Here’s another good reader question about crappy 401k plans. Reader Robert saves enough to max out his 401k each year if he wanted to, in addition to maxing out his Roth IRA every year which he already does. However, his 401k plan is filled with expensive actively-managed mutual funds. He has no company match. Should he contribute to his 401k anyway, or invest outside in a taxable account?

Factor #1: How Long Will You Keep Your Job?
Even if you have a bad 401k plan, remember that as soon as you leave that company, you can roll over those tax-advantaged funds into a Rollover IRA at the company of your choice! You may or may not have a good idea of how long you’ll stay there, but the fact is most of my friends have not worked at any company longer than 5 years or so.

(A few plans offer what is called in-service withdrawals, where you can roll over your 401k fund into a IRA without leaving your employer. These are rare, but it’s worth asking about.)

Factor #2: Can You Help Your HR Department Make A Change?
The reason why expensive 401k plans exist is because they tend to be cheap for the employer. Essentially, the administrative costs for running the plan are shifted to the employees. Big companies tend to have better plans because they offer enough assets for companies like Vanguard to jump in.

Still, you might be able to enact some change. Print out some material about how high plan expenses can really hurt performance and thus people’s retirements. Talk to your co-workers, and make it an worker attraction/retention issue. You may not need to switch providers, but perhaps they’ll at least offer a better option or two. I’ve even read about Congress considering a law requiring all 401k plan administrators offering at least one index fund option.

Factor #3: How Expensive Is It?
Unfortunately for Robert, he shared his available investment options along with their annual expense ratios, and they are the worst I’ve seen yet:

Blackrock Fundamental Growth C MCFGX 1.94%
Blackrock Global Allocation C MCLOX 1.88%
Blackrock Government Income Portfolio C1 BGIEX 1.53%
Blackrock International Value C MCIVX 2.60%
Blackrock Large Cap Core C MCLRX 1.97%
Blackrock Large Cap Value C MCLVX 2.00%
Blackrock Value Opportunities C MCSPX 2.34%
Davis New York Venture C NYVCX 1.71%
Evergreen Core Bond C ESBCX 1.45%
J P Morgan Dynamic Small Cap Growth C VSCCX 2.12%
Mfs Total Return C MTRCX 1.52%

It may be tempting to think “well, no matter how bad the plan is, it will still be better than a taxable account, right?” Wrong. Actually, given current tax rates, it can be better to keep your money in a taxable brokerage account than in a 401(k) plan if the options are expensive enough. Here are some quick and dirty examples.

Let’s say you put in $10,000 in a taxable account. You invest in an index fund with 0.20% expense ratio. The broad US stock market earns 8% per year. Since you get the gains minus expenses, you get 7.8% per year. You get a 15% tax hit at the end for long-term capital gains. Your final after-tax balance after 30 years is $80,906. (Yes, I’m ignoring the annual taxation of dividends for now.)

Let’s say you put in $10,000 of after-tax money in a Roth 401(k). You buy a Blackrock fund with 2% expense ratio. Again, on average, all mutual funds that invest in the broad US stock market will earn the market returns (8%) minus expenses (2%), giving you a 6% return per year. However, you have no tax hit at the end since it is a Roth. (You’d get the same result with pre-tax money in a Traditional 401k.) Your final after-tax balance is only $57,434.

The above is a very simplified comparison, but the point is that the gradual annual hit of a high expense ratio can overcome the tax break advantage. Usually this takes an expense ratio above 1% and a long time horizon.

Recap / WWMMBD
If you think that your current plan options will continue to be this bad for the next 10 years or more, and you don’t think you’ll leave your company before then, then it may indeed be better to just invest outside a 401k plan. (Keep up the IRA contributions!) However, I think that soon 401k plans will be more tightly regulated, and the trend is for plans to at least offer a few low-cost options. I know my plan seems to get a little better every year. If it were me, I’d probably suck it up and still tuck money away in the 401k in the hopes of a brighter future.

