There’s nothing wrong with 401(k)s, except the players involved
Barry Ritholtz
Washington Post March 9, 2014

 

 

This past year has seen a firestorm of criticism casting 401(k)s as mostly terrible. Their performance is too poor, and the fees too high, with poor investment choices built into most of them. Typical plans are complicated to manage and difficult to administer. Most people remain invested at levels far below their retirement needs.

Is all of this the fault of the 401(k)?

No. The problem with 401(k)s, dear reader, is you.

As we shall see, the parties involved in designing, running and investing in 401(k)s have made a hash of it. You, your employer and your plan’s investment managers fail to follow even the most basic rules of investing. You overtrade, chase performance, do not think long term. All of you — ALL OF YOU — have done a horrible job managing your retirement plans.

The good news is that it’s all terribly easy to fix.

First, some history: The Revenue Act of 1978 had buried within it an unnoticed provision creating a deferred compensation plan for retirement savings, technically known as Internal Revenue Code Section 401(k). It was mostly ignored until Ted Benna, a Pennsylvania benefits consultant, petitioned the IRS for an important rule change allowing these contributions to be made pretax. That was approved, and a few decades and many trillions of dollar later, 401(k)s have become the prime vehicle for individual retirement planning.

What’s wrong with these plans? Human behavior, which has managed to turn a relatively simple idea into a complex, overpriced, underperforming mess. Returns have lagged behind a myriad of asset classes doing exceptionally well over the long haul.

The solution is not very difficult: Simplify the plans, reduce the fees, make enrollment automatic and get out of the way.

To understand how to do this better, consider the three parties to any tax-deferred retirement plan, and what each gets out of it: the employer, the employee and the investment-management firm.

The employer gets a low-cost compensation tool. Nearly all companies — the exception being AOL, which seemingly uses its 401(k) plan to discourage people from working there — use these plans to attract and retain high-quality employees. The employee gets a tax-deferred way to fund retirement. The investment community gets a huge pile of dollars to manage.

Not long ago, workers actually got “defined-benefit” plans. But they were expensive, and most companies long ago ended them. Hence, the modern “defined contribution” plan.

Over my career, I have reviewed countless 401(k) plans. Nearly all suffer from the same three problems:

1) An overemphasis on active fund management (versus passive, low-cost indexing).

2) A bewildering array of investment choices.

3) Excessive fees each step of the way.

Combined, these problems are a drag on 401(k)s returns and long-term performance.

An additional 1 percent in fees over a 30-year investment can reduce a plan’s final value by as much as half, according to a study by Vanguard. Low fees should be a priority for all employers when assembling plans. The look on potential clients’ faces when I tell them that “I need you to pay people like me much, much less” is priceless.

The second fix is behavioral: “Active” management should be mostly (not necessarily entirely) replaced with passive indexing. This will result in numerous improvements. It generally lowers internal expense ratios by about 1 percent. Those are the fees that investors don’t see but are disclosed in the fine print somewhere. Mutual funds actually pull these expenses straight out of your holdings. It’s invisible, right off the top of the fund and only shows up in weaker annualized returns.

The solution is simple: Put nearly all of a portfolio into a broad asset allocation model consisting of a dozen or so classes. You can use low-cost funds or ETFs. If you want to have two or three 10 percent slugs to put with an active manager, I can live with that. But the goal is to get yourself out of the way of your portfolio and let the magic of long-term compounding interest work. It is a bit of an urban legend that Albert Einstein said compounding is the “most powerful force in the universe,” but it gets the point across.

Active management leads to lots of poor investor behavior. It sends people chasing after whoever has the hot hand at the moment. Often, investors will discover a manager after he’s had a terrific run, usually when he lands on a magazine cover somewhere. Invariably funds swell up with new investor money just before they revert to their long-term averages. Tying the biggest percentage of your portfolio to a passive index avoids this foible.

Third, the fees in passive indexing are far lower than in actively managed funds. Lower fees accrue to the employee’s benefit.

Lastly, many parties take an administrative fee from 401(k)s. There is the custodian, who charges a fee to hold the assets; the reporting firm that generates regular statements showing the assets’ performance; the plan manager who either charges a flat fee to the employer or a percentage of the total assets to the employee.

