In our financial planning practice, we get to look at many different 401(k) and 403(b) plans and what we’ve seen is alarming. What is most obvious is that many plans offer weak fund choices. Many of the plans offer funds with unusually high expense ratios (fees as a percentage of assets under management). Some offer asset allocation funds with layered fees, meaning that an umbrella fund buys other funds with fees at both levels. Many plans just have too many fund choices, making it difficult for participants to hone in on the most appropriate ones. Not all plans offer low cost index funds.
Over time, though, what has really started to sink in is the lack of counseling in 401(k) and 403(b) decisions. Our clients often end up in high-fee funds with inappropriate allocations—like a young person with more bonds than stock—and they don't know why. It could have been that someone steered them into those choices. Or they could have done eenie, meenie, miney, moe. They often just don’t remember why they made their choices.
How can this be? How can one of the most important financial decisions of a person’s life be so random? With no standardization, no transparency and no individualized education, people are buying 401(k) lemons and they may never know it.
So what can you do? You can ask questions, lots of questions. The truth is that your company—the sponsor of the 401(k)—may be as confused as you are by an industry that thrives on complexity and opacity. You should be aware of the 5 common 401(k) pitfalls and be prepared to ask your company the appropriate questions.
1) Bad Advice. Sometimes no advice is better than conflicted advice. Many so-called advisors in the 401(k) market have significant conflicts of interest and may have a vested interest in pushing you into products they sell or accounts they manage.
Questions to Ask: Do we have access to annual, one-on-one counseling with non-conflicted advisors? Do you strongly encourage attendance? Does our 401(k) advisor hold a CFA or CFP designation? Does our advisor sell any products, like insurance? If so, do we have provisions to negate the conflicts of interest?
2) Under-Saving. While 401(k)s have their pitfalls, the worst mistake most people make is not participating or not contributing enough into the program. All 401(k)s provide tax benefits by enabling pre-tax contributions and allowing the savings to grow untaxed until the funds are withdrawn. Many 401(k) plans offer an employer match, which is free money kicked in by the company. While there is no easy rule of thumb, most people should be putting 10%-15% of their income into a retirement plan and taking advantage of the tax benefits and matching provisions of 401(k) plans.
Questions to Ask: Do we have an auto-enrollment option? What are the default contribution percentages in auto-enrollment? Do we have auto-escalation provisions to increase the savings rate? Do we have a match program? Is it a stretch match to encourage savings (50% of first 10% versus 100% of first 5%)? Do you make it clear to us that we can and should continue to invest beyond the matched level?
3) Inappropriate Fund and Asset Allocation Decisions. Many 401(k) plans offer too many stock and bond fund choices and provide little or no guidance on making appropriate allocation decisions. Typically, younger employees should be mostly in stocks and older employees should be more balanced in both stocks and bonds. Inappropriate allocations could mean lower returns for a young person or devastating portfolio declines for an older person. To make this easier, companies can offer target date funds that change allocations as the employee draws closer to retirement.
Questions to Ask: Do we have a full slate of target date funds? If we don’t, do we have access to one-on-one counseling with a non-conflicted advisor to help us make fund choices and asset allocation decisions?
4) Poor Fund Lineups with High Expense Ratios. Over the past 15 years, more than 90% of stock fund managers have underperformed their benchmarks. It’s very hard to beat the market, especially when those funds are charging fees averaging around 1% of assets under management. For most individual investors, low-fee index funds that simply track a benchmark have historically offered the best long-term returns.
Questions to Ask: Do we have a full slate of low-fee index funds? What are the expense ratios on our funds? Are all the fund expense ratios below 0.2%? If higher than 0.2%, what is our justification for the higher expense ratios? Do you have empirical evidence to support the choice of higher-fee actively managed funds? Do we have a self-directed brokerage option so I can buy index funds directly?
5) High, Hidden Administration Fees. Most people are unaware of the hidden fees of 401(k)s, including record keeping/third-party administration (TPA) fees and advisor fees. These fees tend to be higher for smaller company plans. Retirees need to be aware of these fees, which might make it wiser to roll a 401(k) into an IRA that isn’t burdened by the fees. There are also so-called 12b-1 fees embedded in fund expense ratios that often represent sales kickbacks to advisors that sell those funds.
Questions to Ask: How much do I personally pay in record keeping/TPA fees each year? Are there any 12b-1 fees? How much do I pay in advisor fees each year? Does the advisor get paid a percentage of assets under management or a flat fee? What are those fees? How are record keeping/TPA and advisor fees allocated to participants?