Sometimes the universe has a way of telling us to look more closely or again at something we thought we knew. In my case, two jlcollinsnh readers have caused me to take another look at 401k programs. I don’t like what I see.
Caution! Pickpockets at work.
401Ks were enacted into law in 1978. In fact, the term 401k refers to the section of the IRS code that deals with the law.
But it took awhile for them to spread. As memory serves, it wasn’t until the early or mid 1980s the company I was working for at the time rolled one out. I thought it was the greatest thing since sliced bread. I enrolled in that one and every one since, had the max withheld and never looked back.
In fact in Stocks — Part VIII, where I talk about them, my first bullet point is:
“These are very good things. I always maxed out my contributions.”
Sure, the funds offered back then typically had somewhat high ERs (expense ratios) but the tax savings and the sometimes company match more than made up for those. 401Ks were a no brainer.
Now I’m not so sure.
(Please note: for the purposes of this discussion I refer to 401K plans. But it also applies to 403b plans and other variations of employer sponsored tax-advantaged retirement programs)
Last week in the comment section under Part IX of this series, reader Prob 8 posted:
“If anyone doubts JLC’s claims regarding the impact of fees and commissions on your portfolio, please check out this video from PBS: The Retirement Gamble
There are interviews with Jack Bogle and all you’ll need to know to realize fees and investment advisors are hurting your portfolio more than helping.”
It is about an hour-long and Prob 8 points out the discussion of excessive 401k fees starts at around the 20 minute mark. But I strongly urge you to watch the whole thing. In fact, if you own investments and especially a 401k, you should consider it mandatory viewing.
I was appalled and frankly a little stunned to learn how fully investment companies have plundered what was once a great retirement tool. So important is this new information, I copied Prob 8’s comment and link and created it as an Addendum on:
In the film, the math on how damaging even seemingly modest 2% fees really are is well demonstrated. It is nothing short of breathtaking; and even I didn’t fully appreciate just what a cesspool of fees some 401k plans have become.
But as I was about to learn, we should be so lucky has to escape with 2% fees.
Last Sunday in the comments section of Putting the Simple Path to Wealth into Action, reader Chris posted a comment outlining his situation and asking a few questions. Among other things, he is investing in the “Simple IRA” (think 401k) offered by his employer. The funds in it are all from Fidelity.
He mentioned that he was considering a specific fund: Fidelity Asset Manager 85%. I jumped on the Fidelity site and quickly saw this fund carried a .82% ER. Not great but not a deal breaker either. Pretty much in line with what I’d faced in my own 401Ks.
In his reply, he said some very nice things about the blog, said he would explore his fund options and he provided a link to the Fidelity offerings. Curious, I clicked on it and poked around.
OMG! as the kids say.
Here is my slightly updated reply (you can read the entire exchange over on that post):
…now I’m offended. Not at you, but at Fidelity.
As you and everybody who reads this blog knows, I recommend Vanguard as it is truly the only investment company that puts its customers’ best interests first.
Competition has forced companies like Fidelity to offer a line of low cost index funds and that has allowed me to soften my view on them, especially if Vanguard is unavailable for some reason. But I’ve always cautioned their heart wasn’t really in it and they only served up low-cost funds when forced to and as “loss-leaders.”
But clicking on the link you just provided, I am truly appalled. Not only is the list of funds almost endless and confusing, they are all “Class T” where as far as I can tell “T” means “Take lots of your money.”
These things are absolutely dripping with fees.
You may recall in my first reply I said: “Fidelity Asset Manager 85% is an OK fund but has a pricey expense ratio of .82%.” I got that ER simply by looking up the fund on Fidelity’s web site: https://fundresearch.fidelity.com/mutual-funds/summary/316069707
As high as .82% is for an ER, at least it is the only fee. But in your IRA they don’t offer you this class of the the fund. They force you into their Class-T. Here’s a look at that fund “T” classed and the related fees:
Maximum Sales Charge 3.50%
Gross Expense Ratio 1.37% as of 11/29/2012
Net Expense Ratio 1.32% as of 03/31/2013
Expense Cap: 1.50% as of 10/2/2006
Management Fee 0.56% as of 03/31/2013
Distribution and/or Service (12b-1) fees 0.50%
I poked around and looked at several other funds, and all were laden with fees. For instance another option you might have considered would be this TRF (Target Retirement Fund):
Maximum Sales Charge 3.50%
Gross Expense Ratio 1.29% as of 5/30/2013
Management Fee 0.00% as of 03/31/2013
Distribution and/or Service (12b-1) fees 0.50%
Holy crap, again!
