Firm-sponsored 401(k) plans differ in several important features and overall quality. Many workers could build a more secure retirement by diverting funds from 401(k) plans to an Individual Retirement Account (IRA), a Health Savings Account (HSA), tax-deferred EE-Bonds and I-Bonds issued by the U.S. Treasury, and in some cases an annuity.
Introduction:
The tax code provides generous tax savings and deferral of tax for workers who contribute to a 401(k) plan. Virtually all financial advisors advocate extensive use of firm-sponsored 401(K) plans for retirement savings and much has been written on the amount of funds a worker needs to place in a 401(k) plan to retire comfortably. A recent survey found that 68 percent of firms with a 401(k) automatically enroll new workers.
However, 401(k) plans differ in several important respects with some plans offering more generous and useful options than other plans. The features offered in a firm-sponsored retirement plan can have a large impact on returns and wealth realized from saving through a firm-sponsored retirement plan. Workers at firms with less generous or low-quality 401(k) plans can often achieve better outcomes by using an IRA and through alternative investments outside of a retirement account.
Some of the features impacting outcomes from investing in a 401(k) plan include — (1) the existence of an employer matching contribution, (2) vesting requirements on employer contributions, (3) the allowable employee contribution, (4) fees, (5) the availability of a Roth option, (6) loan and early withdrawal features, (7) investment options, and (8) payout options.
Matching contributions from employers:
The tax code allows both the employee and the firm to make contributions to a 401(k) plan. However, firms are not required to make contributions on behalf of their workers and the level of employer contributions varies substantially.
Around 49 percent of employers with 401(k) plans do not match employee contributions.
Two common 401(k) matching formulas are 50 percent of the dollar amount contributed by the employee up to 6.0 percent of the employee’s salary and 100 percent of contributions up to 3 percent of the employee’s salary.
The employer matching contribution to 401(k) plans is an attractive benefit. Most financial planners advise their clients to always take full advantage of employer matching funds.
I have argued that new entrants to the workforce with substantial debt can delay all retirement savings until their debt is reduced to a sustainable level.
Some workers at firms that match employee contributions will set their contribution limit to the level that takes full advantage of the matching contribution but will divert any additional saving for retirement to an IRA.
Employees at firms at 401(k) plans that do not match employee contributions may be better off contributing to an IRA. The choice between using an IRA or a firm-sponsored plan depends on other characteristics of the firm-sponsored plan, including the level of 401(k) fees and whether the firm offers a Roth 401(k) option.
This study by EBRI reveals that many workers are now choosing to contribute to a health savings account instead of a 401(K) plan even when the firm matches contributions to the 401(k) plan. People who cannot afford to contribute to both a 401(k) and a health savings account might in fact be better off by contributing to a health savings account even if the 401(k) includes an employer match because contributions to the health savings account are not taxed, the health savings account allows for tax and penalty-free distributions on qualified medical expenses prior to retirement, and some health savings accounts also include an employer match.
Vesting Requirements:
Most companies that match employee contributions to 401(k) plans require workers stay at a company for some time prior to receiving full ownership of the employer match. The length of time a worker must stay at a company to receive full ownership of employer matching contributions is called a vesting requirement. Around 28 percent of companies have no vesting requirement. Vesting requirements range from one to six years with around 13 percent of companies vesting at one year and 10 percent of companies vesting at six years.
Vesting requirements are irrelevant for workers who have stayed at the company longer than the vesting periods.
A recent poll found that one in four workers is considering changing jobs in 2021 and the number of potential job changers is higher for younger adults. Many people who will lose their employer matching contributions because they will not meet the vesting requirement might be better off contributing to an IRA instead of the firm-sponsored retirement plan.
New workers who have not reached the vesting period should consider the likelihood they will leave for a new job and not receive the employer match. Many of these new workers may choose to contribute to an IRA instead of a 401(k) plan, depending on the vesting requirements, their long-term plans, their job satisfaction, and other features of the retirement plan.
Allowable contributions by employees:
The tax code allows for generous employee contributions to 401(k) plans. The maximum allowable employee contribution to 401(k) plans in 2021 is $19,500 or $26,000 for workers 50 and up. However, most companies limit the amount their employees can contribute to a 401(k) plan to a certain percent of salary because non-discrimination rules limit contributions to highly compensated employees.
Some higher-compensated employees at firms with a relatively low employee contribution limit may choose to use IRAs once the contribution limit is met. This is a relatively nice problem to have.
Retirement Plan Fees:
A report by the Center for American Progress revealed that annual 401(k) fees are a substantial drain on retirement income for many workers.
The level and impact of fees documented in the report differed substantially across plans.
