DebtFreeGuru.com's - Tip of the Week - Monday, October 11, 2004
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Is
it Time to Dump Your 401(k)?
These
retirement plans are the foundation of retirement saving. But at many
companies, the plans are so bad that it might make sense to opt out and
invest the money on your own.
By Timothy Middleton (As seen on
MSN.Com)
Now that
you’re back from vacation and tidying up your desk, maybe it’s time to
toss out your worn-out 401(k) plan.
Unthinkable?
That’s the conventional wisdom, but like sacred cows in general, it
doesn’t stand up to scrutiny. The plain fact is that millions of
Americans are stuck in lousy self-directed pension plans called 401(k)s in
the corporate world, 403(b)s at not-for-profits and 457s for government
employees.
It’s
impossible to tell how many bad plans there are because nobody keeps
track. But my back-of-the-envelope estimate is that 8 million American
workers have really bad plans, and countless others have plans that
aren’t as good as ones they could construct themselves.
Rob Boykin,
office manager of an auto-body shop in
The answer
is yes.
The problems with
401(k)s
Company plans make
little or no sense if there's no employer match. They're an albatross if
investment options are too limited or expenses are too high, and they're
so high that Congress and the Securities and Exchange Commission are
running separate investigations. They're ghastly if the investment options
are annuities, a particularly expensive fund form that tacks insurance
charges onto all the others.
The issue is
control, says Stewart Welch III, a financial adviser in
Chances are,
so can you.
Employer-sponsored
plans such as 401(k)s currently enroll about 55 million American workers,
42 million of them in the private sector and the balance evenly divided
between government and not-for-profits.
The Profit
Sharing/401(k) Council of America, the principal trade
association of plan sponsors, estimates 15% of all plans do not offer any
employer-matching contribution whatsoever. Contrary to what I expected to
learn, big companies are no more likely to match contributions than small
ones. That produces my estimate of 8 million disadvantaged workers.
Readers speak out
The number is surely higher,
because many matches are lousy. In our MSN Communities, debates about
these plans are raging in the Start Investing community, which I moderate,
and the Your Money forum.
-
“My main beef is that the matching contribution is in company stock. You aren't allowed to diversify out of it until you're 50 years old.” -- zakblue
-
“Our company will still continue to match 5% of our contributions, but they will not deposit those matches until between Dec. 31 and March 31 of the following year AND only if the employee is still employed on Dec. 31.” -- razorback RN
-
“5% company match? That's great! We only get about 1.5%.” -- IlluminatedCringle
Any
company match makes it worthwhile to participate in a plan, but only up
to the amount of the match. After that, a plan should be judged on its
merits. Too many don’t have any.
Boykin,
38, has the worst of both worlds: no match and poor plan offerings.
He only
recently began to get serious about saving for retirement, but now he’s
saving like crazy: He contributes about $12,000 a year into his plan.
That's its chief allure to him, because the individual equivalent, the
IRA, has much lower contribution limits.
|
Retirement
plan contribution limits |
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Sources:
Investsafe.com, Fool.com
But while he
appreciates the tax deduction, which is $3,000 in the 25% federal bracket,
he doesn’t like the plan options, which are B shares of a half-dozen AIM
funds. He's invested in the two he dislikes the least: AIM Mid Cap Core
Equity (GTABX,
news,
msgs)
and AIM Constellation (CSTBX,
news,
msgs),
"although I consider neither to be that great of a fund with the
returns or fees they charge,” he says.
Dropping a plan with
fat fees
No kidding. The
mid-cap fund charges 2.06%, despite the fact the fund is one of the
largest at AIM and, in Morningstar's opinion, could afford to share
economies of scale with shareholders. AIM Constellation, a large-cap
growth fund that Morningstar faintly praises as “adequate,” charges
1.99%.
One full
percentage point of those expenses is for what the industry delicately
calls “distribution.” Says an AIM spokesman: “Those fees are
intended to compensate the broker for servicing the participants who are
invested in the funds through the plan.”
Good for
him, but not for Boykin. Welch says those charges are at least twice what
they should be, and here’s what he suggests Boykin do:
-
Stop making contributions to the 401(k) plan. Don’t withdraw the money immediately; B shares also come with back-end loads that can last as long as seven years. Wait until that slate is clean before rolling the money over into an IRA.
-
Open a conventional IRA at a mutual fund company that offers inexpensive index funds. Vanguard Group is a good choice. But as I reported last week, Fidelity Investments is suddenly very competitive, particularly with a broad-market fund like Fidelity Spartan Total Market Index (FSTMX, news, msgs), which charges 1/20th the amount Boykin is paying. He can contribute $3,000 this year and more next, and get a tax deduction for that.
-
Open a conventional, taxable account with the other $9,000 he is saving. Actually, since he will be taxed on that amount ($2,250 in the 25% federal bracket), the net contribution is reduced to $6,750, for a total of $9,750 per year.
How the private plan
measures up
Losing that tax
deduction is big, but so are high expenses. Welch calculates that if
Boykin can cut his effective annual charges in half, to 1%, his private
portfolio would achieve parity with the 401(k) plan in the 30th year, when
he's 67.
Here’s how
that works: Assuming gross annual average returns of 10.5%, the market’s
historical average since 1926, his 401(k) plan, whose net return would be
two percentage points less, or 8.5%, would have a balance of $1,553,926.
His private plan, whose net return is 9.5%, would have a balance of
$1,507,447.
That's a
lesser amount, owing to smaller contributions over the years, but it is
effectively more. This is because all proceeds from the 401(k) would be
taxed as ordinary income, whereas proceeds from the sale of equity funds
in the $1,058,384 taxable account would be taxed as capital gains, a rate
nearly half that of ordinary income.
(Welch used
2004 tax rules in his calculations. Higher deductibility in future years
would've made this comparison much more favorable to the private plan.)
Over the
years, Boykin would have to pay taxes annually on distributions from the
taxable account, but he could more than recover that expense by investing
in tax-efficient funds with expense ratios well below 1%, namely index
funds.
Boykin is
unusual in that he’s contributing so heavily to his retirement at such a
young age. But that only means tax law disfavors him extremely. If you're
earning $50,000 and put 6% into your company plan, that's $3,000. Absent a
company match, you lose nothing and gain everything by taking a hike to a
cheap no-load fund shop.
What’s behind big
401(k) fees?
Cynics will suspect
something nefarious underlies extravagant fees inside 401(k) plans. They
could be right. Brent Glading, principal of a pension-plan consulting
group in
Such
fee-shifting is common in the retirement market. Especially in mid-size
plans, “the employer refuses to pay a penny,” says Robert McCarthy,
president of Kanon Bloch Carré, a Boston-based pension consultant.
Told of
Welch’s research, Boykin says: “I’m going to look into this very
hard, even with having to pay the taxes on it. Plus, it gives me a little
more control.”
The whole
notion of 401(k) plans was to give employees more control over their
destiny. In practice it often doesn’t work out that way. So you’ve got
to take control yourself.
At
the time of publication, Timothy Middleton didn’t own any securities
mentioned in this article.
DebtFreeGuru.com - Tip of the Week - Monday, October 11, 2004
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