Have you heard? Your 401(k) could be a bad deal. Evidence is mounting that many 401(k) plans are overcharging their participants. A PBS Frontline special from 2013 lays out the argument particularly well, and a 2011 Deloitte report corroborates. The 2011 report states that the average 401(k) administrative fees charged by employers were .78% in that year. This number may not seem huge, but consider this: low cost index funds from companies like Vanguard regularly sell for around 0.15% in yearly fees, and can sell for as low as 0.05%. This is a premium of between 500% and 1500%! Put more succinctly, over the course of a career it means several extra years of working to make up the difference. And at this point, most companies seem either to be not motivated or not savvy enough to select efficient plans for their employees This makes me angry on many levels, as it should you. With pensions rapidly disappearing, the 401(k), along with a constellation of other tax-advantaged plans, is all most of us have. They need to be better. So I say this through gritted teeth: even if your 401(k) is bad, like shake-you-down-with-a-baseball-bat bad, I think that you should still contribute to it, especially if there’s an employer match.
I’ll illustrate why using a simplified example. Let’s imagine a worker named Rhee Tyre (get it?). Rhee has a 20% marginal tax rate and she’s holding a humble hundred-dollar bill in her hands.
If Rhee becomes disgusted by her 401(k) fees and says, “Forget this – I’m investing this money myself!” she’ll definitely be able to find a low fee investment option. However, her $100 will actually turn into less than $80 because of federal, state, and payroll taxes.
If instead Rhee grits her teeth and invests in her 401(k) plan, she is not only not taxed for on the $100, but her tax liability is actually decreased for the year she invests. So this $100 is actually worth $120 to her. In addition, her employer may match her contribution up to %50, meaning that the total worth of this $100 could actually be $170! It’s true that Rhee will have to pay taxes on the money when she eventually withdraws it, but in the meantime she can invest this money and reap some serious benefit from it.
This is why 401(k) plans matter, even bad ones. The difference between $170 and $80 is large enough that, even with onerous fees, it’s still likely that a 401(k) plan provides a benefit over a taxable account. For example, if we take Rhee’s two values ($170 and $80), ignore market gains, and just let the two different fees (.78% and .15%) erode the money over time, we’ll find that it takes roughly 120 years for the 401(k) balance to drop below the taxable account balance.
This doesn’t excuse bad plans, nor does it mean you should take them sitting down. All workers should be researching their plans and asking tough questions of their employers. Some companies may not even know their plans are bottom of the barrel. Make it your job to educate them. But through it all, keep investing. Think of it this way: your bad 401(k) plan is like the mob: you may not like that they’re shaking you down, but the alternative to not paying could be worse.
Please note this article deals with 401(k)’s in a simplified way for clarity and uses simplified examples. Differences in account size, age of clients, risk tolerance, timing of transactions and market conditions prevailing at the time of investment may lead to different results. It’s important for each person to do research and make decisions based on their particular situation. The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor or serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities.