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401(k) Pros and Cons

Thu, 16 May 2013

These plans offer investors many benefits in saving for retirement, but they also have their drawbacks.

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Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar. As company defined-benefit pension plans become a rare species, the 401(k) has become many investors' primary investment vehicle. But they are not all cut from the same cloth. Here to talk about the pros and cons of 401(k)s is Christine Benz, our director of personal finance. Thanks for being here, Christine.

Christine Benz: Jason, great to be here.

Stipp: So 401(k)s can be a great vehicle for investors. In fact, it's maybe the only choice through your employer for a lot of investors. There are some pros and cons you should keep in mind about investing in 401(k)s. Let's start with the pros of 401(k)s. You say one of the biggest is just the discipline that a 401(k) brings to the retirement-investing process.

Benz: Right. It's enforced discipline. Your contributions go in without you having to lift a finger except to initially get the thing going. So it does keep you investing in good markets and in bad, and that I think tends to serve as a safeguard against investors' own worst behavioral tendencies.

The other thing is that they really make it easy for people who are a little bit lazy about their investments. So you can add on nice features that can get your plan back into whack. So you can put in place auto-escalation in a lot of plans, so your contributions bump up if you get a raise in salary. You can also auto-rebalance if you want to have your portfolio periodically scaled back to your target allocation. So those are additional features that a lot of plans have these days, and they really make it quite easy to stay disciplined and stay on track with your plan.

Stipp: Another very important feature of many 401(k) plans is some form of employer match, which can really make your money work a lot harder.

Benz: Absolutely. So regardless of the quality of your plan, once you've done a little bit of homework on what the investment options are like, you do want to contribute at least enough to earn that match if your company is indeed offering one. That's something that you will not get, obviously, if you invest outside of the confines of a plan.

Stipp: One thing that a plan can bring to investors is because it may be a bigger company you might have access to funds you wouldn't necessarily have access to otherwise, or you might get a better deal on some of those funds perhaps?

Benz: Absolutely. So there are institutional share classes of mutual funds. They often feature very, very low costs alongside the share classes that are available to retail investors buying the funds on their own. So that is a nice perk for 401(k) investors. If they are in a larger plan where the management company has swung a nice deal on behalf of participants, your total cost load for owning that plan can be very, very low.

An additional thing, Jason, is that there are investment types that only appear within 401(k) plans. You won't find outside of them. So stable-value funds, for example, would be one option. The key feature there is that you do typically get a higher interest rate than you would earn on your cash, but you get all of the safety or nearly all of the safety of cash, or you get cashlike attributes, I should say. People who invest in the Thrift Savings Plan that is available to federal government employees have a nice option that is somewhat similar called the G Fund, where you have higher interest rates, but again a lot of safety built in. You will not get these particular funds outside of the 401(k)/403(b) plan confines.

Stipp: In some states there may also be some additional asset protection for funds you have housed in a 401(k).

Benz: That's right, and this does vary by state, but typically in many states, the 401(k) plan assets are safeguarded against bankruptcy or any sort of lawsuit that you might find yourself involved in. You do have some greater safeguards than you would if you had your money within an IRA or in some sort of taxable brokerage account.

Stipp: Lastly, on the pro side there are some very important tax benefits to saving in the 401(k) as far as reducing your taxable income now, and also there are ongoing benefits.

Benz: That's right. If you are contributing to a traditional 401(k), you will earn a tax break on your contribution, so your money will go in on a pretax basis. It will accumulate on a tax-deferred basis. You'll owe money on the way out, when you are in retirement and taking withdrawals. If you are contributing to a Roth 401(k), the tax treatment is almost exactly the opposite. So you will put in taxable contributions, you'll have that tax-deferred compounding, and you will be able to take tax-free withdrawals. Either way, it's a nice tax break.

Stipp: On the flip side, not all 401(k)s are the same. So the tax benefits are the same across all 401(k)s, but the investments within those 401(k)s, for example, are different. You do want to do some due diligence when you are looking at the options in your 401(k)?

Benz: Absolutely, because the quality can vary to such an extreme. Often times, unfortunately, it breaks down to the size of the plan. So, generally speaking, the larger your plan, the more likely you are to find some of those very low-cost investment options. You are more likely to find that a little bit more thought and care went into putting together the plan. Of course, I often talk to people who say, "Wait, I work for a large employer. I don't like my plan that much."

But generally speaking, people in smaller plans might be contending with higher-cost options. They might also have a layer of administrative fees in addition to anything that's embedded within the funds themselves. So, you'd want to do your homework about the quality of your plans specifically. You are looking at the investment options, and you can find research on those individual funds on Morningstar.com. But you also want to look for what's called the Summary Plan Description. It's a document about your plan available from your employer. You want to look specifically at the administrative costs being levied on participants.

Stipp: And you say folks who are older and may have more fixed income in certain plans, they might find their options more limited.

Benz: Right, and this has just been my casual observation looking at other people's 401(k) plans. That's where I found that menus on 401(k) plans often fall short, in the fixed-income option. I recently looked at a plan, for example, where the sole option was a government-bond fund, sort of an intermediate-term government-bond fund. That's not enough for someone who is getting close to retirement. They need more diversity in their bond holdings at that point. So, certainly if that's you, if you are in that position and you are looking at very limited choices in bond-fund land, you'd want to make sure that you are augmenting your 401(k) holdings with holdings outside of the 401(k) plan to give you a little bit of extra diversification.

Stipp: And you mentioned that there can be extra layers of fees in some 401(k)s. How do I know when that is excessive?

Benz: That's really good question, Jason. I typically think, if you are looking at the administrative costs, anything that's much higher than say 0.5% is a lot, and that is a significant headwind and possibly negates some of the positive features that might come along with your plan. You may be better off just contributing enough to earn the match in that plan, whatever your employer is making in terms of matching contributions. Then go outside of that plan and make Roth IRA contributions or traditional IRA contributions if you can get a tax break on your contribution. Then if you find you still have money to go back and invest, then you can look at the 401(k) plan again. But that's the sequence I would use if I were stuck in a high-cost 401(k) plan.

Stipp: And you said that you might be paying some fees even if you don't see that administrative fee as a separate line item in your plan?

Benz: Right. So plans do it in different ways. They may charge it as an explicit line item. You might see the administrative expenses, but sometimes the fund company simply offers a higher-cost menu of funds, so you are in a higher-cost share class that embeds some of those administrative costs. If you don't see that high administrative fee, you still want to make sure that you are looking at the expense ratios on a fund-by-fund basis because those admin costs could be stuck there.

Stipp: And you mentioned earlier that 401(k) assets will be taxable when you do make withdrawals in retirement, and also with 401(k)s you have to make withdrawals at some point in retirement.

Benz: That's right. Required minimum distributions come into play once you hit age 70 1/2, and they are a fact of life for people in 401(k)s, whether traditional or Roth. Although if you do have a Roth 401(k), you can simply convert to a Roth IRA, and you won't owe any taxes. If you are in a traditional 401(k) and you want to get your money over into the Roth column, your only option then is to do a conversion, and that will be a taxable event for you. So, RMDs are a fact of life if you are sticking within a traditional 401(k).

Stipp: Certainly, a lot of benefits to 401(k)s, but they are not created equally. You certainly have to do your homework. Thanks for helping us with those details today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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