After Monday’s heart-wrenching post, I decided today I would do something lighter and more fun. So I decided to do a deep-dive into my companies 401k plan. “That doesn’t really sound like fun, CMO” you might be thinking. Au contraire, my good friend! First, it was much more fun than the three hour meeting I was stuck on at the time I jotted down these notes. And second, I found the information told a fascinating tale of how a typical 401k at a big company might work, what most people do when enrolled in it, and fees.
I have to say, locating the information wasn’t too hard – but it certainly wasn’t easy. The appropriate documents weren’t found on my 401k plan site. Instead, I had to dig around my company intranet and locate the several documents that I needed. I’m fortunate that I’m an extremely fast reader (which is how I read so many books)-I was able to review, digest, and re-assemble the information into an easy to understand format rather quickly. They could have put all the key information on a single page, instead of burying it throughout a 60 page document, but I guess that would be too difficult. As the quote from Ernst Schumacher goes, “Any intelligent fool can make things bigger, more complex, and more violent. It takes a touch of genius — and a lot of courage to move in the opposite direction.”
First, The Good
I have to give some props to my company – there are multiple things that are excellent about their 401k plan. Here’s the places where I give them a gold star:
- Auto Enrollment: They have automatic enrollment at 3% of your salary, automatically put into their version of a target date fund. I can remember when this was not a thing (before 2006) and the media would often complain about just how few people opted in. Using an “opt out” method (because you can opt out of this) helps protect against people getting paralyzed and never signing up. Research from the Bureau of Labor and Statistics seems to indicate that this method increases participation
- Auto Increase: If you’re contributing less than 8% of your salary, the company will increase contributions by 1% every year until you hit 8% (again, unless you opt out). They do this around the same time they dole out raises, so you’re likely to still see an increase in your salary but at the same time be saving more for your future. I used a similar method – but on my own – to eventually max out my 401k. This is a great feature, because research has found that one downside to auto-enrollment is apathy. People will just leave it at whatever the company has picked.
- Matching: The company matches 100% on the first 3% of contributions, and 50% on the next 3%. So if you contribute a total of 6%, they’ll match 4.5% of your salary. This is a better match than my last company, which was 50% on the first 6% of contributions (so total of 3%). So someone maxing out the match would be putting 10.5% of their salary into the 401k every year. Very generous!
- True-Up Match: If you miss out on part of the match, the company will “true up” the contribution the following year. This can happen if you max out your 401k early in the year, or if you suddenly go from contributing under the matched amount (say, 3%) to over the matched amount (say, 8%). This is good, because some companies just say “too bad, so sad, no match for you”.
- Two Year Vesting: This applies to the companies contributions, and is much shorter than some places I’ve seen. Some companies have five year vesting, so you don’t get to keep the match until you’ve been there over 5 years! Or they might have “stepped up” vesting, where you vest a little bit over many years. My company has two year “cliff vesting”, so it all vests at once.
- Age Banded and Auto-Rebalancing: The 401k provider offers age-banded target date funds that will automatically rebalance every year. The automatic rebalancing means that if the market goes up or down sharply, you can still keep your same asset allocation. Also the age-banding means the fund gets more conservative as you approach retirement. In my humble opinion, it gets much TOO conservative, as I’ll show you in “The Ugly” section of this post.
Just the Facts, Ma’am
As I dug through the sixty pages, I came across many facts-often on different pages. For those who are numbers inclined, like me, feast your eyes on the details. As you read this, I want you to try to guess which funds are part of the target date lineup, and which one’s aren’t.
|Fund Type||Subfunds||10 Year Performance||Expense Ratio|
|High Yield Bond||N/A||7.32%||0.37|
|Large Cap Blend||Fund 1||5.34%||0.43|
|Mid Cap Blend||Fund 1||7.39%||0.56|
|Fund 2 (five year performance)||8.91%|
|International Stock Blend||Fund 1 (five year performance)||1.11%||0.69|
|Small Cap Blend||Fund 1||6.89%||0.72|
|S&P 500 Index||N/A||7.02%||0.05|
|Mid/Small Cap Index||N/A||6.75%||0.07|
|Company Stock||N/A||12.28%||3 cents per share trading cost|
Looking at this chart, you’ll see that the best investment over the past 10 years was actually in company stock. You’ll also notice a small selection of index funds, which is another gold star in favor of this plan. Too many 401k plans have no – or almost no – index funds. You’ll also notice that none of the funds have an expense ratio over 1%, which is also pretty good. But there’s a big expense difference between the blend funds and the index funds.
You also might have noticed that two of the funds are tagged as “five year performance”. Those funds haven’t existed for 10 years, so can only provide 5 years of history. This means that comparing those earnings to the other earnings is meaningless. Five years of history doesn’t cover the Great Recession, and so paints a rosier picture.
What are the “subfunds”, you might ask? Well the “blend” funds are actually composed of two separate funds, each of which makes up 50% of the blend. These blends are new, being offered for under a year, although the underlying funds have been around for a while. Why did they change to these? The old blends were under-performing the indexes significantly.
