401K Fear and Loathing

On Saturday, I adjusted the asset allocation in my 401K plan. It was nerve wracking. I was putting down 25% for this fund, 15% for that fund, and so on. I truly believed that my retirement depended on my ability to do this right, or else I would be totally screwed. Which is true, actually. None of us little people are ever going to save enough money in a bank account to retire. We need to have the magic of compounding returns in tax-deferred retirement accounts to have a prayer of a dignified, self-sufficient old age.

For 2013, the maximum you can set aside in 401K plans is $17,500. (This amount adjusts upward every year or so, according to inflation and the whims of the IRS.) That is A LOT of money. It is a huge privilege to be able to max out your 401K. The truly privileged put the entirety of their retirement contribution in a Roth 401K. With Roth 401Ks, retirement contributions are made from after tax income. You pay taxes on contributions now, and you do not have to pay ordinary income taxes when money is withdrawn later.

Did you catch that last sentence? Unless you can Roth it, you have to pay the prevailing tax rate on withdrawals from your 401K plan when you are in retirement. If you pull out $32,000 during a calendar year, you have to pay the IRS the same taxes you would owe if you had a job that paid you $32,000. So, the amount you have in your 401K isn’t really the amount you have available for retirement! However, you don’t have to pay FICA (social security and medicare) taxes on 401K withdrawals. You have already paid into social security and medicare during your working years, so you can supposedly reap the benefits of those contributions in your golden years.

It is a privilege to even have a 401K plan. According to Vanguard, only half the workplaces in America have a 401K plan. Companies are not legally required to have them! If company owners want to participate in a 401K themselves, they have to offer it to all employees. Without a 401K, the other option a company owner would have for retirement is an IRA, and contributions are limited to $5,500/year for 2013. This is far less than $17,500. (Remember, the name of the game is to put away as much as you can for as long as you can and experience the miracle of compounding returns!) Of course, if a company wants to attract talented employees with a shred of self esteem, a 401K plan is a standard benefit, as is health insurance.

Interestingly, company owners and “highly compensated employees” of a company cannot contribute the maximum annual amount into a 401K unless the plan passes certain nondiscrimination standards. This means, non-highly compensated employees must also contribute to their 410K plans, and if they don’t contribute enough, the big shots cannot squirrel away the maximum $17,500. Of course, there are ways around this. An obvious one is that companies could pay their employees more, so rank and file staff have some money left over at the end of the month for 401K contributions. Or companies can refund a portion of 401K contributions back to highly compensated employees, so the ratio of highly compensated employee contributions versus staff contributions fall back into a nondiscriminatory ratio.

The common option that most companies take is to give a bonus paid directly into non-highly compensated employee 401K plans, and the size of that bonus fulfills the ratio requirements necessary so the big shots can max out their $17,5000. I promise you, the bonus is small because the ratio requirement sucks. Interestingly, as underling employees scrimp and put as much into their 401K as they can, this erodes the size of the so called “bonus” they get in their 401K. There are other ways employers can find safe harbor from 401K compliance hurdles, such as mandatory 401K participation or matching contributions. 401K compliance is complex, but it is designed to make sure there is equitable participation in 401K plans. These nondiscrimination compliance standards exist because the 401K plan has replaced pensions, which were available to all full-time employees of a firm. You cannot eliminate pensions and then have a retirement benefits plan solely used by the executives of the company. The peasants would revolt.

There are a number of reasons why I really hate the 401K system:

1. Can I trust the mutual funds in my 401K plan?
Honestly, how many of us have any experience in mutual fund selection? ZERO. It’s because we’ve never learned anything in K-12 about investing or financial literacy or personal finance. And for those of us with company stock as one of the options in the 401K plan, how are we supposed to decide if it is better to invest in the company stock versus the funds? Pro tip, DO NOT purchase company stock in your 401K plan. This is what Enron employees did and look what happened to them! Enron stock became worthless and their life savings were lost.

Do you know how many investment professionals typically work in a company’s HR department, which makes decisions on company benefits like the 401K plan administrator and mutual fund selection? ZERO. The number is zero. So how do these HR professionals choose who administers the plan and the mutual fund selection? They ask their colleagues, they hire consultants, they interview various plan administrators. But they really cannot profess to have backgrounds in investments in order find a worthy fiduciary for the plan with low fees and responsible fund selection.

You can rest a little easy if your firm’s 401K plan has an S&P500 Index Fund AND the expense ratio on the S&P 500 Index Fund is less than 10 basis points (0.10%, if you invest $100 the fee is ten cents). At least you’ve got that going for you. Every retirement plan should give investors large cap US exposure for the lowest fee possible. If your firm doesn’t have this, write the plan sponsor and ask for the Vanguard S&P 500 Index fund to be included in your plan. Don’t be a hero and try to tell Human Resources or your boss that the options in the 401K plan are lousy. You will be insulting those that approved the plan. You will be seen as a trouble maker or whistle blower. And you will probably get laid-off or fired.

Many 401K plans are entirely made up of “actively managed mutual funds”. This is a big no-no, and a decent plan will always include a couple of index funds, such as the aforementioned S&P500 Index Fund. Some 401K plans are heavy on “blended funds” which are part bond and part equity, and it is pretty much impossible to benchmark these funds effectively to assess if they are performing well or poorly. You know how many blended funds your 401K should have? ZERO. You should always be able to see and control how much bond and how much equity you have in your asset allocation.

