In Defense of the 401(k)
December 04, 2013I began my career in 1994 as an enroller for a large 401(k) provider. From the moment I started, I was indoctrinated in the virtues of this particular savings vehicle. Things like “tax-deductible savings” and “payroll deduction” became everyday vernacular, and before you knew it, I was out there evangelizing the masses on the greatness of this extremely important part of the tax code. So imagine my chagrin when I learned that my beloved 401(k) has come under attack recently by some who are calling for its demise.
Americans are facing a retirement savings shortfall thanks in part to a failing Social Security system, diminishing employer-paid retiree benefits, and increasing longevity. For that reason, any program that makes it easy to save for retirement should be championed. I confess that the 401(k) is not the Holy Grail when it comes to saving for retirement, but compared to the alternatives, it’s perhaps the best system we’ve got.
The 401(k) is not without its defects, but to borrow from Shakespeare, I believe there has been much ado about nothing. Troy Adkins wrote an article titled “6 Problems With 401(k) Plans” that outlines some of the perceived problems with the 401(k) system. While there may be some validity to the spirit of these issues, I don’t think any of them should cause you not to participate in this effective retirement-savings device.
Problem #1: The way contributions are made is a structural flaw
One criticism of the 401(k) system is the structure in which investments are made, i.e. payroll deduction. The argument is that it forces investors to buy investments when those investments may be overpriced. Instead, it argues it would be better if contributions were made to a conservative option and then moved to other options when the time was right.
This sounds good in theory, but it also sounds a lot like market timing, which most financial professionals agree is a bad idea. Payroll deduction is one of the primary reasons the 401(k) has been so successful because it doesn’t rely on us to save money that we could otherwise spend. Similarly, dollar cost averaging—an investment philosophy whereby an equal amount is invested periodically so that the investor buys more shares when the share price is lower and fewer shares when the share price is higher—takes the emotion out of investing, which stops many investors from buying at the wrong time, i.e. when the market is high.
Problem #2: A fund manager’s tenure compromises a long-term investment strategy
Actively managed mutual funds rely on portfolio managers to decide when to buy and sell investments within the fund, and since it is rare for the same mutual fund to have the same manager for a really long period of time, Mr. Adkins suggests that short-term tenure creates a problem for a long-term investor. It is true that managers don’t stay in place forever, but most actively managed mutual funds have a mandate that dictates how the fund should invest and a well-established methodology that doesn’t come and go with the fund manager. Even so, financial inertia causes many investors to hang on to under-performing investments rather than look for alternatives.
Again, that’s where the 401(k) has been a big help. Your plan sponsor has a fiduciary responsibility to make sure the investments in your plan are competitive, and many have an investment policy statement that they use to evaluate the current lineup of funds and fund managers.
Problem #3: 401(k) plans are too expensive
Because of the regulatory environment in which 401(k) plans operate, expenses may be higher than other savings alternatives. This may be especially true for smaller plans, but most employees in the U.S. work for large companies, and as a result of the economies of scale, many 401(k) participants benefit from institutional pricing not available in the retail marketplace.
Recently, I spoke with a young lady who rolled money over from a previous 401(k) into a traditional IRA. She paid a 5.75% front-end load to purchase a mutual fund with a 1.05% expense ratio, and her IRA custodian charges a $40 annual maintenance fee. By contrast, her new employer offers a 401(k) that has no loads, no maintenance fees, and equivalent investments with an average expense ratio of 0.16%. (Needless to say, she is rolling over her IRA to her 401(k).)
Problem #4: 401(k) recordkeeping makes it difficult to track progress toward meeting long-term financial goals
I admit that when I started in the business twenty years ago, toll-free numbers and 401(k) statements were not pretty, but times have changed. Thanks to marvelous advancements in technology, many of today’s participants have access to sophisticated recordkeeping tools and resources that make it easy to track progress, measure performance, and manage investments. Many plan sponsors are even beginning to offer online advice tools and managed account services to further assist participants in reaching their long-term goals.
Problem #5: Your 401(k) plan does not offer enough investment options
Years ago, participants could choose from dozens and dozens of mutual funds, but while the idea of choice seemed like a good thing, the reality was that participants were simply overwhelmed by too many options. They would pick funds at random, usually based on past performance, and end up with five or six mutual funds that invested in similar securities, thus creating a false sense of diversification.
To combat this problem, many plan sponsors have chosen to simplify things by offering only enough options to cover the basic asset classes, along with target-date funds which offer the benefits of automatic diversification, re-balancing, and asset allocation adjustments over time, all in one investment option. Such modifications have greatly reduced the incidents of overlap and in some instances, have increased investor confidence.
Problem #6: 401(k) plans have limited tax advantages
When the 401(k) was first conceived in the 1970’s, personal income tax rates were much higher than they are today. As the personal income tax rates have come down, so has some of the allure of tax-deferred saving, but even in a low tax bracket, deferring taxes may have its advantages (see my January 18, 2012 blog post). That said, 401(k) plan sponsors are starting to add a Roth option to their plans so that employees that want to pay taxes on their contributions today for the benefit of tax-free earnings in retirement can do so. This is especially good news for those participants that have been excluding from making Roth IRA contributions because of IRS income limits.
These concerns wouldn’t exist if there were not instances when they were true, but thanks to a competitive, free-market environment, the 401(k) industry, at the behest of plan sponsors, has done a lot to remedy these problems. In light of where things are heading with Social Security, Medicare, and other retiree concerns, I shudder to think where we would be without it.