As you might imagine, employers would rather not pay a flat fee when they can simply let the employee cover it by paying a percentage on assets. If the employer is unwilling to pay the flat fee, it should secure the lowest possible fees its employees pay on assets. These fees should be below 0.50 percent, and ideally as low as 0.25 percent. Too often, they can be as high as 2 percent.

How can we fix these issues? In theory, all it requires is an educated employer concerned with the long-term financial well-being of its employees. Then we need employees to stop making foolish investment choices. Finally, the people who are compensated for managing these plans must agree to be paid less.

It’s that simple!

It sounds farfetched, but it’s really not. A well-designed 401(k) plan is an enormous competitive edge when recruiting and retaining employees. Investors can be taught to stop making so many bad choices in their investing. A default allocation plan helps a lot when designing these. And, finally, the competitive bidding process for 401(k)s is an opportunity to negotiate fees lower.

The 401(k) structure is just fine. See if you people can stop messing it up.

~~~

Ritholtz is chief investment officer of Ritholtz Wealth Management. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. Twitter: @Ritholtz.

Category: 401(k), Apprenticed Investor, Investing, Psychology

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

21 Responses to “What’s the problem with 401(k)s? You.”

  1. chartist says:

    The problem with 401Ks is, they were invented at all….Thanks to no pensions, many won’t have enough money in retirement.

  2. rd says:

    A good article by Jason Zweig today in the WSJ about how to manage your investing regrets to handle the behavioral side of your 401k and other accounts:

    http://blogs.wsj.com/moneybeat/2014/03/14/haunted-by-the-bull-that-got-away/?mod=WSJ_hpp_MIDDLENexttoWhatsNewsForth

  3. mpetrosian says:

    I’ve seen plenty of plan fund options that did not include index options. And I have rarely seen people trade away performance in these funds. Nobody matches anymore, it’s increasingly rare. You’re usually stuck with options from one company. I could go on. 401ks suck. Why not just raise the contribution limits on IRAs? If you’re company doesn’t match then it’s a no brainier. No admin fees, investment freedom, portability. Maybe the increased competition will force the industry to make these changes you’re calling for.

    • DeDude says:

      That is an excellent idea. Let the limits on IRAs be the same as the limits on 401Ks if the employer does not provide any matching funds. Why should there be any difference on these limits except to further insure that Wall Street get its greedy hands into peoples retirement funds. Maybe you should only allow for a somewhat higher level if the company provides a match (limits increased by twice the company contribution). That would at least serve as an incentive for companies to provide some funds (it would enhance the benefits aspect of their contribution).

  4. Blissex says:

    «Not long ago, workers actually got “defined-benefit” plans. But they were expensive, and most companies long ago ended them. Hence, the modern “defined contribution” plan.»

    In an article where a lot of importance is attached to the fees of defined contribution plans just saying “expensive” is ambiguous, because defined benefits plans were not expensive in overheads like defined contribution plans are.

    They were “expensive” in the sense that they delivered “good pensions”, and a “good pension” requires contributing (at least) around 25% on top of the overt wage to the employee; and most employees are gullible and don’t realize that the pension contributions are part of their pay, just deferred pay.

    Most companies who used to pay 25% contributions into defined benefits plans pay around 8%-on-top into defined contribution plans, and this have given their employees a nice 16% pay cut, which results in pensions that are 70% lower than the previous plan.

    Because in general the value of a pension plans depends mostly on contributions paid, not on the type of plan; except that defined contribution plans are far more expensive to run than defined benefits ones, so the cut in the value of the resulting pension is even bigger.

    The biggest problem of 401k defined contribution plans is that *as a rule what gets paid into them is less than a third (far less “expensive) than what used to be paid into a defined benefits plan, and the resulting pension will be less than a third of what used to be a pension in a defined benefit plan.

    • DeDude says:

