Related Articles
5 critical fixes for 401(k) plans
How the 401(k) system fails most people
Company in trouble? Protect your 401(k)
Related Resources
401(k) Quick Check
Retirement Planner
Start Investing message board
Your Money forum
Related Sites
Profit Sharing/401(k) Council of America
Mutual Funds
Recent articles:
• Top funds at fire-sale prices, 9/7/2004
• Finally, your funds secret votes revealed, 8/31/2004
• Build a portfolio that pays when you need it, 8/24/2004
More...
| | Mutual Funds
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
Now that youre back from vacation and tidying up your desk, maybe its time to toss out your worn-out 401(k) plan.
Unthinkable? Thats the conventional wisdom, but like sacred cows in general, it doesnt 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.
Its 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 arent as good as ones they could construct themselves.
Rob Boykin, office manager of an auto-body shop in Woodbridge, Va., is stuck with a particularly crummy plan stuffed with B shares (the most expensive kind) of a handful of mediocre load funds. He doesnt like any of them, and wonders, Is there actually a time when investing in a 401(k) plan would not make sense?
The answer is yes.
The problems with 401(k)s
Company plans can be an outright loser 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 Birmingham, Ala. I do like having control of my money. He has done extensive research into alternatives to company plans, and at my request, analyzed Boykins situation. His conclusion: Boykin can do better on his own.
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 dont 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 hes 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 | | Type of plan | Up to age 50 | | Age 50 and older | | | 2004 | 2005 | 2004 | 2005 | | IRA | $3,000 | $4,000 | $3,500 | $4,500 | | 401(k) | $13,000 | $14,000 | $16,000 | $18,000 |
|
Sources: Investsafe.com, Fool.com
But while he appreciates the tax deduction, which is $3,000 in the 25% federal bracket, he doesnt 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 heres what he suggests Boykin do:- Stop making contributions to the 401(k) plan. Dont 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.
Heres how that works: Assuming gross annual average returns of 10.5%, the markets 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 hes 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.
Whats 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 Montclair, N.J., says employers can avoid paying firms like his $50,000 to $100,000 to search for the best providers simply by soliciting bids from stock brokers, who charge nothing upfront and instead make their money from high fees charged to participants.
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 Carr, a Boston-based pension consultant.
Told of Welchs research, Boykin says: Im 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 doesnt work out that way. So youve got to take control yourself.
Do you have a problem with your 401(k)? E-mail me because I'm going to continue to dig into issues involving these retirement plans.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
|