Traditional Three Legged Stool of Retirement
(post, image via Michigan.gov)

Over the weekend, I finally got around to reading this Time magazine article about Why It’s Time to Retire the 401(k) which has been getting some buzz. The author promotes bringing back what I call “portable pensions” to replace the employee-controlled 401(k) plan, which would guarantee say 50% of your last year’s salary for the rest of your life. Sounds nice, but how will it work, and who’ll pay for it?

Take the Mr. Shively in the article, who is still working at 68. About 25 years ago, his employer dropped the pension and replaced it with a 401(k). Over those two and a half decades, he has managed to save $70,000 in a 401(k). Yet it is suggested that if only his company kept the pension, he would be getting $1,308 per month, or $15,700 a year. Such a lifetime of cashflow from age 65 would cost at least $200,000 according to ImmediateAnnuities.com ($250,000 if joint, covering a spouse also age 65). Where did the $130,000-$180,000 difference come from?

Pensions are more expensive to run than 401(k) plans. Let’s say you have average employees making $50,000 a year and you match 100% up to 5%. That costs $2,500 a year – bang, you’re done, and you don’t have to worry about investing the money to meet future liabilities. Where does the savings go? Either Shively got paid more (through higher salary or matching contributions) and didn’t save it, or his employer pocketed the savings, or likely a little of both.

This brings us to the other problems of the 401(k) system are, which were explored in this 2001 Barron’s article by William Bernstein after the last stock market crash. “The 401(k) is likely to turn out to be a defined-chaos
retirement plan.”

Employees are not saving enough. Will this be fixed by a portable pension? Only if employers are willing to pay higher total compensation, which is unlikely. Otherwise, will people really be okay with forced savings like an additional mandatory 5-10% contribution? Folks tend to see that as a tax, like Social Security.

Investors are depending on future market returns which will likely not be as high as in the past. The idea of gaining 8% per year, 5% after inflation, sounds nice but may not happen in the future. Current P/E ratios are still above average current. This means people will need to save even more than they thought. Again, where will this money come from?

401(k) expenses are too high, which reduces returns even further. Having a guaranteed income for life requires insurance companies. Which means instead of mutual fund expenses, you’ll have hidden insurance fees and guaranteed returns that will have to be significantly less that market returns. If more transparency and direct competition existed, perhaps the costs could be minimized.

Investors have poor investing knowledge. This is kind of an unsaid reason of why 401(k)s are bad, because there will always be those invested poorly. My concern is related to this recency bias. 401ks got traction initially because markets were hot at the time. Talk of pensions increase now because the recent performance was awful. What happens when the markets get hot again? Will people be happy with their 6% steady increases when others are gaining 30% in year?

I’d like to see what happens with this “portable pension” idea, but the practical realities concern me.

If you haven’t noticed already through your portfolio statements – the stock markets are doing well in 2009. The broad US stock market and the broad developed international markets are up 22% and 29%, respectively. Some funds are doing especially well, such as the Vanguard Emerging Markets Stock Index Fund (VEIEX) which is up +62.6% year-to-date.

Vanguard recently sent me a newsletter with a link to an article titled Strong 2009 performance warrants yellow flag, which states in part:

While it may be gratifying to see these robust gains lift the balances of your funds, the markets have “come a long way in a hurry,” as the saying goes. At this point, it may be wise to ensure that your asset allocation is in line with your long-term goals.

A discussion thread on this article at Bogleheads had member Robert T pointing out the following comparisons in 2008 and 2009 YTD performance data:

Many of the asset classes that got hit the worst in 2008, have made the largest comebacks. Of course, we can’t know for sure if this surge will continue or if we’re headed back down again. But I think Vanguard’s advice is sound, to make sure our asset allocations are on target. If you had the guts to rebalance at the end of 2008, then buying more stocks “low” would have paid off nicely. Right now, you’ll want to make sure you’re not overweight in stocks.

I have been using my ongoing investments to balance out my asset allocation through the year, but as my latest portfolio snapshot shows, I am still overweight in Emerging Markets and underweight in bonds.

Is your asset allocation where you want it to be?