This is nothing short of a money grab on Fidelity’s part and shame on your employer for not better protecting your interests.
All of this is enough for me to seriously suggest you skip investing in your 401k all together. Here are the three things that you might want to consider before you do:
1. Does you employer offer a match? A match would help offset these horrible fees, so you might still invest but only up to the full match.
2. Are you in a really high tax bracket? 25%+. Even without your 401k deduction, you are not.
3. Does the 401k get your income below $41,952 for the EIC (see #3 below) as we discussed?
As troubling as all those fees are, they are only the ones we can see. Even more troubling are those, as that video points out, so deeply buried as to be undetectable.
So what should you do?
Well, unfortunately, Fidelity isn’t alone in this money grab. Indeed, with so much money at stake, my guess is virtually every other investment firm is engaged in this same disgraceful plundering of your retirement fund. Vanguard being the sole exception for the reasons I’ve already described.
The time has come to seriously reconsider participating. To do so, you are going to have to take hard a look at your plan. I know this is unpleasant, and it runs counter to my contention that investing should be simple. If you wanted to just step away, things are bad enough that I wouldn’t argue. (Although the Mad Fientist would, so be sure to read his take in the Addendum.)
But there might still be some value in your plan and with a little work you should be able to figure it out. Here’s how:
1. If your plan offers Vanguard, you’re golden. More and more do. Good for them.
2. If you plan offers any other investment firm, you’ll want to take a close look. The Fidelity plan we have above offers a great template as to what to avoid.
- Notice first the huge range of funds offered. This is not done for your benefit. It is done to force you into throwing up your hands in despair and asking for their help in choosing. Making investing complicated is a way of gaining control. What they will choose for you likely will be what costs you the most and works best for them.
- Beware if the funds offered are in a special class. When Vanguard does this, it is because the economies of scale allow them to offer even lower costs. VTSAX has a super low ER of .05%. The Institutional Shares version — what would be in your 401k, VITSX — is even lower at .04%. But as we can see, when Fidelity does it, it is designed to drain as much of your your money as possible into their pocket. This will be true of most other 401k special class fund groups.
- Look, as always, for index funds offering the total stock market index or the S&P 500 index. These not only are the best investments, they should have the lowest cost. But in our Fidelity example above, not only do they offer a huge range of funds all in the hyper-expensive “T” class, they seem to have held back their Spartan (low-cost index) funds. At least I couldn’t find them.
Once you’ve assessed just how bad your 401k plan is, you can decide if and how you want to participate. Here’s how:
1. Does your company offer a match and if it does, how much? Sometimes it can be as high as 100%. Sometimes less, sometimes nothing. Usually up to some limit that will be less than the maximum you can contribute. This match is “free” money. If it is generous enough, it can make up for even the horrible fees we see in our Fidelity example above.
2. Think about your tax bracket. Federal income taxes here in the USA are actually pretty low for most people. For instance, if you are married and filing jointly you are in the 15% tax bracket until you earn more than $70,700. But that’s what’s known as AGI (Adjusted Gross Income). You’ll also have a standard deduction of $11,900 and a $3800 personal exemptions for each of you, your spouse and any dependent children. Looking at our friend Chris above with his two kids, this means he could earn $97,800 before hitting the 25% bracket:
$97,800 in income, less…
$11,900 standard deduction
$15,200 in personal exemptions — ($3800 x 4) =
$70,700 AGI for the 15% tax bracket.
Any additional deductions would drive the threshold for income taxed at 15% even higher.
Now this is just one example and taxes being taxes, there are lots of variations. If you are single you’ll hit the 25% bracket at $35,350, for instance. So you really do need to explore your own situation.
Remember, too, that 401Ks don’t eliminate taxes. They only defer them. There is a lot to be said for your investments growing tax free for decades. But 15% is also a very, very low tax rate. In retirement your rate could easily be higher. Maybe you’ll be wealthy enough to be in higher brackets. Maybe the government will have simply raised the rates. Maybe both.
But if your 401k plan is fee heavy as so many appear to be these days and your bracket is 15% or less, you’ll want to think long and hard. For you, maxing out your 401k might not be the slam-dunk it was for me in my day.
3. Does maximizing your 401k get your income down low enough to qualify for the EIC? (Earned Income Credit). The EIC is a very desirable credit where the government basically gives you money. It can wipe out any tax due and, importantly, it is a “refundable” credit. This means once your tax is zero, they give you the rest as a cash payment.
The EIC is designed to help low-income people, especially those with children. Your Earned Income and AGI must both be below certain limits. Here they are direct from the IRS website:
Preview of 2013 Tax Year
Earned Income and adjusted gross income (AGI) must each be less than:
- $46,227 ($51,567 married filing jointly) with three or more qualifying children
- $43,038 ($48.378 married filing jointly) with two qualifying children
- $37,870 ($43,210 married filing jointly) with one qualifying child
- $14,340 ($19,680 married filing jointly) with no qualifying children
Tax Year 2013 maximum credit:
- $6,044 with three or more qualifying children
- $5,372 with two qualifying children
- $3,250 with one qualifying child
- $487 with no qualifying children
Investment income must be $3,300 or less for the year.
(One caution when looking at those credit dollars, they are figured on a sliding scale. The closer to the income limit you are, the lower your EIC will be. So just tucking in under the ceiling won’t really help all that much.)
So what is the bottom line?
It is a little hard to say as I have no way of knowing how bad your plan might be, (and please don’t send it to me. I simply don’t have the time to wade thru them all.) The Fidelity plan above is awful, others could be even worse. But we can use this one as a measuring stick. After you investigate your own, you can adjust my recommendations accordingly. But for this one Chris is stuck with….
Go for it if:
- Your tax bracket is 25% or higher.
- Your 401k deduction will lower your income enough to get the EIC.
- Your employer offers a match, and then contribute only up to the match ceiling.
Consider skipping it if:
- Your tax bracket is 15% or less.
- Your employer doesn’t offer a match.
- You think your tax bracket might well be higher than 15% in retirement.
*Personal Capital is a great free tool to manage and evaluate the investments you have, including costs. Most folks reading already have a range of investments and now you can track and compare them. At a glance you’ll see what’s working and what you might want to change. Very cool. *(This is an affiliate link and should you choose to use their free service this blog will earn a small commission.)
But absolutely, positively roll any 401k you have over to an IRA at Vanguard the moment you can. Unfortunately, this is usually not until you leave your employer.
Never, ever leave your 401k with your employer once you move on. Too much chance for mischief.
Finally, please join me in thanking Chris and Prob 8 for opening my eyes to how the 401k world has changed. I’m grateful to have such bright readers contributing and asking astute questions. If you don’t already, let me encourage you to read the comments after the posts around here. Some of the best stuff is found in them.
Before publishing I sent this post out to the Mad Fientist for a peer review. His efforts have made it both more accurate and more complete. He also did a little additional analysis and as you’ll see he concludes that, as ugly as all these fees are, you are still better off funding your 401k. Here it is:
I’d argue that it is usually always prudent to invest in your 401(k), even if you only have high-fee investment options, due to the fact that the tax savings resulting from the 401(k) contributions will more than compensate for the higher fees.
To get some numbers to support my argument, let’s compare two different scenarios.
