In mid-December, defense contractor Lockheed Martin elected to settle an eight-year-old class-action lawsuit brought by more than 100,000 of its workers and retirees, alleging excessive fees inside the company’s 401(k) plan. While the suit was unusual in its size and scope, it was indicative of a recent trend toward greater employee awareness and vigilance with regard to the management of company retirement plans.
In recent decades, as companies have increasingly moved away from “defined benefit” pension plans toward “defined contribution” plans, the onus of saving for retirement has fallen more directly on the employee. Unfortunately, many individuals are unprepared to deal with the responsibility of managing such accounts, and many do not even know where to begin. If you have questions about your own 401(k), what follows is a basic framework for understanding your employer’s plan.
Know The Benefits
Like traditional IRAs, 401(k) plans allow employees to contribute pretax money from their salary into an investment account. Taxes on both contributions and any earnings (via capital gains, interest, or dividends) are deferred until the employee’s retirement years, when withdrawals will be taxed as ordinary income. Roth 401(k) plans—which accept after-tax contributions and allow for tax-free withdrawals of contributions and earnings in retirement—are increasingly frequent, but still much less common than traditional 401(k) plans.
There are a number of benefits to 401(k) plans that IRAs do not enjoy. For one, 401(k) plans have higher contribution limits. While IRA contributions are capped at $5,500 per year ($6,500 for individuals age 50 or older), employees can direct up to $17,500 ($23,000 for employees age 50 or older) toward their employer-based 401(k) plan. Better yet, those 401(k) limits will increase to $18,000 and $24,000 in 2015, while IRA limits will remain unchanged.
Also, perhaps the greatest benefit to a 401(k) over an IRA is the opportunity for a matching employer contribution. Many companies will match an employee’s contribution up to a pre-specified percentage or dollar amount, with the formula varying by company. Any employer-provided funds represent “free money” for the employee, income that cannot be replicated in an IRA.
Know The Costs
A recent AARP study found that as many as 80% of 401(k) plan participants are unaware of how much they are paying in fees. Some industry players do a particularly clever job of disguising or outright hiding plan fees (for example, by netting the fees against a fund’s investment returns, rather than breaking them out as a separate expense on an account statement), but it is imperative that participants know and understand their plan’s fees. Doing so may require looking beyond account statements to the plan’s summary documents.
There are two primary sources of 401(k) fees. The first source is direct investment expenses, charged by the companies who manage the funds that comprise a plan’s investment options. Depending on the fund and how it is managed, this fee can be just a few hundredths of a percent, or up to 2% per year or higher. It is not uncommon for funds with nearly identical investment returns to have significantly different expense ratios—it is incumbent upon the individual to know the difference, and to determine whether the higher expenses are justified.
Beyond the fund-specific fees, there will also be general administrative fees. These fees, which are usually smaller than the direct investment expenses, are typically charged by the 401(k) vendor in order to cover the costs of administering the plan. While some employers will cover these costs on behalf of their employees, the fees will often be passed on to plan participants, and not always in a way that is evident to the employee. Additional transaction fees or sales commissions are typically smaller in magnitude than the two main categories, but they can also sometimes be significant enough to impact investment returns.
If, after learning about your plan expenses, you find that your plan isn’t competitive with other company plans (or if your all-in costs are higher than 1.5%, with average investment expenses higher than 1%), consider asking your company’s benefits manager about ways to improve the plan.
Know The “Menu”
The employer—typically along with a plan vendor or an investment advisor—will select investment options for its employees. The plan sponsor has a fiduciary responsibility to ensure that the selected funds are appropriate for the plan participants, in consideration of income and wealth levels, ages, and state of residence. Beyond that, though, it is the responsibility of the employee to choose how to allocate investments among the available funds.
According to research from the Plan Sponsor Council of America, 401(k) plans offer an average of 19 funds to choose from, a number that can often be overwhelming for an unsophisticated investor. Unsure of how to proceed, many employees will simply default to investing in target-date funds (which nearly 70% of plans offer), which are set up to gradually shift from a riskier (stock-heavy) portfolio to a more conservative (bond-heavy) portfolio over time. While these funds are simple and low-maintenance, not all target-date funds are created equal, and some do a better job for investors than others. Take time to understand what your target-date fund is doing—check the fund’s Morningstar rating to get a feel for its relative performance, study its asset allocation schedule to see if it may be too aggressive (or too conservative) for you in a given year, and finally, check to be sure that its fees are competitive. If the target-date fund falls short, then you may be better off building your own asset allocation strategy.
Know Your Exit
Upon leaving the company, there are usually four options available to the employee: a lump-sum distribution of plan assets (which creates tax consequences), a rollover into an IRA, a rollover into another employer’s 401(k), or simply leaving the money in the existing 401(k). Depending on your plan’s setup and your investment approach, these options will carry varying costs and benefits. While it’s typically best to roll into an IRA—where investment flexibility is generally greatest—there are many circumstances in which an IRA may not be best.
Either way, you can’t leave the money in the plan forever. Like IRAs, 401(k) plans have required minimum distributions (RMDs) starting at age 70 ½ (unless you are still employed by the 401(k) provider, in which case RMDs are suspended until your retirement). These RMDs will be treated as ordinary income, so if you have other income streams—like Social Security, real estate rental income, deferred compensation, or annuities—the tax impact of these RMDs may start to affect decisions about whether (or how much) you’ll want to contribute to a 401(k).
There are always a number of moving parts as retirement nears, but thoughtful planning in the early years can minimize tax impacts and maximize the income you’ll have to enjoy your golden years.
Other Considerations
While the above issues are typically the most important ones, secondary matters can also merit consideration. For investors with liquidity concerns, early withdrawal penalties and the availability of 401(k) plan loans can be significant considerations. And since pre-tax 401(k) and IRA withdrawals are taxable as ordinary income, investors may lose the ability to avail themselves of lower rates on long-term capital gains. Because of this wrinkle, certain assets are less appropriate than others for 401(k) plans, and might be better held in taxable brokerage accounts.
