Diem Wealth Management

5 401(K) TRAPS THAT CAN DAMAGE YOUR RETIREMENT AND WHAT YOU CAN DO ABOUT IT

In 1980, Ted Benna, an employee benefits consultant, started the first known 401(k) plan at his own employer, The Johnson Companies.  Ted found an obscure provision written into law in 1978 enabling companies to help their employees save on a pre-tax basis for retirement.

Over time, companies found 401(k) Plans to be an employee benefits panacea.  By replacing expensive defined benefit plans with 401(k) plans, costs were slashed for the employer.  This shift to 401k also created a new set of costs for employees.

So let’s dive right into what your 401(k) plan is quietly taking from you.

INVESTMENT LEVEL MANAGEMENT FEES

When you open any investment account, 401(k) or not, you pay Investment Management Fees to compensate the investment team that creates and manages the portfolios of individual investments. Stocks, bonds and money funds are the most popular choices. Some investment fund accounts will include commodities, real estate and other alternative investments.

INVESTMENT LEVEL TRANSACTION FEES

Just as if you managed your own account of individual investments, managers will pay commissions to the brokerage firm(s) executing the trading of any investments being bought and sold within the portfolio. These are referred to as trading costs. Through some research you may be able to find these costs. The statement of additional information, often referred to, as part b of the prospectus will have the gross dollar amount. To find the percentage charged to your fund you would divide the gross costs by the net asset value listed in the main prospectus and you would have part of the trading costs for one fund. Simple enough, right?

The trading costs are more than just brokerage commissions. There are costs associated with what is called a “Bid-Asked Spread” on every trade done within the investment portfolio. If you ever have been to an auction you know there is an auctioneer and some bidders. The auctioneer asks for a price to be bid and the bidders bid against each other in hopes of getting something at the lowest possible price. Every time a bid is accepted, the auctioneer raises his asking price until no one will bid a higher price.  At this time, the auctioneer lowers his asking price to equal the highest bid. It works the same way in an investment market except the auctioneer does not lower his asking price to the highest bid. Instead there is a spread between the highest bid and the asked price. This spread goes to the market maker handling the trade. These are very sneaky costs and can only be estimated. Your best bet here is to invest in funds with a low turnover rate. The average stock mutual fund has a turnover rate of over 100% per year. This means the manager buys and sells the equivalent of everything in the portfolio every year. This trading activity contributes greatly to your investment costs and greatly reduces your investment returns.

PLAN LEVEL ADMINISTRATION FEES

401(k) Plans have additional costs over and above investment fees. These are related to the administration of the plan itself. A third party administrator sees to the individual accounts being reconciled for values, investment choices elected by each employee, plan loans elected by certain employees, filings to the IRS and reporting to the employer and the employees.

These 401(k) costs, like trading costs and management fees, can greatly reduce investment returns. None of these administrative costs are assessed to an individual account the employee has opened on his or her own.

PLAN LEVEL INVESTMENT FEES

These are the payments to the financial adviser (if your plan is small) or firm (if your plan is large) that manages your 401(k). Just like hiring a plumber or an electrician because of their expertise in their field, a plan sponsor may hire a plan-level adviser as a guide through tax-deferred benefits offerings. The fees charged by the plan-level adviser serve as compensation for several things, which include some or all of the following:

Providing guidance during establishment of the plan, and assembling qualified service providers;

Continuing to serve as a subject matter expert and liaison between various parties associated with a 401(k) plan, advising about the worth of supplementary products and services;

Advising your plan sponsor about which investment options to offer in the 401(k) plan; and

Conducting employee meetings to educate 401(k) participants about the facets of each investment option and other plan services.

You may need to ask your plan sponsor to clarify how much you’re paying toward plan-level investment fees because they’re deducted from your investment returns.

INVESTMENT PERFORMANCE

Another silent enemy to 401(k) participants, are costs of investment underperformance. I am always amazed yet unsurprised at the responses when I ask someone how their investments are doing. Almost every person I have ever met has no idea how to measure the performance of his or her investments. I cannot blame the investor for not having this crucial knowledge. It’s generally not taught in school. In fact one can get an MBA and never have to take a single investment class in most of the universities in this country.  The financial industry and the financial media work hard to create noise in an effort to hide this commonality of underperformance. Think of it like this. If the markets were up say, 30% (like last year) and your stock portfolio went up only 20%, you lost 10% to underperformance. It is very unlikely you will ever, in your lifetime, make up that kind of underperformance. Now imagine this going on for an investing lifetime. Also keep in mind it is widely held that most professional investment managers routinely underperform their investing benchmarks. Most investment options in 401(k) plans rely on the same underperforming investment managers.

SO WHAT TO DO WITH THAT 401(K) MONEY?

DIRECT ROLLOVER TO AN IRA

The first thing to look at is if you can get any or all of your plan money rolled tax-free into an IRA account you manage. The possible advantages here can be reduced fees, better diversification, a more efficient portfolio and better available beneficiary designations.

If you have had a life event that qualifies you for an IRA rollover it may be beneficial for you to complete a tax-free rollover to your own IRA account. If you have a 401(k) still at a previous employer you would be eligible for a rollover. If your plan terminated by the employer, you would have to either roll the funds to an IRA, transfer the money to another retirement plan or take a taxable distribution.

IN SERVICE DISTRIBUTION

For employees over age 59½ there is a largely unknown way to get a tax-free rollover to your IRA account done while still working at your current employer. This in service distribution is available through either a direct rollover from your 401(k) to your IRA or a distribution to you and you roll it into an IRA within 60 days after the distribution is made. The direct rollover option is easier but some plans do not allow the direct option leaving the indirect rollover as the only option. There is a catch to this indirect method in that there will be a mandatory 20% tax withholding by the IRS. If going the indirect route you should have cash equal to the withholding to roll into your IRA account within the 60-day window. Otherwise, you would be taxed on the amount withheld.

MAXIMIZE MATCHING CONTRIBUTIONS

If still contributing to a plan it is always good to know the matching formula. Most plans have a matching contribution from the employer. A common formula is a 50% match up to 6%. This means for every dollar you put in the employer puts in 50 cents. This arrangement would max out when you have put in 6% of your gross earnings and your employer has put in 3% for a total of 9% being contributed to your account. Despite the fees, it is generally a good idea to contribute enough to max out the employer’s contribution.  It could boost your annual return by 50% in this case.

LOWER YOUR INVESTMENT FEES

As mentioned earlier it is always a good idea to find lower turnover funds. It may substantially reduce your costs.

Knowing that active investment managers tend to underperform, it would behoove you to find any low cost index funds in your plan. Investment options can be very limited in many plans. If no index funds are available look for funds with lower expense ratios.

DON’T CHASE RETURNS

Try not to get caught up in recent past performance. Often, recent winners are tomorrow’s losers.

HELP IS AVAILABLE

If you are still unsure what to do, a fee-based or fee only advisor may prove valuable in guiding you through this maze. A Certified Financial Planner™ specializing in retirement planning would be a good start toward finding the right professional. Ask the professional to describe their ideal client and their most common client. Keep in mind most investment professionals market actively managed investment products. While there is an age-old debate about passive vs. actively managed portfolios, most of the evidence supports a passive approach. Choose an Advisor who is a Fiduciary. An advisor who is a Fiduciary, by law, must put your interests first. Many advisors are only required to adhere to Suitability Standards.  In this broad-brush standard, your answers to a few questions on an investment account form can cast a very wide net of options that pass as Suitable. Many of these options may not meet a Fiduciary Standard and not be in your best interests.