The only semi-responsible blended funds are the “target date retirement” funds that were required by the Pension Protection Act of 2006 to be included in 401Ks. Because nobody knew anything about asset allocation, people were screwing up their investment options and target date retirements funds are supposed to be the answer. Note, there are no mandatory guidelines for how targeted date asset allocation is supposed to work, but they are supposed to become more bond heavy the closer a person gets to retirement.

2. How do I decide my asset allocation in my 401K plan?
I really love it when I read, “past performance is no indication of future results.” This is not a confidence builder! I’m supposed to forego part of my hard-earned salary for something that I kind of don’t even believe in and have no experience with? Say what? But invest you must, because you’ll never make it on savings alone. You really do need those returns to compound over time, and that doesn’t happen if you leave it all in cash.

Here is a stress relieving tip. Contact a certified financial planner and ask them if you could meet for an hour to discuss your 401K plan. There are many planners that charge by the hour and will give you great advice. If you cannot do this, invest in the target date retirement fund available in your plan, and the expense ratio of this fund should be under 40 basis points. If the expense ratio is anywhere near 1% or above, you are getting ripped off and just put your money in the US Large Cap fund as a placeholder as you educate yourself.

If you are willing to do the homework, get “The Bogleheads Guide to Retirement Planning” and read the chapter “Basic Investment Principles”. Heck, read the entire book. You will learn that it is good to have a mix of equity exposures such as US large Cap, US Small-Mid Cap, International and Emerging Markets, REITs, and then some bonds.

You do not have to invest in every fund in your firm’s 401K plan. It is difficult for me to suggest an asset allocation here because 401K plans have investment choices that are all over the map, literally.

I’m just going to come out and say it right here. Vanguard is the best place for your firm’s 401K plan and your IRA if you have one. They have the lowest fees, and a broad array of Index Funds.

 3. What if the year before I retire, the stock market falls 40% like it did in 2008?
Yes, you are even supposed to know how to adjust your asset allocation more bonds over time so you don’t loose it all in the end. And how are you supposed to know this if you’ve never received any education on it? A very simple rule of thumb is that you should have as many bonds as the decade of your age. If you are 34 years old, 30% bonds. 

4. How do I know if the fees are reasonable? 
You have no idea. You have no idea because you were never given a proper education during K-12 for Things That Matter.

Some 401K plans have mutual funds with front-end loads, a huge rip off which only erodes your investment performance. A front-end load is a fee you pay just to invest in a mutual fund. This is completely unnecessary as there are a world of great no-load mutual funds out there. This fee is just another way that Wall Street lines its pockets at your expense. A typical front-end load is 4.75%. I guarantee you, when the S&P 500 falls 4.75% this is headline news all over the world! It is a stock market calamity, and it happens to YOU every time you invest in a front-end load mutual fund. Believe me, Wall Street is making plenty enough money off of you in the regular annual management of the fund. If your 401K only includes front-end load funds, absolutely write your plan sponsor and demand that the front-end loads be waived AND low fee index funds be added to your plan. Actually, just look for another job, you work for morons.

The annual management fee of the fund is expressed in the expense ratio. This is the percentage of your investment that goes to pay the fund manager every year. Most of the mutual fund expenses in your 401K plan should fall below 40 basis points, with only a few of them costing more.  Emerging Market funds and REITs are more expensive to manage, but if you see a lot of funds that cost almost 1% or more, something is definitely wrong.

5. The 401K just hasn’t worked out for a lot of people.
How is your 401K? How is your IRA? Yeah, I thought so. It’s not going so great, is it?

Friends, it is not your fault. Since American employers have mostly let go of corporate pensions and embraced the 401K, wages have not kept up to enable workers to save in a 401K. Pensions have been eliminated, wages have flatlined, and where have company profits gone? Those profits were paid out as dividends to people who own the publicly traded stock in your company and ever increasing executive salaries and useless acquisitions, but not to you. The switch over to 401K plans and elimination of pensions created a huge cash surplus in corporate America. The 401K plan was the best thing that ever happened to those at the top.

In America, if things haven’t worked out, we tend to blame ourselves. We say to ourselves, “It’s my fault for not making enough money,” or “It’s my fault for not planning better.” There is this puritanical guilt associated with financial failure. I’m telling you, the cards were stacked against you, the system is bigger than you. The entire 401K industry is a fee generating machine for Wall Street and service providers. In any business where there is information asymmetry and a lot of middle men, the consumer is going to lose.

Quinn Curtis of University of Virginia Law School and Ian Ayres of Yale Law School argue that plan fiduciaries have failed in their responsibility towards the individual investor, and the majority of bad performance in 401K plans is from excessive fees.

With all of the conflicting information out there and the lack of education in personal finance, you could not have had a clue. You had no idea how to make investment decisions in your 401K, or even how to know if the fees in your 401K plan were excessively high.

6. If the market doesn’t provide the performance, you are screwed anyway.
Despite all of the saving and squirreling away, if the stock market doesn’t perform well and give you the compounding you need to grow that nest egg, you are screwed. You can only pray that Social Security can cover your needs.

These are just some of the reasons why I hate the 401K system. Let me know if you have any questions!

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