      Yes providing workers with a pension benefit of (2 x ”years worked”) % of the average of the 3 highest years of income, from an age of 55, is expensive. However, the expense of providing such benefit from 401K plans is no less than providing it from a company retirement plan. There may even be a benefit to having it done by a group of professionals hired by the company, since a lot of stupid mistakes individual make are less likely to be done by professionals running a company plan (under supervision of a company that has real skin in the game). Some of the company 401K plans that do not give matching funds but give the companies kick-backs are basically scams that rip off the employees (coming to an employer near you) – and government mandated automatic signup for such plans for all its good intentions are basically a buy in to such scams.

      • Blissex says:

        «Yes providing workers with a pension benefit of (2 x ”years worked”) % of the average of the 3 highest years of income, from an age of 55, is expensive. However, the expense of providing such benefit from 401K plans is no less than providing it from a company retirement plan.»

        That’s precisely one of my points, yet your comment seems to ignore the really big problem with 401k plans which is another of my points: that *usually* they contribute one third of the funding that used to be contributed to «(2 x ”years worked”)» defined benefit plans, and thus result in pensions that are at best one third the level those plans gave (at best because the defined contribution plans have far higher overheads as BarryR reports).

        The switch from defined benefit to defined contribution was largely done to mask the large cut in the value of the new plans.

        Probably it was also done to create a vast number of “stupid money” investors to be ripped off by Wall Street…

        «a company that has real skin in the game)»

        Companies had skin the game with the defined benefit plans, but virtually zero with the defined contribution ones.

        That is actually an advantage in one way: it makes it harder for company executives to loot the company using the vagaries of the pension plans. With defined benefit plans company executives would stop contributing to the plans when the stock market was going up, add the missing contributions to the bottom line, and take a large chunk of these bigger “profits” as bonuses.

      • Bottom line is 401ks are much cheaper for the company, more expensive for the employees

      • Blissex says:

        «Bottom line is 401ks are much cheaper for the company, more expensive for the employees»

        Indeed (mostly) cheaper in terms of contributions for the company, and more expensive in terms of overheads for the employees.

        But by far the biggest aspect is the first: because usually a third of the sums that used to be paid into a defined benefit plans get paid in a defined contribution plan, and this means that even if overheads were not more expensive, the resulting defined contribution pension would still be one third of the defined benefit one.

        It amazes me that many the discussions about defined benefit vs. defined contributions omit this most vital aspect, that the most important thing is not the change of type of plan or size of overheads, it is the enormous cut in the contributions and therefore in the resulting pension.

        There have been many discussions of DB vs. DC pension plans in “ThE Economist” magazine, but few as clear as this:

        http://www.economist.com/node/18502061
        «A report by Charles Cowling for Politeia, a think-tank, found that last year it cost £25.50 to buy a British annuity that paid £1-worth of pension a year. In 1990 it could have been bought for £12.70.

        Logically, therefore, employees should be contributing more to their pension pots. But in the shift from DB to DC the reverse has happened.

        Employers contribute around 20-25% of payroll to DB plans. The combined total of contributions (by employers and employees) to DC plans in America and Britain is around 9-10%.

        The amount put into a plan largely determines the resulting pension, so the current level of DC contributions will not deliver anything like the old final-salary pensions.»

  5. Blissex says:

    «In theory, all it requires is an educated employer concerned with the long-term financial well-being of its employees. Then we need employees to stop making foolish investment choices. Finally, the people who are compensated for managing these plans must agree to be paid less.»

    Again, the biggest thing would be that gullible current generations of employees were to realize that the cut in pension contributions to one third of those in old style defined benefit plans will result in pensions at less than one third the level of the previous generations of employees.

    «A well-designed 401(k) plan is an enormous competitive edge when recruiting and retaining employees.»

    The only competitive edge most employers care about is paying their employees as little as possible, to achieve levels of labor costs comparable to those in third world sweatshops, and since current generations of employees don’t realize or don’t care that the 401k plans are not just different but worth usually a third of previous defined benefits ones, 401k as they are are fine for employers.