The average annual fee for all workers was 1.0 percent of assets. The average fee at firms with fewer than 100 401(k) participants was 1.32 percent of assets. A well-managed retirement account at a larger firm could have a fee as low as 0.25 percent of assets.
The report calculates lifetime 401(k) fees for a median age worker at three different annual fee rates – 0.25%, 1.0%, and 1.3%. The scenarios assumed the worker contributes 5% of salary and receives a 5% employer match.
The lifetime 401(k) fees for a median-wage worker under these conditions are $42,000 at a 0.25% annual fee, $138,000 at a 1.0% annual fee, and $166,000 at 1.30% annual fee.
Higher retirement fees were associated with a higher likelihood of ending up with insufficient retirement income. An increase in retirement plan fees from 0.5% of assets to 1.0% of assets will reduce the likelihood a worker will have sufficient retirement income from 57% to 69%.
High retirement fees are an especially important issue when interest rates are low, as with the current macroeconomic environment. The de-facto interest rate on investments in bonds inside high-fee 401(k) plans is currently negative.
Workers are often unaware of retirement plan fees and their impact because the fee is an indirect charge. Workers need to be aware of the fees at their retirement plan and seek alternatives if their plan has high fees.
Some investment managers argue for the use of high-fee actively managed funds. However, Warren Buffet, arguably the best active stock picker of all time, argues sticking with the S&P 500 will lead to better returns than active management for most investors.
Workers at firms charging high 401(k) fees that do not match employee contributions could likely do better with a low-cost IRA, at a firm like Vanguard or Fidelity, than through a higher-cost retirement plan.
Workers at firms matching employee contributions could participate in the firm-sponsored retirement plan, take full advantage of the 401(k) match, and immediately roll over funds to a low-cost IRA when switching employers. Some firms allow in-service roll overs for older employees, another difference in 401(k) features.
Workers at firms with high-cost 401(k) plans could increase returns by shifting investments in bonds to Treasury Direct, where there are no transaction fees. This approach would leave the 401(k) plan more fully invested in equities and subject to losses during market downturns. However, the entire portfolio including both equity investments inside the 401(k) plan and bond investments through the Treasury would be in balance.
The main beneficiary of a system that provides matching funds to high-cost funds is Wall Street. Congress should consider rules allowing employers to match employee contributions to IRAs combined with automatic enrollment in low-cost IRAs.
Such rules don’t exist. 401(k) fees can have a major impact on resources available during retirement. It is up to the worker/investor to maximize the use of low-cost funds either by selecting a low-cost IRA over a high-cost 401(K) or by rolling over funds to a low-cost plan when switching positions.
Availability of a Roth 401(k) option:
Workers have a choice between contributing to a traditional pretax retirement plan or an after-tax retirement plan, also called a Roth account. Roth 401(k) plans became available January 1, 2006. Prior to that date after-tax or Roth retirement options were only available through IRAs.
Seven in ten firms now offer a Roth 401(k) option. However, only around 18 percent of workers contributed after-tax dollars to their 401(k) plan in 2016.
Contributions to a traditional retirement plan are not taxed in the year they are made but are fully taxed when disbursed.
By contrast, funds placed in a Roth retirement plan are fully taxed in the contribution year but are not taxed at disbursement after age 59 ½. In addition, distributions from Roth accounts, unlike distributions from traditional retirement accounts, do not increase the amount of Social Security benefits subject to federal income tax.
Another advantage of the Roth account is that workers can disburse contributions from the account prior to age 59 ½ without penalty or tax. However, funds disbursed from investment returns in the Roth disbursed prior to age 59 ½ are subject to penalty and are fully taxed.
In general, workers with a low marginal tax rate at a firm that does not match employee contributions to a 401(k) plan should use a Roth 401(k) or IRA instead of a traditional retirement vehicle. This worker should use a Roth IRA when the firm does not offer a Roth 401(k) plan.
A worker that does contribute to the traditional 401(k) plan, perhaps because of the employer match, can in the future rollover the 401(k) assets to an IRA and convert the IRA to a Roth. The conversion is economically desirable in a year the person has a low marginal tax rate.
Availability of hardship distributions and 401(k) loans:
The tax code allows but does not require 401(k) plans to take hardship withdrawals from a 401(k) plan or to borrow funds from their 401(k) plan. Most firms with 401(k) plans do allow hardship distributions and 401(k) loans. Also, the tax code allows all employees to distribute 401(k) funds early and pay both a 10 percent penalty and tax on the withdrawal.
Research has shown that 401(k) savings is being used to finance current consumption. One recent paper has shown that leakages from 401(k) plans are primarily from highly leveraged households. The early use of 401(k) funds may leave many households with insufficient income in retirement.
