11/6/2013 5:15 PM ET|
How to tell if your 401k stinks
Some 401k plans offer better benefits to plan participants than others.
Investing in a 401k plan allows you to defer paying income tax on the money you save for retirement, helps automate your decision to save for retirement by having the money withheld from your paycheck and often allows workers to get valuable employer contributions.
However, investing in a 401k plan isn't always worth it, especially if your plan has high fees, poor investment choices and no employer contributions. Here's how to tell if your employer is providing a subpar 401k plan:
No immediate eligibility. Ideally, you should start saving in a 401k plan with your first paycheck, but many employers won't let you. Only 54 percent of 401k plans offer immediate eligibility, according to a recent Vanguard analysis of 2,000 401k plans with 3 million participants. And 16 percent of 401k plans require workers to be with the company for an entire year before they are able to put their money in the plan. "It's sort of a legacy of when record keeping was more manual," says Jean Young, a senior research analyst for the Vanguard Center for Retirement Research. "You want to make sure that somebody is going to be with your organization before you enroll them."
No employer contributions. Most Vanguard 401k plans (91 percent) offer an employer contribution. The best 401k plans immediately provide employer contributions to workers, but the majority of 401k plans impose a waiting period before new employees are eligible for a match or other company contributions. Many 401k plans require between one and six months (27 percent) or even an entire year of service (28 percent) before employees become eligible for a 401k match.
A very small match. The maximum possible match employees can get is a median of 3 percent of pay among all Vanguard 401k plans. The bottom quarter (24 percent) of 401k plans offer a maximum possible employer match of less than 3 percent. The top 15 percent of plans provide employer matches worth 6 percent or more of pay.
A match that is difficult to take advantage of. Employer contributions vary considerably by employer, with Vanguard alone administering 401ks with more than 200 different match formulas. Almost half (48 percent) of 401k plans require employees to contribute 6 percent of their pay to the 401k plan to capture the maximum possible 401k match. Other employers require workers to save between 3 and 5 percent of pay (37 percent) or at least 7 percent (11 percent) to get the entire match offered.
The exact match formula plays a role in how easy it is for employees to actually take advantage of company 401k contributions. The most common 401k match is 50 cents for each dollar contributed up to 6 percent of pay, and 24 percent of 401k plans use this match formula. Another 14 percent of 401k plans offer a multi-tier match formula such as $1 for each dollar saved on the first 3 percent of pay and 50 cents for every dollar contributed on the next 2 percent of pay. And 7 percent of plans cap the maximum amount of employer contributions workers can get.
Match formulas have the biggest impact on workers who can only afford to save a small amount. Consider a worker who is able to save 3 percent of her salary in a 401k plan. If her employer matches 50 cents for each dollar contributed up to 6 percent of pay, she would get 1.5 percent of her pay as a 401k match instead of the maximum possible match of 3 percent. If her employer instead matched dollar for dollar the first 3 percent of pay, she would be able to take advantage of the entire match offered with the same maximum potential cost to her company.
No nonmatching contributions. Some employers contribute to a 401k plan on behalf of employees without them having to save anything on their own, contributing a median of 4.2 percent of pay. The most generous 401k plans (16 percent) provide employer contributions worth 10 percent or more of worker salaries.
Long vesting schedule. Employees who leave a job before they are vested in the 401k plan could forfeit some or all of their employer's contributions. Only 44 percent of 401k plans offer immediate vesting, which means you will get to keep all of your employer's contributions whenever you leave the company. Some 401ks have cliff vesting schedules in which you don't get to keep any of your employer's 401k contributions until you have been employed by the company for a specifc number of years. "If you are likely to change jobs a lot because of the nature of your career, and the company has a generous match but that is subject to a three- or five-year cliff vesting schedule, it's not likely to benefit you," says David Loeper, author of "Stop the Retirement Rip-off: How to Avoid Hidden Fees and Keep More of Your Money." Other employers have graded vesting schedules in which you get to keep a gradually increasing proportion of your employer's contributions based on your years of service – typically getting to keep the entire 401k match only after five or six years of service. "The employer doesn't want to invest in the employee and then have the employee up and take off," says Christopher Carosa, a retirement plan consultant and chief contributing editor of FiduciaryNews.com. "From the employee's standpoint, it's better to have immediate vesting."
Poor investment choices. The average Vanguard 401k plan offered 27 investment options in 2012, up from 16 in 2003, many of which were recently added target-date funds. "If you have more than 20 options it's probably not going to be a user-friendly plan," Carosa says. "It's going to put too much of the burden of deciding what to invest in on the employee." However, almost half of Vanguard 401k plans now offer at least four low-cost index funds that invest in U.S. equities, international equities, bonds and cash, up from a quarter in 2004. "The index core is going to have the lowest cost typically, and costs have been demonstrated to be very important in terms of predicting future outcomes," Young says.
High fees. Most 401k plans charge a variety of fees ranging from record-keeping costs to expense ratios on each investment option. You want to make sure that the expenses aren't excessively high. "An easy to remember rule of thumb is to look and see who is selling the fund to the plan. If the fund is being sold by a broker or an insurance company that is working in a non-fiduciary capacity there is a good chance that you will have these excess fees," Carosa says. "You want to make sure that none of the options in the plan have 12b-1 fees or revenue sharing."
401k plans are now required to give all investors information explaining the fees associated with each investment option in the plan, due to new U.S. Department of Labor rules. Make sure you look at these quarterly and annual 401k statements, and keep costs in mind when making investment decisions. "The fee is 100 percent certain; the return is not guaranteed," Loeper says. He recommends aiming to pay no more than 75 basis points for most investments, and less than 20 basis points for index funds. "If you are paying more than three-quarters of a point," he says, "somebody is making excess profits or is gambling with your money."
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