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Top 5 Myths About Your 401(k) Plan

Over the last three decades, 401k plans have become a venerable darling of the investment world. Millions of U.S. employees currently contribute to their tax-deferred accounts with the hope of a prosperous retirement. However, the high level of confidence in 401k plans may be more attributable to misinformation rather than the actual facts regarding these accounts.

Myth #1: The 401k plan was designed to provide adequate income for retirement.

401k plans were originally just one part of a trifecta intended to provide individuals with a means to comfortably retire, with the other two components being social security and defined benefit pension plans. With social security facing an uncertain future, it remains to be seen whether the program will be able to provide retirement income in the coming years. The situation is no different with pensions as they are rapidly becoming a relic of the past.

While at one point defined benefit pension plans were the main retirement vehicle available to employees, employers soon realized that pensions were an expensive proposition which imposed a great burden on their companies. As a result, the 401k plan was a welcome alternative as it allowed the employer to avoid contributions altogether or simply match a contribution made by the employees. This was a much less expensive approach which meant that the company could avoid the substantial liabilities resulting from the obligation to provide pension payments for the life of each retiree.

An interesting dichotomy emerges when considering employer sentiment regarding 401k plans. According to the 401k Benchmarking Survey (2008 Edition) published by Deloitte, 81% of employers surveyed considered their plans to be “an effective recruiting tool” and 75% of employers held that these plans “assist in retaining existing employees”. However, it is also noted that “…only 18% of employers polled in this year’s survey believe ‘most’ of their employees are ‘saving adequately’ for retirement. An almost equal number (17%) believe that ‘very few’ are saving adequately.” Essentially, employers are knowingly providing access to a retirement vehicle which they feel is not likely to provide adequate funds for retirement. This represents a profound disparity between the employer and employee perspectives regarding 401k plans.

Myth #2: 401k plans benefit employees by providing more freedom.

The growth in the popularity of 401k plans was hailed as a revolution which allowed employees to have more choice as well as the ability to carry their plan from one employer to another. The unfortunate result, however, was that millions of Americans were left to fend for themselves in the highly complex and often unpredictable financial markets. During the booming years of the 80’s and 90’s, this was a welcome alternative as many employees enjoyed double digit gains due to the bull markets. However, with the volatility and uncertainty of today’s financial environment, it is becoming increasingly more difficult to accumulate adequate funds for retirement. Accordingly, the likelihood of a prosperous retirement amongst Americans is rapidly decreasing, along with their confidence in the once glorified 401k plan.

Myth #3: 401k plans provide access to the best investment options available.

401k plans provide a menu of investment options (usually mutual funds) which employees must choose from. Investors are often surprised to learn that in many cases, the investment options offered within a 401k plan are there simply because the issuer of the fund paid the plan administrator to have them included – not because they are the best investment options available at a particular time. Alternatively, the mutual funds offered may be those which are in some way affiliated with the plan administrator. As a result, over time the typical 401k menu of investments has turned into a list of underperforming and overpriced funds which may provide lower returns and carry higher risks than other alternatives available in the market.

It is often argued that the limited nature of the investment options within a 401k plan is actually a benefit which helps employees make investment choices more easily. The reality, however, is that even when the number of investments available is limited, the construction of a well-diversified and risk-managed portfolio requires careful analysis and financial understanding. This is not made clear to plan participants who are often left to allocate their retirement savings haphazardly and without considering the actual risk exposure within the portfolio.

It is an unfortunate fact that many Americans have not been adequately educated in the financial matters that can greatly affect the outcome of their investments, and therefore they require more guidance than what is provided within a typical 401k plan.

Myth #4: The tax-deferred treatment of 401k plans means that investors will pay less in taxes.

The tax-deferred treatment of 401k plans is often hailed as a benefit to plan participants. However, the fact is that the account is still taxed, although taxed at a later date. Proponents of 401k plans maintain that the effective tax bracket for an individual is likely to be lower in their retirement years because their amount of income will decrease. This statement is questionable, however, because future income – just as anything else in life – is difficult to accurately predict. Even more unpredictable is the tax rate which will apply 20 or 30 years from now. As tax rates tend to fluctuate significantly over time, the extent to which retirement funds will be taxed is simply unknown. As a result, you might pay less in taxes on your retirement account, but then again, you may end up paying more.