If you’re into personal finance like me, you might have read that under-performing funds are usually folded, and so don’t get counted in long-term mutual fund returns. That’s exactly what happened here. So people who aren’t like me and don’t dive into the details of the underlying funds (a.k.a. most people) don’t know what the long-term performance of these funds looks like.
The expense ratios aren’t the only expenses to this plan. There’s three other types of fees you can incur:
- Administrative Fee – charged to everyone. This fee is 0.05 percent and is capped at a max of $200 per year, which you won’t hit until you’re over half a million in the 401k. This fee in and of itself is pretty modest, but it increases the costs of those index funds by a large percentage
- Loan Fee – charged whenever you want to take out a loan. This is $50 per loan
- QDRO Fee – QDRO stands for “Qualified Domestic Relations Order”, which is fancy terminology for splitting the retirement account in the event of a divorce or legal separation. This fee is $750.
There are also some hidden fees. Remember those expense ratios in the prior section? Those are actually composed of two separate types of expenses:
- Management Expenses – This is the actual expense ratio of the fund
- Other Expenses – These are expenses for running the 401k-legal fees, auditing expenses, compliance with legal requirements, mailing and postage, etc. Why is this not the administrative fee? No explanation is provided
Looking at this entire picture, I got rather annoyed. Remember that nice S&P 500 index fund? Looks pretty reasonable, as does that mid/small cap index fund.Once you tack on the administrative fee, the expense is really 0.10. Still very low, but twice as much as it should be. That, my friends, is absolutely ridiculous.
There are two truly ugly things about this 401k – what people are actually invested in and the way the target date funds work .
First, the above was what was offered. If you’re into personal finance, you might think that of course people are invested in those awesome index funds. After all, the fees are higher than they should be, but they’re still pretty reasonable-right? Sorry, no. Take a look at this nightmare. Particularly bad parts are in red.
|Fund Type||Percentage of Investments|
|High Yield Bond||2%|
|Large Cap Blend||12%|
|Mid Cap Blend||6%|
|International Stock Blend||6%|
|Small Cap Blend||6%|
|S&P 500 Index||7%|
|Mid/Small Cap Index||3%|
Forty percent is in that fixed income fund! With another 16% in company stock! This means that 55% of peoples money is invested between those two funds.
Perhaps you’re thinking “oh, that fixed income fund isn’t bad”. But it’s bad, all right. The yield on that fund the past few years is 3.35%. With an expense ratio of almost half a percent. And that’s where almost 40% of people have their money!
If you’re really good at math, or decided to get out a calculator to check mine, you might have noticed the numbers don’t add up to 100%. So where’s that missing 2%? Participant loans.
It’s also outrageous that people have 16% – more than any other fund except that stupid fixed income – in company stock. Although it’s had the best 10 year return, and I’m sure those folks have done well overall, it’s still extremely risky to have so much of your retirement connected to your employer. I found this article on Forbes recommending 10% at the most. Personally, I keep nothing there. My last employer’s stock was over $100 a share back in 2007. Guess what it went to in 2009? THREE DOLLARS AND SIXTY-TWO CENTS. I worked there at the time and we all thought the company was going to go bankrupt, it was that bad. People who had company stock in their 401k were absolutely crushed, watching $100,000 investment dwindle down to $3,620 in a matter of months. Luckily I didn’t have any company stock in my 401k back then either, for the same reason. Never tie your investments up with your employer. If they go down, you lose your income and your investments in one fell swoop.
How about the second part of that ugliness, the way the target date funds work?
If you remember from the “just the facts” section, I asked you to guess which of those funds were part of the target date lineup. If you guessed all the blended funds and that fixed income fund, all with the higher expense ratios, congratulations! You win the internet today.
So now you know that the funds with the highest expenses are part of the default. And most people stick with the default, as you can see by looking at those index funds vs. the blended funds. A total of 11% of plan assets are in the three index funds, while 69% are in the blended funds and the fixed income.
The way the target date funds work is actually the key as to why so much money is in that fixed income fund. When I dug into the details behind how the target date funds work, which most people never do, I found out they’re not using that high-yield (aka junk) bond at all to balance out risk. They’re just using that fixed income fund. So if you consider yourself an “aggressive” investor with 0-5 years until retirement, 46% of your money is in that fixed income fund. What if you’re conservative? Then 76% of your money is in that fixed income fund.
So for someone approaching retirement, who might have 20 or 30 years for their investments to last, over three quarters of their money is parked making a little over three percent. Wow.
How I’m Invested – And I Want To Hear From You!
I’m invested in those index funds, obviously, as well as that high yield bond fund. I don’t have high yield bond exposure outside my 401k so parked some of my money there. The index funds have done well for me over the years, with the only con being I have to remember to rebalance it myself. I bet 90% plus people inside my company have no clue how this 401k works, and instead just parked their money in the target date fund (which is, of course, heavily promoted in literature and all over the website).
How about you – what’s your 401k like? Have you ever dug into the nitty-gritty details like I did, and found outrageous and ridiculous things? Let me know in the comments.