401(k)s have been a staple of American retirement plans since their inception in the early 80s. But as with any asset, this essential part of your retirement planning comes with its own set of pitfalls. And in an industry that thrives on hidden fees and commission-heavy products, it’s easy to see how many hard-working employees are losing out.
But it’s not all doom and gloom. There are advisors who are genuinely interested in helping clients succeed in their financial goals.
Before we can get to the best way to manage your 401(k), we need to discuss how 401(k)s work in the first place.
What is a 401(k)?
In 1978, Congress passed a Revenue Act to enable employees to avoid taxes on deferred income. This tweak to the Internal Revenue Code isn’t just where the 401(k) name came from - Section 401(k) - but it also provided leeway for benefits managers to create unique packages.
And this is exactly what happened in 1980 when consultant Ted Benna used Section 401(k) to devise a retirement package with tax benefits. After his company instituted the program, it didn’t take long for the 401(k) to take off. In fact, within two years, nearly half of all companies were providing 401(k)s to employees. These qualified plans – meaning investments in the plan grow tax-free – even come in different forms, such as the 401(a) or 401(b).
While regulations regarding 401(k)s have continued to change, it remains one of the most popular retirement assets around.
The problem with most 401(k)s
Despite its long history, the vast majority of 401(k) plans suffer from the same ailments as other common financial assets. Generally, 401(k)s, IRA, annuities, mutual funds, and other common investments are offered by brokers and fiduciaries - but the brokers are far more visible.
The problem with investing in a 401(k) is the lack of transparency, which is further complicated by the plan structure. Every 401(k) involves at least four main parties:
- Trustee – The Trustee is generally your employer.
- Recordkeeper or Custodian – The Recordkeeper or Custodian provides the plan, directs the Trustee, and monitors the investments.
- Plan Administrator – The Plan Administrator is a third-party individual who knows the laws around retirement benefits and advises the employers about the plan.
- Financial Planner – The financial planner could be a major advisory firm or a local business. They may be a fiduciary or a broker.
No one on this list, except for maybe the financial planner, is required to be a fiduciary. In other words, they are salesmen at heart – they don’t have to think about the employees’ best interests.
In many cases, employers choose a plan with both high fees and low-quality investment options. An example would be employees with 6-12 investment options within your 401(k), with an overall expense of 3% per year. And it could very well be worse, depending on your specific plan.
To make matters more complicated, employees aren’t given clear information about their investments within the 401(k). Are they good? Are they bad? Information that should be transparent and concise is often obscured - much to the investor’s detriment.
The employer, who selects the plan, may know every detail. And while the Employee Retirement Income Security Act (ERISA) of 1975 mandates that plans must provide disclosures to participants, these documents may be so long and difficult to read, that many employees give up. And this makes it difficult for employees to see the big picture.
While many employers do want to assist their employees and make their organization more competitive - there are several others who skimp on retirement benefits. Choosing the cheapest 401(k) plan is one way to cut corners.
How employers pick 401(k) plans
Employers have a significant range when choosing employee 401(k) plans. If you really want to know how fees can add up, looking at the process from the employer’s side can really shed light on the issue.
Let's say Business Owner A wants to give a 401(k) plan. Well, they go to the 401(k)-plan people - usually a company that specializes in benefits.
What the typical owner of the business is going to say is that they want to set up a 401(k) plan that matches their budget and adheres to the bare minimum legal requirements. The employees are not part of that discussion.
Once all of the customizations have been discussed, such as how much the employer will pay and how often, the owner asks about the cost. In response, the 401(k) company may say $5,000 a year. And then comes the big question:
The 401(k) will ask if they should bill Business Owner A or “the plan”. Many business owners stick with shifting the cost to the “plan”, which means the participants of the plan (the employees) end up paying.
The worst part is, most employees don't realize this!
But there are ways to find out. Your retirement plan has to file with EIRSA. If you search for your 401(k) reports on Google – normally, but not always, a 5500 form – you can get all the details of your plan.
The good news is that you can take control of your 401(k), reduce your fees (sometimes by up to 63%), while broadening your investment options.
Advantages of a Held-Away Account
A held-away 401(K) account means that an RIA or another third party is helping you manage your account. When you manage your finances through an RIA, you get access to thousands of institutional funds that would be unavailable otherwise, as well as lower fees. Let’s look at this example.
Client A has a joint account with their spouse, and they both have an IRA as well as a single 401(k) with TransAmerica. I work with TD Ameritrade, soon to become Charles Schwab. Client A asks me to manage his accounts - the joint account and both IRAs.
I would open these three accounts at TD Ameritrade. But the 401(k) is a separate entity. I can't bring them into TD Ameritrade. The 401(k) is held away from TD Ameritrade. But I can still manage all four of them.
Now, RIAs should be fee-only firms. This fee may vary, but 1% is the norm, and that’s what I charge. So what do you get for that 1% fee?
I show Client A all the funds in their 401(k) and the performance over the last 10 years. And they can see it. Most of the time, my clients aren’t happy with the progress. So, what can we do?
I would scan my database for more details about the investment options within your 401(k). By choosing funds with lower fees, in part because I avoid commission-based funds, and higher expected returns, Client A’s expenses immediately get reduced. That 3% expense may become .10%. Add on my 1% fee, and Client A has still reduced their expenses by 63%!
Spending less on expenses means your retirement account can truly grow.
At the end of the day, investments should be about how much you can earn from your savings. Any platform or plan that is hindering your progress with high fees and low returns, no matter how convenient they seem at the time, will only hold you back.
Two More Tips for Managing 401(k)s Yourself
These days, you’re likely to go through career changes – which can be confusing when it comes to a retirement plan that is linked to your employer. Below are two things you should keep in mind when self-managing your 401(k):
1) Many people choose to keep their 401(k), even after they’ve left the company and started work elsewhere. Don't do that. Staying with that plan means you’re limited by its chosen investments and all the fees. Instead, it can often be more beneficial to roll that money into an IRA when you leave a company. Then, an RIA can give you access to thousands of high-quality investments and lower your fees.
2) Only put money in your 401(k) so that your employer will match. Don't put in any more. After all, the matching is free money – don't give that up. But there are many other investments that give you more control over your money.
Learn more about financial planning
Sign up for our free newsletter for more tips on how you can improve your finances, make better investment decisions, and avoid common pitfalls in the market.