Approximately 51 million Americans have invested an estimated $3.5 trillion in 401(k) plans, according to the Investment Company Institute. If you're one of them, you're probably being ripped off, big time.
How? Your plan likely includes a dizzying array of investment choices. These options are dominated by funds that have high management fees and are actively managed, in which the goal of the fund manager is to beat the returns of an index, like the Standard & Poor's 500 index.
A February 2014 paper by Ian Ayres and Quinn Curtis, "Beyond Diversification: The Pervasive Problem of Excessive Fees and Dominated Funds in 401(k) Plans," provided sobering advice for plan participants. The study looked at more than 3,000 401(k) plans with more than $120 billion in assets. It found that fees were so high (compared with an index fund) in 16 percent of the plans that, for young employees, these fees consumed "the tax benefit of investing in a 401(k) plan."
The study also found that roughly 52 percent of the plans had "dominated funds," defined either as funds that were more expensive than comparable funds in the plan, or funds that were unattractive options in which no prudent participant should invest.
This combination of high costs, poor investment choices and poor investor behavior has resulted in low returns for plan participants. In another study, "Measuring Fiduciary and Investor Losses," the same authors had found that participants would have earned returns 23 percent higher if they had invested "optimally without menu restrictions or fees."
It would be simple to invest "optimally." All 401(k) plans should be required to offer low management-fee, target-date retirement funds in which the underlying funds are all index funds and globally diversified portfolios, at various risk levels, consisting solely of low management-fee index funds, passively managed funds or exchange-traded funds. Don't hold your breath awaiting this kind of reform. The securities lobby is powerful, and pro-consumer legislation to reform the 401(k) system is unlikely to be on the near-term horizon.
In the interim, here are some tips for dealing with a 401(k) plan that may be ripping you off:
Decide whether you should contribute. Christine Benz, Morningstar's director of personal finance, says there are many considerations to weigh before contributing to a 401(k) plan, including whether you have high consumer debt, whether your employer matches your contribution, whether you need the built-in discipline that comes with automated contributions and whether you have the money to invest.
Make the best of a bad plan. In my book, "The Smartest Money Book You'll Ever Read," I discuss how to make the best of a plan consisting largely of expensive, actively managed funds. Even plans with lousy choices may offer some index funds or target-date funds. Check to see if there is a broad-based U.S. stock market index fund with a benchmark like the Wilshire 5000, a broad international index fund with a benchmark like the MSCI All-Country World Index (excluding the United States) and a broad U.S. bond index fund with a benchmark like the Barclays Capital Aggregate Bond Index. Using these three funds, you can construct a relatively low-cost, globally diversified portfolio in a suitable asset allocation. I discuss how to do this in more detail in "The Smartest Investment Book You'll Ever Read."
If the plan offers target-date funds (aka, life cycle funds), and the asset allocation is suitable for you, these funds can be excellent choices. They greatly simplify your decision because you invest 100 percent of your money in a single fund with a target date closest to the date of your projected retirement. The fund automatically rebalances to become more conservative over time. Target-date funds in which the underlying funds are index funds are optimal choices.
Calibrate your contribution. If your plan has options limited to high-cost, actively managed funds and no index funds, invest the minimum necessary to obtain the maximum employer match.
Self-invest. Consider investing on your own in a traditional or Roth individual retirement account. Current contribution limits for both are $5,500 if you are younger than 50, and $6,500 if you are 50 or older. Contributions to a Roth IRA may be limited based on your income. The contribution limits on traditional and Roth IRAs are not affected by the amount you contribute to your 401(k) plan.
The basic difference between a Roth IRA and traditional IRA is your Roth IRA contributions are made after taxes. Withdrawals from a Roth IRA at retirement are tax-free. With a traditional IRA, you typically will be able to deduct your contributions, but you'll be required to pay taxes at your marginal rate when you withdraw funds.
Both Roth IRAs and traditional IRAs have additional rules and requirements.
You can open IRA accounts with any of the major fund families. Limit your investments to low-cost index funds or target-date retirement funds, which will minimize your costs.
If you can save beyond the limits imposed by IRAs, consider an after-tax account, following the same investment principles. Index funds are tax efficient while you hold them. You won't incur capital gains taxes until you sell your shares, which is another form of tax deferral.
While the 401(k) system is full of pitfalls for the unwary, you can take some basic steps to protect yourself. The sooner you do so, the greater your prospects for reaching your retirement goals.
Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, "The Smartest Sales Book You'll Ever Read," has just been published.
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