Is Your 401(k) a Rip-Off?

Nov 1, 2013 by

The job I liked most in my career so far was a 6-year stint as Manager of Financial Analysis at a medium-sized (~75 employees), family-owned (four brothers) manufacturing company in Minnesota. I ran the company’s budget process, did all the capital investment analysis (which I really enjoy) as the company aggressively expanded, produced cost variance reports, contributed to strategic planning, managed the company’s computer systems (a job for which I was poorly qualified, but I did my best), and more or less served as the CFO/co-owner’s ‘go to’ guy. I got to do lots of different tasks and special projects. I liked that because I have to be learning new stuff to avoid boredom and stay motivated.

My Employer Goes 401(k)

When I started with this employer, it offered a defined benefit pension plan (DBPP). If you’re under 40 years old, you’ve likely never been involved in a DBPP. And if you’re under 30, you’ve perhaps never even heard of defined benefit pension plans. That’s because the now supreme 401(k) plan largely supplanted DBPPs during the 1980s and 90s. Today private sector DBPPs are pretty much extinct. I can’t remember the last time I ran into somebody whose employer still maintained a DBPP.

In the early 1990s my employer in Minnesota made the same choice and elected to replace its DBPP with a 401(k). I was excited about the change and enthusiastically endorsed it. This mattered to some skeptical employees—particularly the unionized plant workers—because I was the most financially knowledgeable person at the company who was not an owner (i.e., of suspect motives). Probably in part because of my genuine enthusiasm, the CFO tapped me to lead the transition and help “sell” the concept to employees. I made presentations to small groups of employees and met individually with a few key and long-time employees to explain the alleged benefits of the 401(k):

  • Company match — I don’t recall the exact match my employer planned to make, but it was material. To me, enrolling in the 401(k) amounted to giving myself a 6% (or whatever it was) raise.
  • Immediate tax benefits — Everyone needs to save for retirement. With the 401(k), I could stash $1 in my nest egg but see my take-home pay drop by only ~70 cents. How cool is that!
  • Deferred tax benefits — If I saved for retirement outside of a 401(k), I’d have to pay income tax each year on dividends, interest, and capital gains, stunting my nest egg’s growth. Inside the 401(k), all these taxes were postponed until I began withdrawing money from the 401(k) at what seemed at that time a point in the future approaching infinity when, the story went, I’d be in a much lower tax bracket.
  • I manage my own money — I’m as smart as any pension fund manager, right? 🙂 With the 401(k), I’d get to make my own investment choices. This would give me the opportunity to ‘hit home runs’ and retire earlier than I might otherwise. (I blocked out mentally the prospect of ‘striking out’ and an emerging crash-prone stock market culture.)

The transition meant every employee would receive a present value payout from the company’s DBPP. For some, this amounted to a 5-figure chunk of change. That certainly made it easy to convince them they’d be better off under the 401(k)! All but a couple of employees embraced the idea of the 401(k).

What I Didn’t Know About 401(k)s at the Time: FEES

Much more is written and known about investment fees today than was the case one or two decades ago. Today 401(k)s are under attack because of the debilitating fees charged by many plan administrators, especially for smaller companies. Take a look at this chart:

Average fees per asset level

Plan asset levels Average total plan cost
2009 2010 2011
$1 billion-plus 0.38% 0.36% 0.35%
$800 million-$1 billion 0.44% 0.42% 0.42%
$600 million-$800 million 0.45% 0.49% 0.44%
$400 million-$600 million 0.50% 0.49% 0.47%
$200 million-$400 million 0.53% 0.50% 0.50%
$50 million-$200 million 0.66% 0.64% 0.63%
< $50 million 0.97% 0.93% 0.94%

Source: BrightScope.

Certainly my employer’s 401(k) plan’s assets were far less than $50 million. I doubt they exceeded $500,000 during my time at the company. Shame on me, but I never asked and never paid attention to whether the growth of my account was being hamstrung by the plan administrator’s fees. About twice a year a guy—Chris—came out to our offices to meet with all the employees, talk up the 401(k), and answer questions. I do remember thinking, gee, I wonder how this guy’s getting paid? But you know how it is—sometimes you don’t want to think about things too hard that might keep you awake at night or upset your idealized view of a matter.

Investment Fees Are a Killer

As I quantified in my article “Fund Fees: Nest Egg Killer“, a 2% annual fee assessed on an account averaging a 6% annual return nearly halves the account’s 10-year return. In other words, the investor is practically splitting evenly the return on his money with the party or parties assessing the fee.

Is a 401(k) Worth It?

Many are arguing today for replacing 401(k)s with a vehicle that’s more investor-friendly. (See Slate.com’s Matthew Yglesias’ writing on the topic, for one example.) My guess is I did pay a lot of fees during the many years I’ve had money in 401(k) plans. But I must say that list of 401(k) benefits above still strikes me as compelling, and I’d probably still opt to put money into a 401(k), even knowing the fee-sters were robbing me. But I think the point is, why can’t investors have 401(k)-like benefits AND low fees at the same time?

Are You in a 401(k) Plan Today?

Are you putting money in a 401(k) or equivalent today? Do your statements fully disclose all fees? How do you know?

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