How to Cope With a Lousy 401(k)
Morningstar's Christine Benz explains how to size up plan costs and investment options as well as key workaround strategies.
How to Cope With a Lousy 401(k)
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Jason Stipp: I'm Jason Stipp for Morningstar. Over the last 30 years, 401(k) plans have taken on an increasing role in investors' retirement plans. But what if your 401(k) isn't so hot? Here to offer some coping plans for investors who have lousy 401(k) plans is Morningstar's Christine Benz, our director of personal finance. Christine, thanks for joining me.
Christine Benz: Jason, great to be here.
Stipp: What are some signs that a 401(k) is not so hot?
Benz: The biggie that you want to be on the lookout for is the total costs that you are paying. There are really two levels of fees that you want to concentrate on. The first is very much out there in the open--that's the fees associated with the specific investment choices in your lineup. This should be pretty easy information to find. Whether you look on Morningstar.com or some other resource, you should be able to match the share class that's in your plan with the share class on some other information source to see how much you are paying for the specific funds. Anytime you see equity funds that are charging more than 1% per year or bond funds that are charging more than 0.75% per year, I think those are benchmarks that you might use to say, "This plan, at least when I look at these investment choices, is a fairly high-cost plan."
You also want to look at the plan's total administrative costs. Are you paying any additional charges on top of what you are having to pay to invest in those individual funds? Here, you'll have to do a little more digging; you'll have to request a document called the Summary Plan Description, or you may be able to find it in your plan's annual report. Here, you are looking for the administrative fees associated with investing in the 401(k) plan.
I typically think anytime you see administrative fees that are running over 0.5% per year, when you add on the fund expenses, that can add up to be a costly plan. So, try to get your arms around the total costs of being in the plan. If it is a high-cost plan based on those two levels of fees, that could be an impetus to perhaps invest elsewhere before you invest in the plan.
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Stipp: What if I check the underlying fund fees and they are about average, and maybe the fund's performance is about average and maybe the administrative fees aren't terribly high, but yet it's not also at the top of the charts either? How should I think about that?
Benz: This is a common issue with 401(k) plans. I think of it as kind of an also-ran problem, because when you look at a lot of 401(k) menus, what you see are funds that were great maybe 15 or 20 years ago, and they haven't done a lot for investors since. It's not that they have been terrible, just perhaps they have gotten large and have begun to kind of mirror the market's exposure. I think you need to keep that in perspective. While they may not be the most exciting funds that you would choose from scratch if you were, say, investing in an IRA, nor are they likely to really drag down your results. So, if you don't have very high costs associated with the plan and your fund choices are just looking a little bit mediocre, I don't think that should be a deal breaker--that shouldn't be a reason to say, "I'm not going to invest in this plan."
Stipp: What if those administrative fees do look high and it looks like your fund fees are also pretty high and the plan, overall, just doesn't feel like it's very good? Should I just get out or not invest at all?
Benz: The first step is to check on matching contributions, and I think anyone who has followed personal finance and investing knows the importance of investing at least enough to meet the matching contributions because that's 100% return on your money. It can be a real stinker of a plan, but you are earning those matching contributions and it's really hard to beat them. So, at a minimum, if you're getting matching contributions, invest up to the match before you look outside the plan.
Stipp: So, let's say I'm getting a match; I'm not crazy about my 401(k). You have some ideas on how I might be able to augment the 401(k) by investing outside. So, what would be a strategy, then, if the plan is not so great but I want to get that match and I want to try to build a stronger portfolio?
Benz: One of the first steps to take would be to take a step back and look at your total household's retirement assets together. It may be that you--or if you have a spouse or partner--you may be able to make the best of your respective plans, even though you're not running those plans as well-diversified portfolios unto themselves. That's not a big deal as long as the asset allocation of the total portfolio adds up to something reasonable, given what you want its asset allocation to be.
So, take a step back and see if you can't find a few decent choices within your 401(k) plan. One option that is increasingly popular is the index fund, and we're seeing them in more and more 401(k) plans. Even if you don't have the cheapest index fund available to you--say yours charges 40 basis points and you can find index funds that charge under 10 basis points--you still may be able to ring out a decent result by investing in that overpriced index funds. So, see if you can find a few investments that do look at least semireasonable, and you can dramatically overweight your positions in those specific funds.
Stipp: So, you can try to make the best of the better-looking funds in your plans--same with your spouse, perhaps--and find a good mix of better funds that way. Some plans also have the option of what's called a brokerage window, which can give you a few other choices, but it also has drawbacks.
Benz: Right. This can really be a salvation if you have a truly lousy plan but you do have access to a brokerage window. What you are able to do if you invest through the brokerage window is that you'll have access to many more choices than are on your plan's preset menu. The drawbacks, though, as you mentioned, Jason, are that you may pay administrative expenses to participate in the brokerage window versus sticking with the preset menu. And then the biggest drawback, in my view, is that you will pay transaction fees to put your money to work in those ETFs or other funds that aren't on the preset menu. And those are usually dollar-based fees, meaning they are going to take a particularly big bite out of the investments for people who are making small regular contributions. So, you want to make sure that if you are going this route, that potentially you are ganging up larger contributions so that, as a percentage, those fees aren't taking as big of a bite out of your contributions.
Stipp: If you don't want to use the brokerage window and you find a couple of good funds in your plan or your spouses' plan but it doesn't fill a full portfolio, then maybe it's time to invest outside the plans.
Benz: Absolutely. And I think investors can nicely use IRAs to help augment those pieces of their 401(k)s or their company retirement plans that are missing. Anecdotally, one area where a lot of 401(k) lineups look pretty light is in the fixed-income space. They might just have one or two funds; they might be Treasury-only funds, and you might want some additional exposures. You can use your IRAs to supplement those funds that are on your menu.
Stipp: And, of course, when you are going IRA, you have a world of choices and you can find really best-of-breed funds.
Benz: It's wide open, and you can really keep the costs way down, too.
Stipp: Lastly, you say that if things don't look that great with your 401(k), let somebody know.
Benz: Absolutely. Check with your HR or plan administrator, or maybe there is a 401(k) committee at your company that's charged with overseeing your plan. Let them know what your specific issues are. If you've got colleagues who feel the same way that you do, put a letter together showing them the shortcoming that you think exist in the plan, how you think it could be better, document it, commit it to writing--either electronic or physical delivery of that document. But let them know you are serious about the plan's shortcomings and continue to let them know even if things don't change right away.
Stipp: These plans are going to be a big part of more and more people's retirement planning, so thanks for helping us get the most out of them.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.
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