A person using retirement funds prior to retirement may be better off contributing to a Roth retirement account than a traditional retirement account because the amount contributed to a Roth IRA is not subject to tax or penalty at any time. The funds from investment returns prior to age 59 ½ are subject to tax and penalty.
The use of the Roth can be done inside the firm’s plan if the firm has a Roth option or through an IRA if the firm plan does not have a Roth option.
Investment Options
Most 401(k) plans offer a range of stock and bond funds to invest in. A core issue shaping 401(k) investments is the ratio of assets in stock funds to assets in bond funds. Younger investors generally have most of their assets in stock funds while older investors move assets to bond funds as they near or enter retirement.
The core fund is usually a broad low-cost passively invested stock fund, often covering the S&P 500, however, funds investing in stocks of small companies or international stocks are also usually offered.
The bond funds hold either government bonds, corporate bonds, or a mix of both.
Target-date funds are a way to automatically move funds from stocks to bonds as a person nears retirement age. Around 77 percent of 401(k) investors have at least some of their retirement savings in a target-date fund.
There are some limitations with 401(k) options which can lead to adverse impacts for investors.
Some 401(k) plans might not offer a low-cost option. As previously noted, the solution to this problem is to use IRAs instead of 401(k) plans when the employer does not match contributions and to eventually roll over the assets to a low-cost IRA.
Most 401(k) bonds do not offer bonds or bond funds that will rise in value with inflation. This is a major potential risk for 401(k) investors in the current low interest rate macroeconomic environment.
A person looking for an inflation hedge should consider purchasing I-Bonds or EE-bonds directly through the Treasury. There are no fees on purchases of bonds through Treasury Direct.
The advantages associated with investments in I-Bonds are discussed here. The interest rate on EE-Bonds is currently very low but all EE-bonds double in value after 20 years.
Other ways to hedge against inflation risk and interest rate hikes is purchase Treasury inflation protection (TIPs) or to purchase funds specializing in TIPS like VTIP, STIP, or VIPSX. These funds are generally not offered inside 401(k) plans. Investors can purchase them inside an IRA or with funds outside of a retirement account.
In general, fund managers of 401(k) plans do not invest in individual stocks. IRAs do offer this option. Stock picking is challenging, and most investors should seek to achieve broad diversification through low-cost funds before attempting to create their own portfolio.
Use of Annuities:
During working years, the financial focus of 401(k) investors is on the accumulation of wealth. After retirement, the focus turns to assuring that people have sufficient income going forward.
One way to lock in sufficient income in retirement is through the purchase of an annuity, an insurance contract that provides regular payments to investors some point in the future.
Around, 10 percent of 401(k) plans offer an annuity inside their 401(k) plan. It is also possible to use funds in an IRA to purchase an annuity.
There are costs and risk associated with the use of annuities to fund consumption in retirement.
- Annuities are not guaranteed by the FDIC.
- A recent law, the Secure Act, reduced liability to plan sponsors if the insurance company offering the annuity were to fail. This Act basically transfers risks from firms to workers.
- The use of annuities often reduces inheritances from retirement wealth because with many annuities payments stop once the recipient dies.
- Annuities can be expensive because people with long life expectancy are more likely to purchase an annuity than people with short life expectancy.
Annuities can reduce the risk of outliving retirement resources, but the products are expensive and difficult to evaluate. One proposal designed to reduce the likelihood of a person outliving a retirement option, discussed here involves automatic use of a portion of 401(k) funds for the purchase of an annuity. This approach is not widely available, if at all, and most people entering retirement cannot easily convert their retirement wealth to a stable income stream.
Conclusion:
The focus of retirement planners is to automatically enroll workers in 401(k) plans and to maximize lifetime 401(k) contributions. However, not all 401(k) plans have the same level of quality. Many workers will be better off by diverting some investments inside their 401(k) plan to an IRA or other investment vehicle.
- Workers at firms that do not match employee contributions are often better off in a low-cost IRA than a high-cost 401(k) plan.
- Workers that contribute to the high-cost plan because of the employer match can move funds to lower cost plans either through an in-service roll over or when switching positions.
- Low-marginal tax rate workers at firms that do not offer a Roth 401(k) are often better off using a Roth IRA than the traditional firm-sponsored retirement plan.
- Workers who are likely to disburse funds prior to retirement may be better off with a Roth IRA than a firm-sponsored plan.
- Most 401(k) plans do not offer adequate investment options that adequately insulate workers from an increase in inflation or interest rates. These risks can be better addressed by investments outside of a 401(k) plan.
The analysis presented here suggests whether a worker is ready for a financially secure retirement cannot be summed up with a single number like the value of assets inside a 401(k) plan or even net worth.