For most of us, our first taste of investing is through our employer sponsored 401k. The 401k was created to provide a relatively low cost means for all employers to provide retirements savings for their employees. Generically referred to as a defined contribution plan, the 401k is primarily funded from the employee’s earnings with some employers contributing a matching amount. Before the 401k, large employers funded a pension for their long term employees. This is known as a defined benefit plan. Generally, you had to remain with this employer for many years in order to vest any benefit which you could begin to receive when you reached retirement age. Defined benefit plans can be complex and expensive to administer so generally only large employers offered them. With the emergence of the 401k, pension plans have been largely phased out for newly hired employees. However, the pension obligations remain for the employees who have already vested benefits.
By way of contrast, the 401k belongs to the employee. If you change jobs, you can leave your 401k in your former employer’s plan, move your account to your new employer or you can roll the account into an IRA. In any case, this tax deferred account will continue to grow until you are ready to tap it for retirement at any time after you turn age 59 ½.
Here’s how this works. You are the plan participant, your employer is the plan sponsor and there’s a third party who is the plan administrator. The employer will select the plan administrator from among a wide variety of financial service providers. The plan administrator handles all of the paperwork associated with enrolling participants, providing account information to the participants, selecting the investment options, directing contributions as specified by the participants and handling any distributions. Plan administrators will present a variety of mutual funds from which employees can choose to direct their contributions. In recent years, these will likely include target date funds that provide an asset mix appropriate to the age of the participant.
Naturally, there are costs. Guess who pays those costs. That’s right, the participant. Each of the mutual funds will have expenses related specifically to the management of that fund as we have discussed previously. Then there are the expenses of the plan administrator to provide all of those services to the sponsor and participant. Generally, your employer pays none of this. There may be some exceptions, but for the most part these costs are extracted from the contributions of the participants. I would challenge you to find how much these expenses are costing you. At this point in time, the plan administrator is not required to tell you. So imagine that you go to the grocery store and there are no prices posted. You do your shopping and go through the checkout. No prices are displayed on the cash register. You swipe your card and some money is transferred from your account to the grocery store but you don’t know how much. That’s pretty much the situation with the 401k. Once in a while there is a weak attempt by congress to force plan administrators to reveal these costs but the financial services industry gets it quashed. Unfortunately, it’s up to employees to put pressure on their employer to in turn pressure the plan administrator for this disclosure. Until plan sponsors make it clear that they will not do business with plan administrators that don’t disclose their costs, nothing will change. Having these costs disclosed will lead directly to lower costs for everybody.
For a sense of just how great a difference fees make, consider this example: You’re an employee with 35 years to retirement who’s managed to save $25,000 in your 401k. If your returns average 7% a year and fees and expenses shave 0.5% off of your returns, you’ll retire with $227,000, even if you don’t contribute another dime to your account. But if fees rise to 1.5%, your account will grow to just $163,000, according to the Department of Labor. That’s a 28% ($64,000) difference.
Despite the issue of cost, the 401k represents your best option for building retirement savings. It’s best to begin participating at your first opportunity and taking full advantage of any employer match. Not all employers will provide a match but the employer match may be up to 50% or more of your contributions. This is something that you should take full advantage of. Usually you will have to remain with the employer for a period of time, eg. 5 years, in order to have the matching amounts fully vested. Your contributions are always yours no matter what. Also, keep in mind that your employer’s HR representative is not necessarily your best resource to address your questions about the 401k. They may not know any more than you do. The plan administrator is supposed to provide information to help you choose your investments as well as people to discuss your options in detail. You are not supposed to be left completely on your own.
The earlier discussion related to stock ownership and ETFs don’t really apply to the 401k. There are some plan administrators beginning to offer ETFs in the 401k but that’s not very common yet. Therefore, you will need to review the investment options presented to you and choose how you want your contributions to be allocated among them. If you are offered target date funds, I would say that this is the best choice for most participants. If these are not offered then you will need to choose an allocation among stock funds and fixed income funds that is appropriate for your age.
Also, a footnote about other workplace retirement plans. The 401k is only used for private sector employees. School teachers and other public service employees will have accounts similar to the 401k but will go by a different moniker. They will have similar structures and offer similar options.