Even if the effective tax rate does indeed drop, this may not be as advantageous as it seems. This can be clearly illustrated with an example. Let’s assume for a moment that the effective tax rate for a 45 year old individual is 35%. Let’s also assume that the effective tax rate for that individual drops to 15% at 65 years of age. In this simplified example, this amounts to a 20% difference over 20 years. In other words, the decision to hold funds in a 401k for 20 years produced a 20% return over the life of investment, which amounts to just roughly 1% per year.

This 1% annual benefit raises an important question: how are plan participants being compensated for dealing with the limited liquidity of their 401k? As you would typically be charged a 10% penalty in addition to paying taxes on the withdrawal of funds from your 401k before a certain age, the accounts are therefore relatively illiquid and limited in their possible benefit to the plan participant.

This illiquidity represents an increased risk because your money may not be available for you when you need it, which typically calls for a higher return to be provided to the investor. This higher return, however, is not made available to 401k participants. Instead, participants are left to simply accept whatever the market produces for them, including losses incurred by the limited selection of funds made available to them. So as you can see, even when assuming that the effective tax rate is substantially lower in retirement years, it is evident that the benefit to the individual is marginal despite the advantages constantly hailed by the financial industry.

In addition, investors should be asking how they are being compensation for the limited selection available to them in their 401k plans. When evaluating investments, investors typically demand higher returns when their options are limited or when they face restrictions related to a particular investment. However, this is another factor missing from 401k plans. Additionally, the high fees charged by many 401k funds can significantly erode investor returns over time, leaving less money for retirement.

Myth #5: 401k plans are most beneficial to the individuals investing in them.

With all of the downsides attributable to 401k plans, the obvious winners are the plan administrators, employers, and the mutual fund companies whose funds are featured in 401k plans. As mentioned earlier, employers are enjoying the lower costs involved with providing 401k plans instead of pensions.

As for the mutual fund companies, they are benefiting because their products are exposed to a captive audience for many years at a time. There are often few options available for plan participants, and as such, mutual fund companies need not allocate substantial resources to manage such funds as investors are unable to withdraw their funds anyway. In cases where an investor does sell shares of a particular fund, the investor may unknowingly transfer the money to another fund issued by the same mutual fund company. This changes little since the same company will collect fees regardless of which fund the individual chooses. In the end, there is often just one winner in such circumstances, and it’s unfortunately not the investor.

Plan administrators are also benefiting from the established 401k system as they receive payments made by the mutual fund companies which seek inclusion into the plan. The plan administrator also collects administrative fees from the plan participants. As is the case with the limited selection of mutual funds available to employees, the choice of plan administrator is usually not a choice at all. As a result, plan participants must accept and pay whatever fees are charged by their particular plan administrator.

Perhaps the biggest contributor to the success that plan providers and mutual fund companies have enjoyed relating to 401k plans is the mentality that Americans have regarding their retirement accounts. Participants typically consider the 401k as an investment with a far away target date that does not need to be actively considered or carefully managed. Instead of utilizing constant monitoring and risk management necessary to achieve success in investing, participants typically apply an overly passive “buy and hold” perspective which can lead to disappointing investment results and inadequate income in retirement. This is particularly troubling given the time and care usually allocated to making other, less financially critical decisions such as choosing which car to buy or planning a vacation.

What can investors do as an alternative to investing in a traditional 401k plan?

When considering the restrictions, limits, complexity, and lack of transparency associated with 401k plans, it becomes clear that there are inherent pitfalls which contrast the stellar benefits touted by the financial services industry. However, plan participants seeking a better alternative are advised not to simply withdraw funds from their plan as this may trigger significant tax consequences as well as a 10% penalty if funds are withdrawn before the participant reaches a certain age.

In order to enjoy more freedom and control over their finances, investors should consider the alternatives before contributing funds to tax-deferred accounts. As these accounts are typically invested in the stock market through mutual funds or annuities, investors may be better served by making the same investments on their own and without the 401k plan acting as an expensive and restrictive intermediary. With the abundance of investment options currently available, investors are urged to seek the help of a qualified, experienced and trusted financial professional to guide them through the markets and assist them in finding the best investment options available, whether or not they invest through a 401k plan.

Alexander Efros, MBA, CPA
President / Founder
Athelon Wealth Management, LLC