    «Investors can be taught to stop making so many bad choices in their investing. A default allocation plan helps a lot when designing these.»

    No they cannot, because they are “stupid money” and stupid money always gets screwed. That’s why it is called “stupid money” after all, and why Wall Street is so keen to get huge amounts of stupid money into 401ks and invested into the stocks casino.

    «And, finally, the competitive bidding process for 401(k)s is an opportunity to negotiate fees lower.»

    Why ever would an employer or an HR or finance manager spend effort negotiating lower fees if it employees who pay them, and those employees are “stupid money” who have proven that they are so gullible that they have not noticed that at the same time the plan type changed the contributions were cut to one third?

    For employees who are not that gullible, and who are intelligent enough to realize that they are still “stupid money” compared to Wall Street, the best options are:

    * Realize that their wages have been cut by 15% and contribute at least that much more to their pension plans.
    * Invest almost all of their pension plans in quality bonds and government bonds, because Wall Street is a casino rigged against them.
    * If they put a small part of their pension plans in stocks, buy non-USA stocks, because they are already far too exposed to the USA economy with their jobs and properties (if any).

  6. Livermore Shimervore says:

    After the flash crash and the role of ETFs in HFT WMD’s, I’m not sure I would sleep well at night knowing that a big chunk of my old age security is dependent on proper oversight in the execution of ETF creation/redemption. Bit murky for me… As Volcks said “the only useful innovation of Wall Street has been the ATM”. I’m very, very leary on kosherness of transactions carried about by a only a few for the many.

  7. Livermore Shimervore says:

    Also, Warrant Buffett is on record saying that “a few” basis points for [index fund] management is pretty hard to beat”. He also noted that it has a tendency to discourage active tinkering over ETF DIY’ing.

  8. Giovanni says:

    Barry, I think you hit on an essential truth when you said: “What’s wrong with these plans [companies, markets, organizations, governments]? Human behavior, which has managed to turn a relatively simple idea into a complex, overpriced, underperforming mess.

  9. GrenfellHunt says:

    The 401k of my new university (courtesy of Lincoln National) is guilty of 2/3 of the sins you mention: high fees & excessive active management. The lowest cost option is an S&P 500 index fund for 0.25% expense ratio PLUS 0.29% in fees=0.54% total. Since my Vanguard IRA offers VOO for 0.05%, how does Lincoln’s 401k differ from highway robbery?

    I would be grateful for your thoughts: a) how can employees best lobby management for low-fee 401ks? b) what in your judgment are the leading low-fee 401k providers?

    • 1. Print out the article

      2. Hand it to your head of HR/Boss

      3. Explain to them they may have liability for a poor 401k

    • Blissex says:

      «differ from highway robbery?»

      Usually one or all three of these options apply:

      - The HR or finance manager selecting the plans gets under-the-table “loyalty incentives” by the funds managers.
      - The employer is paid over-the-table but confidential “marketing commissions” by the fund managers.
      - Neither the manager nor the employer give a damn about what the suckers pay, as long as they can minimize their own time and cost. If you don’t like the funds on offer at one employer, “you are free to find another job sunshine” is the usual attitude.

      • Blissex says:

        «The employer is paid over-the-table but confidential “marketing commissions” by the fund managers.»

        http://news.yahoo.com/supreme-court-could-stop-401-k-rip-off-143605439.html
        «Plaintiffs allege that Edison added a number of mutual funds to the plan in 1999. Six of those mutual funds had both institutional and retail share classes. Both share classes invested in the same securities and were managed by the same fund managers. The only difference is the retail shares have significantly higher fees that were shared by the fund family with the plan’s record-keeper. This fee-sharing arrangement permitted Edison to lower its administration costs by $8 million.»

  10. bigsteve says:

    I have a pension and 457B account for retirement. The fees total over the funds I have selected for my defer comp with the 0.45 % fee of the company running the program are about 1.45%. I have worked hard to keep fees down and be diversified. When I retire some time in the next two years I plan on moving the money into an IRA with low cost index funds . I should of all along put some of my investment into an IRA. I learned late but better late than never.

  11. mpetrosian says:

    But wait, the article title was The Problem With 401K’s? You. Don’t give a copy to your boss. Barry is a big fan of the mea culpa. Lets go ahead and admit that the title of this WaPost article was a bit much.