) plan, and sometimes it’s easier (not better) to stick with what you have than to find something new.
One of the hardest things for most companies when it comes to looking for a new benefits program, is knowing what a good plan looks like.
Here are three telltale signs that your employer has a crappy plan.
1. The Fees are Too High
Over a long-term investment horizon, the biggest risk to a 401(k) retirement portfolio isn’t market fluctuations, it’s fees. The average small business 401(k) plan has annual fees equal to 1.56% of assets. That means for every $10,000 invested, $156 goes toward fees every year.
That may not seem like much, but compounded over the course of a worker’s career, the numbers add up.
For example, let’s say an investor contributed the maximum amount into a 401(k) plan on a monthly basis over the course of 25 years, from 1990 to 2014.The annualized S&P 500 return over that period was 9.62%.
In this example, if your managed mutual fund returns equalled the S&P 500 annualized returns, but you had to pay 1.56% in fees, you’d end up with $860,000 at the end of 25 years, having paid $106,000 in fees.Instead, if the participant invested in a typical low-fee S&P 500 index fund with an expense ratio of .25%, they would **have $1,046,000** after 25 years, **paying just $19,600 in fees**. **That’s a difference of $186,000 in retirement savings!**
The average expense ratio of the funds available in my own plan is 1.08%. That’s in addition to administrative fees. I’ve selected the lowest cost stock funds in my plan. Some are much higher than that.
So how do you know if your 401(k) plan’s fees are too high?
Fees generally come in two forms:
- plan administrative costs
- investment management fees
Plan Administrative Costs
These are basically the costs associated with running the program. Many large companies pay these fees for employees, but to cover costs small businesses often pass along the fees to participants.
The fees are required by law to be disclosed, but they can be hard to find and opaque even after you read the disclosure. On my own 401(k) statement, they are listed as “custodial fees” and “recordkeeping fees”. If you have sufficient patience and perseverance, you can investigate the specifics of your plan’s administrative costs by reading a copy of the plan’s annual summary.
Most of us have better things to do.
Out of curiosity, I called my plan administrator to find out exactly what those fees meant. Recordkeeping fees, I learned, are a flat fee to cover the cost of the website. Custodial fees are “general fees for safekeeping, plan security and security of assets”. I asked the representative to elaborate, but couldn’t get past the standard description. I was hoping for more by way of customer service.
Investment Management Fees
Investment management fees take a larger slice of your retirement savings each year. These fees go to the mutual fund management team for their efforts. Depending on your plan, some of these fees may also line the pockets of a third-party plan adviser in a revenue sharing agreement.
On the bright side, you have some control of how much you pay in investment fees by choosing lower cost funds.
The fund’s expense ratio is how you determine what percentage of your assets is annually withdrawn for investment fees. You can find this number in the mutual fund prospectus (keep your eye drops handy), or through various financial data sources such as Morningstar, Yahoo Finance, or an online broker.
Or an easy way if you already know which funds you have is by doing a quick Google search on the fund name.And you should see this box at the top of the page: How do you know if your fees are exorbitant or not? In my opinion, expense ratios for managed mutual funds should be in the 0.8% or below range, but can be higher or lower depending on the type of fund, the fund company, and the size of the fund. Expense ratios greater than 1% should be considered excessive.
Index funds, on the other hand, often have expense ratios around 0.25%.
As a rule of thumb, an annual total cost to the employee of 0.60% or below is considered excellent. Good plans will make fee disclosures easily available.Crappy 401(k)s put fee disclosures in the fine print.
Lower fees mean more money in your account to grow and compound over the life of your account.
2. The Plan isn’t User Friendly
Was it easy to sign up for your 401(k)?
If it’s difficult to join a 401(k) plan, a participant may never even get started. Automated enrollment is becoming the norm and should make the onboarding process easier for a new employee. Remember the chart above showing how much you accumulate in your 401(k) over time? You want to start investing in your 401(k) from day one.
Administrators of inferior 401(k) plans focus on bringing in new customers instead of improving the user experience for existing customers. That’s because they know the employees generally don’t have a say. It’s more cost-effective to invest in customer acquisition than user experience.
And what good is a 401(k) plan if it’s too difficult to maintain or make investment decisions?
A good plan should have easy access through all the modern technologies that we use for banking, investing, shopping, and connecting with our friends. Simply stated, your 401(k) plan should be easily accessible through whatever device is most convenient for you.
Specific fund information should be readily available and written in plain English. Employees shouldn’t need to study the full prospectus to learn about their fund choices. A clear summary is sufficient for most investors.
Further, a common practice for middle tier 401(k) plan administrators is to invest heavily in the sales website and literature, but neglect the user experience for participants.
This is exactly what annoys me about my employer’s plan. When I type in the web address to log in, I land on a modern and elegantly designed website that’s easy to read and navigate. But once I log into my account, it’s the same screens and views that were available 10 years ago.
If the user interface to access your account seems unnatural and outdated, it probably is.
3. Lack of Fund Diversity
Fund selection goes far beyond fees.