Assume two investors make $80,000 per year. Investor A decides to max out his 401(k) with $17,500 every year and invests his 401(k) money in the Fidelity fund with the awful fees mentioned in the post (3.5% front-end load and 1.32% expense ratio). Investor B does not contribute to a 401(k) and instead invests his money in a Vanguard taxable account with an expense ratio of 0.05%.
Thanks to the fact that 401(k) contributions are pre tax, Investor A’s taxable income decreases from $80,000 to $62,500. This means that he only has to pay $9,225 in federal tax instead of the $13,600 that Investor B has to pay.
Due to the front-end load of the 401(k) fund, Investor A’s $17,500 contribution would actually only buy him $16,888 worth of shares. Combining that with the tax savings I already mentioned, however, means his $17,500 401(k) contribution would actually fetch him $21,263 worth of shares ($16,888 into his 401(k) and $4,375 of tax savings into his taxable account). Compared to Investor B’s $17,500 contribution, Investor A is able to invest $3,763 more every year. These additional contributions definitely add up and more than cover the higher 401(k) fund expenses.
Assuming both investors contribute to their accounts for 10 years and earn an 8% return, Investor A would end the 10-year period with $293,056 in his portfolio ($229,828 in his 401(k) and $63,228 in his taxable account) and investor B would end up with $252,914 in his portfolio (all within his taxable account).
As was mentioned in the post, it is important to roll over 401(k)s into a low-fee IRAs as soon as possible, since there’s no point paying high fees if you don’t have to.
By rolling over his 401(k) into a Vanguard Traditional IRA after the ten years, Investor A would then have the benefit of tax-free growth within his IRA, an expense ratio equal to that of Investor B’s, and $40,142 more than Investor B.
Obviously the money in Investor A’s Traditional IRA could be taxed at withdrawal, although it doesn’t have to be if he slowly rolls it into a Roth IRA. (http://www.madfientist.com/traditional_ira_vs_roth_ira/) But I’d still choose the extra $40,142 and the possibility of multiple decades of tax-free growth any day.
Using this calculator I ran some numbers to illustrate the difference in having Vanguard v. Fidelity in your 401k.
First, I set the current age to 55. With the retirement age preset at 65 that gives us a 10 year window, a reasonable job length/holding period for a 401k. I used an 8% projected return and set the “lower fee” option to 0%. Then I ran both scenarios separately to get a cleaner look.
Scenario I: Fidelity’s Asset Manager 85% Class-T.
401k contribution of $17,500 less 3.5% load (commissions) = $16,888 invested.
Plugging in 1.32% for the net expense ratio, after 10 years the account would be worth $262,076 and Fidelity would have collected $19,033 in fees in addition to the $6120 in load/commissions. ($612 per year x 10 years)
Scenario II: Vanguard’s VTSAX.
401k contribution of $17,500 + zero load (commissions) = $17,500 invested.
Plugging in the .05% annual fee, after 10 years the account would be worth $290,520 and Vanguard would have collected a grand total of $776 in fees. That’s right. Less than $1,000.
$290,520 – $262,076 = $28,444 extra dollars Fidelity has picked from our pocket and cost us in lost earnings from that money not being available for investing. That’s an astounding 9.8% of our $290,520 potential.
Here’s another Expense Ratio Calculator
In proofing this post and the two Addendum, it occurs to me it starts to look like you have a choice:
Give you money to Fidelity or give it to Uncle Sam. If the numbers are close, and since Uncle Sam is at least upfront about it and provides some useful services, I’m inclined to lean that way.
But if you take only one thing from this post, this is it:
Reading the Mad Fientist‘s thoughtful case it is clear — most often you’ll be money ahead funding your 401k. Given the highway robbery now imbedded in so many of them, that’s tough for me to say. But there it is.
Here’s a very cool tool that let’s you evaluate your company’s 401k plan: Bright Scope. The link takes you to the report on Google , a company famous for being a great place to work. The 401k plan reflects this and shows they even offer Vanguard. To find your own plan, just enter your company’s name in the search box.
Unfortunately, they don’t provide specific cost numbers, only a scale relative to other plans. Still, fun and useful.
Mr. 1500 shares his own 401k horror-show.