Starting in the 1990s, 401(k) plans began to emerge as the go-to retirement savings vehicle for the vast majority of American workers, replacing the once-popular employer-provided pension plan.
Couple the rarity of pension plans nowadays with a sense of uncertainty surrounding social security and it’s no wonder young professionals assume they will need to fund a retirement without much, if any, help from anyone else. So, they drop a good chunk of their available savings into their 401(k) because, well, why not? It’s tied to their paycheck, they get a tax benefit, and if they’re lucky, their employer offers a small matching percentage.
The problem: not all 401(k) plans are created equal. Hidden fees are rampant in today’s 401(k) marketplace, and if you have a bad 401(k) plan, you may want to do some research before blindly maxing out your 401(k) contributions. But how do you know that you have a crummy 401(k)?
Here are 5 tell-tale signs that you have a bad 401(k) plan
1. High Fees
The all-in costs for 401(k) plans can vary anywhere from under 0.5% up to 4.5% and largely depend on the size of the plan. Large companies that have more bargaining power with plan providers pay 0.5% or less on average. On the other hand, the little guy gets penalized and can often pay 1.5% to more than 2%, according to Brightscope’s 401(k) Fee Chart, also pictured below.
Common 401(k) fees to look out for:
- Administrator fees: These fees go toward the management of the 401(k) plan. They can include things like record keeping, legal services, trustee services, customer service representatives, and providing educational events or materials. Though they may not seem necessary, most of these tasks must be completed by someone to keep the 401(k) active and in good standing with the IRS. It’s kind of like you needing to file your taxes every year…Sometimes the employer will pay these fees. More often than not, though, they get passed on to the 401(k) plan participant (employee).
- Fund management fees: Most often, management fees show up as an “expense ratio,” expressed as a percentage of the amount invested in a particular fund. It is possible that they pop up as ongoing 12b-1 fees, commissions (also known as “loads”), or transaction fees too.Like a lot of other 401(k) fees, these can be hidden pretty well, so you will want to make sure you understand what you’re paying before you make any investment. Let’s be real, though – that’s something you should be doing anyway.These fees get paid directly by the participant (employee) and are usually the largest fee paid within a 401(k).
- Investment advisor fees: Your plan may or may not have an investment advisor associated with it, but if you do, they are also being paid to help design the plan for your company, choose the investment options within the plan, and maybe even educate employees above their 401(k) options.Like the administrator fees noted above, advisory fees can be paid either by the employer or by each employee, depending on how the plan is set up.
- Service Fees: These are miscellaneous fees that vary from plan to plan and can make you feel like you are being nickel-and-dimed by the plan administrator. Some example of service fees are: fees to send checks or ACH requests, fees to close out your account if you’re rolling over your old 401(k), or fees to take out a loan from the plan.All these fees will be disclosed in the plan summary, which your employer should be giving you every year.
If you are paying total fees of more than 1.5% at a small company or more than 1% at a large one, your fees are too high and you should talk to your plan sponsor (your employer) to see what you can do to lower them.
2. No employer match
According to the Bureau of Labor Statistics, 51% of employers with 401(k) plans offer some sort of match on their employee’s contributions. And the average match is around 3%. That means the other 49% of 401(k) plans don’t provide any match at all.
So 49% of you now you have a 401(k) plan that has high fees (as described above) and your employer isn’t going to give you any “free money” in the form of an employer match… Sounds like a sweeeeet deal to me (note the sarcasm).
If this describes your situation, congratulations, you have a crummy 401(k). Take a look at stocking retirement money away in other types of investment accounts before you start contributing to your 401(k). Other account types could be ones like an IRA, Roth IRA, or HSA, assuming you’re eligible.
3. Bad investment options
401(k) investments are almost always made up of either mutual funds or your company’s stock. Unfortunately, most mutual funds available to US investors are built with the aim to outperform the market. If you have ever read my investment philosophy, you know I believe (and academic studies confirm) that trying to beat the market is a fool’s errand.
Instead of diving down the passive investing rabbit hole, let’s get into…
What makes 401(k) investment options bad?
- High fees and costs. As noted earlier, the management costs of 401(k) investments can be the largest fee you pay within your retirement plan, which means they should also be the first thing you look at when assessing your investment options.Things to look out for:
- Funds that have any sort of commissions, sales loads, or 12b-1 fees.
- Funds that have high ongoing expense ratios, which can eat up returns over time. The average 401(k) fund expense ratio is around 0.75%, but why pay that (or more) when you can own a Vanguard index fund or a DFA fund and pay anywhere between 0.04% and 0.3%?? You’ll likely have better returns and you’ll pay less to get them. Win-win.
