How Good Is Your 401(k) Plan?
Our basic audit can help you determine whether to max out your contribution or lobby for improvements.
Your company retirement plan may well be getting better.
As Morningstar's Scott Cooley discussed in this article, the introduction of "nudge" features like automatic enrollment and auto-escalation (participants put more into their 401(k)s when they get raises) and the uptake of professional management mean that many 401(k) investors are able to save more and invest better than they would have even a decade ago. I'm also seeing more and more index funds in 401(k) plans, which usually feature ultralow costs.
But there are still huge variations in plan quality across employers. Although plans from large employers aren't universally good, scale is generally an advantage in the 401(k) marketplace. That means that a plan that contains many millions of dollars is going to have more clout to swing a good deal with providers than will the plan of a tiny firm that lacks a big 401(k) kitty. Moreover, smaller firms, by necessity, frequently require employees to multitask: At a smaller firm, the person who's charged with maintaining the 401(k) plan on an ongoing basis may also be overseeing payroll and selecting phone plans.
If you suspect your plan is lacking, don't just commiserate with colleagues about it. By doing a thorough checkup of the plan, you can decide how much of your investment dollars to allocate toward it; you may decide to invest just enough to earn matching contributions and then turn to an IRA with any additional contributions. Checking up on your plan--and taking the extra step of documenting what you find and communicating it to your 401(k) committee or the individual who oversees your firm's benefits package--can also help you build a case for improving it.
A Basic Audit
You may have noticed that your company retirement plan is lacking a good core bond fund, or your gripe is that matching contributions are low. But before sounding off on these problems on a one-off basis, take stock of the plan from top to bottom, including a review of its administrative costs, fund choices and their expenses, employer matching contributions, and the presence of additional options, such as the ability to make Roth and aftertax contributions. (There's a difference between these two contribution types, as discussed here.) Note that this review process generally applies to 403(b)s and 457s, too.
Unfortunately, you won't be able to find every bit of information you need in a single document; you'll need to gather the information from various sources, including your plan's Summary Plan Description and annual report (Form 5500), both of which you can obtain from your company. Here are the key items to look for, as well as how you'll find them and how you can benchmark them.
Matching contributions: Find the amount of your contributions that you're being matched on in the Summary Plan Description. Also, check up on the vesting schedule for those matching contributions (how long you'll need to stay at the company to be able to take those contributions with you when you leave). Armed with that information, you can assess whether your employer's matching setup is generous, miserly, or somewhere in-between. The last part of this article helps you make that assessment. Of course, you always want to invest enough to earn matching contributions, but if upon further research you determine your plan is subpar, you may want to steer additional retirement contributions elsewhere.
Administrative fees: This is the trickiest part of any 401(k) assessment. That's because plans can charge administrative fees in a number of ways, as discussed in this posting on the Department of Labor's website. The employer can pay administrative costs itself, or it can pass them on to plan participants. If the latter, the administrative costs may be deducted directly from plan assets, or they might be embedded in the individual-fund fees. Those varying fee setups mean that there's no single location for the information. But a starting point is your plan's annual report (Form 5500). In it, you may see your plan's administrative expenses expressed as a dollar amount. You'll then need to divide that dollar amount by the total assets in the plan to arrive at a percentage. BrightScope.com also provides some comparative information on 401(k) plan expenses. There aren't hard-and-fast cutoffs about what constitutes a high-cost plan, and administrative-expense percentages will tend to vary based on employer size. In general, however, if your plan's administrative costs edge above 0.5%--and certainly if they're more than 1%--that's a red flag that you have a high-cost plan. After all, those expenses come on top of whatever the underlying investments charge.
Completeness of investment lineup: Does your plan offer the basic portfolio building blocks for workers at various life stages, including well-diversified U.S. stock, foreign-stock, and core bond funds? Does it include target-date funds for investors who don't want to handle asset allocation? Many 401(k) plans fall short on the fixed-income side, offering just a single government-bond fund, for example. It's not cause for concern if your lineup doesn't offer exposure to each and every small asset class--in fact, that may be by design--but it's fair to ask to be able to build a plain-vanilla stock/bond portfolio within the confines of the 401(k).
Quality of investment lineup: In addition to checking up on the breadth of your 401(k) lineup, you should also assess the quality of the offerings. Morningstar.com offers an abundance of information on this front, including fee comparisons for individual funds relative to appropriate peer groups; but be sure that you're matching the share class in your plan to the appropriate share class on the site. (For a given fund, click the "Expense" tab on its main page to see more details about its expenses.) Also, pay attention to what share classes you can buy: Does your plan hold higher-cost share classes when cheaper ones are available? (The cheaper share classes may not be available to your particular plan, but it's worth asking.)
If you can't find information on your plan's holdings on Morningstar.com, it could be that they're collective investment trusts; this article discusses how to conduct due diligence on such offerings. Not each and every fund option must have ultralow expenses and earn a Morningstar Analyst Rating of Gold (or any medalist rating at all), but document funds that have low ratings and/or above-average expenses.
Additional features: While the quality of the investment lineup is key to making an assessment of it, also take stock of additional features. Does it include additional useful features, such as automatic rebalancing and automatic escalation? Does it include a Roth 401(k) option or the ability to make aftertax contributions? A lack of such features shouldn't be a deal breaker, but if you value any of them, be sure to tell the individual(s) overseeing your 401(k) plan.
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