Mutual funds come in all sorts of varieties. Regardless of how bad your 401(k) plan is, almost all plans offer a mix of large cap and small cap stock, international stock, and bond funds.
But is that enough?
Many 401(k) plans, especially those set up by a third party adviser and geared toward small businesses, offer only a selection of actively managed mutual funds. These funds are run by investment professionals who invest in assets to try to beat a target index. For example, large-cap growth stock mutual funds aim to beat the S&P 500 index.
Since actively managed funds require added human resources for research and administration, the fees are higher. These adviser fees can get up to 2%!
Index funds, on the other hand, are more passively managed, meaning they aim to match the given index by mimicking it. An index fund requires less research and administration costs, and thus, cost less to the investor.
When fees are subtracted from the performance of an actively managed fund, equity returns tend to underperform target indices over long-term investment horizons.
According to a recent Vanguard study, approximately 80% of actively managed domestic equity funds underperformed their low-cost index fund equivalent for evaluation periods of five, ten, and fifteen years.
Fund selection is influenced by the fact that third party advisers that help set up 401(k) plans for small businesses are not fiduciaries, meaning, they are not required to keep the best interests of the plan participants in mind. Therefore, they are incentivized to set up the plan to maximize fees, not performance or selection diversity.
It doesn’t end there. Sometimes novice 401(k) investors are overwhelmed by the various asset classes available, and prefer a simple, self-adjusting fund that changes as they age.
Target date funds (also known as lifecycle or age-based funds) are ideal for inactive investors that want their investments to change as they age, without having to reallocate their portfolios every year. The best of these funds have low expense ratios. Asset allocations are adjusted slowly as the participant approaches retirement
Target date funds are relatively new in the investment world, only gaining popularity in the last 20 years or so. Many 401(k) investors like them for their simplicity.
If your 401(k) plan doesn’t offer target date funds or a managed account option, it’s a sign that your plan is outdated and could be improved.
What About Matching?
One great feature of 401(k)s is the ability for employers to match an employee’s contributions. The match came about as corporations began eliminating pensions for employees. Instead of contributing to pensions and taking on long-term liabilities, the 401(k) allows companies to match, or, make an upfront contribution toward the participant’s retirement.
A match is when an employee contributes a certain percentage of pre-tax income and the employer contributes a matching percentage amount, up to a certain percent.
For example, my company matches my contributions at 100% up to 4%. Meaning, when I contribute 4% of gross salary to my 401(k), my employer pitches in another 4% for a total of 8%. However, if I contribute 6%, I still only get the 4% match. If I contribute less than 4%, my employer only contributes an equal percentage.
This is why you often hear financial advice to contribute to your 401(k) “up to the match”, because if you don’t, you’re not taking full advantage of your plan.
However, 401(k) plan matches are not mandatory for employers. Most large companies are able to offer a match to employees to remain competitive in the talent marketplace. But many small businesses can’t afford a match.
This is especially true for small businesses just getting started with a 401(k) plan. It can be a big deal for them to have a new plan, so employees should be excited to have the option to save pre-taxed dollars.
A 401(k) plan with diverse, low-fee fund choices is still an excellent retirement savings vehicle, even if there’s no match. Consider the match a bonus. As a company grows and becomes more profitable, they can always add a match to their plan.
What to do if You Have a Crappy 401(k)?
Employees often feel powerless when it comes to company benefits. They assume that HR makes the decisions and is reluctant to listen to unhappy employees.
In reality, HR departments of small businesses are sometimes just one person who isn’t familiar with what a good or bad 401(k) plan is. They either inherited the company 401(k) duties, or relied on a third party adviser to choose a plan.
The first thing you can do as an unhappy 401(k) participant is to let your HR department know why you’re unhappy. Ask for an appointment to discuss your expectations for a good plan and point out specific issues.
For example, if your plan doesn’t offer index funds, tell your company administrator and offer suggestions for the type of funds you want to invest in. They may not even know what an index fund is!
If your employer is made aware that its 401(k) plan doesn’t stack up to the most robust plans out there, they may start shopping for an alternative. Once they do, they’ll likely realize that administrative costs are excessive.
No matter how crappy your plan is, it’s generally a good idea to invest enough to receive the full match (if there is one). Even if the fund selection is lousy, do it. You can always invest the remainder of pretax money into your IRA for a better selection. But the match is money that you should rightfully claim.
Lastly, if your employer’s 401(k) plan is terrible and they won’t listen to you, you may want to think about leaving for greener pastures. The long-term effect of fees, lack of fund selection, and matching contributions can have a severe impact on your retirement savings.
Nothing in this article should be construed as investment advice, or a solicitation or offer, or recommendation, to buy or sell any security. Investing in mutual funds, exchange traded funds, and other securities carries risk of all or part of the amount invested. Past performance is no guarantee of future results. ForUsAll assumes no responsibility for the tax consequences to any investor of any transaction. Investors should confer with their personal advisor or tax professional regarding their particular circumstances.