- Lack of diversity in investment options. 401(k) providers are getting better at offering a broader lineup of investment options within their plans. Even still, I’ve seen plenty of 401(k) investment lineups that offer lots of options to make it look like there is diversification without actually providing any real diversification in the underlying investments.Let’s look at an example. This particular 401(k) has the following options:
- 1 U.S. large growth fund,
- 1 U.S. large value fund,
- 2 U.S. large blend funds,
- 1 U.S. mid-cap growth fund,
- 1 U.S. small-cap value fund,
- 1 foreign large blend fund,
- 1 foreign large growth fund,
- 1 foreign mid-cap growth fund,
- 1 emerging markets fund, and
- 9 target date retirement funds
OK. At first glance, it feels like there are a decent number of choices, until you look at what those funds actually invest in. Upon investigating further, the U.S. Large funds invest in mostly the same companies – the top 5 holdings for all 4 funds are Microsoft, Intel, Amazon, Boeing, and Apple. Likewise, all three foreign funds are investing in the same companies as well – Amadeus, Bunzl, OBIC, and Sika.
Diversification matters. And if you aren’t able to get any real diversification with the limited investment options available in your 401(k), you can potentially expose yourself too much to any single investment.
- No substantial track record. Over a 10-year period, only about 58% of mutual funds stay in business. What that means is that only 58% of the U.S. based equity mutual funds that were around 10 years ago are still around today.
It’s not the end of the world for investors in the other 42% of funds that don’t stick around, but it’s not great for them either. Do your best to avoid the headache and make sure that the funds you plan to invest in will be around for the long-term.
The best way to do that is by looking at the fund return performance in the investment pamphlet that you’re given with your 401(k). The key here is not to look at the actual percentage return each fund has had. Instead, look at the time-period for those returns. If it doesn’t have a return number for a given time period, that means the fund has not been around long enough to calculate the return for that period.
Though nothing is ever guaranteed in life, funds that have been around for 10-years or longer have a higher likelihood of continuing to be around for the foreseeable future.
Regardless of the investment options within your 401(k), if you are offered any sort of self-directed option, like a Fidelity BrokerageLink, Schwab Personal Choice Retirement Account (PCRA), or TD Ameritrade Self Directed Brokerage Account (SDBA), that can be a good way to choose your own investments, increase diversification, and reduce your costs. Make no mistake, it’s a riskier move for you because you have full control of your investments. But if you invest wisely, it can be worth it.
4. Lack of transparency & education
As an employee, understanding your 401(k) contributions, costs, and investments empowers you to maximize what the benefits of a 401(k) can do for you. Unfortunately, not all 401(k) plans are provided with the employee in mind, and the workings of the plan are not always as clear as they should be.
More and more providers are auto-enrolling employees into the company 401(k). However, the necessary information isn’t always given to employees and can be difficult to find without an onboarding process into the plan. That can make it tough for those employees to get a good handle on how much they’re contributing, what the employer match is (if there is any), how to access their 401(k) account, change their contributions or investments, and retrieve the plan documentation.
Admittedly, this is more of an HR problem and is more prevalent in small businesses where there’s one person wearing multiple hats. Still, it has happened at larger companies as well, and can really impact the experience that you, as an employee, have with your 401(k).
The good thing is that there’s a simple solution, though it may not be easy. You’ll need to talk to the right people at work, do your homework, and educate yourself on how to best take advantage of your 401(k).
5. Ease of use
I will reiterate that bad 401(k) plans are usually not built for employees. The typical employee has very little say, so 401(k) administrators focus their efforts and money on building up sales processes that appeal to the owner or employer. The end result is a plan that has outdated management systems and poor employee service (which, as the employee, you’re paying for).
This lack of attention to areas that are important to the employee can hurt in a variety of ways that may have an impact on the value of your 401(k) over the long-term. It can:
- make it difficult to join the plan, if you’re not already being auto-enrolled,
- lead to your employer taking more or less out of your paycheck than you would like,
- cause delays in administrative requests, and
- create confusion for plan participants on how to allocate or re-allocate their 401(k) contributions.
The one sure-fire way to determine if your 401(k) provider is more concerned with acquiring customers than providing a good user experience is by visiting their website. The public part of the website will look sleek, but once you login, the software will feel old and clunky, like it was built for one of the very first IBM computers:
So…what can you do?
I’ll go into more detail with my next blog post, but the main things you can do when you have a bad 401(k) are:
- Talk to your employer about getting a better plan, or
- Use the best options available to you within the 401(k) to maximize your match and minimize costs. Then build out a better portfolio using other types of accounts: a Roth IRA, Traditional IRA, HSA, or other brokerage account.
