Employer-Sponsored Plans Are A Great Way To Stay Poor
If you follow me on social media, you probably this post with saw me running my mouth recently about investing fees.
I’m going to continue to do so here, because fees make me irate.
I’ll get into Dave another day. We have too much to cover here without getting me started on him. Right now we need to have a come-to-Jesus meeting not just about the Great Mutual Fund scam: I’m here to tell you about how your entire 401k is a money pit.
It’s alarming to me how many people are unaware that they are perfectly capable of building wealth for retirement without the help of their employer,and without even knowing much about investing. In fact, generally speaking, 401ks are awful, and if your employer prompts you to open an IRA through a specific company that they aren’t helping you fund, you should run far and fast. These companies are only there to sell you expensive products with sub-par returns that will never allow you to build the wealth you could elsewhere if you learn some basics.
You are not even going to believe this. I didn’t.
To be clear: if your employer is offering a match on your contributions in any retirement account they offer, you should probably take it. (After I did the actual math, I cannot say this with certainty anymore. Keep reading). Studies show that on average, when employees are offered benefits through their employer, they are paid less to compensate for those benefits.
Basically, they’re paying you less in cash to give you these “benefits”. It’s like if you’re buying a new TV, and one is priced at $950 + $50 shipping, and one is priced at $1000 + free shipping. Yes, they’re touting the shipping as free, but that’s only because they’re adding it in to the cost of the product. Benefits are part of your pay, so you’d better just take them. (Not so sure about that anymore).
Back to the fees: beyond getting whatever your employer will match, your 401k is one of the worst places to invest to build wealth. Not only are they tax-deferred instead of tax-free, but they are full of seemingly small fees that, over time, will kill your chances of financial freedom.
How A 401k Can Destroy Your Wealth
Lack of choices
Your 401k could have 8 or 12 choices as far as investment products, and most of these are mutual funds. I detest mutual funds, generally speaking. Most, around 75%, underperform the market as a whole. This underperformance has averaged 1.6% from 1994-2014. (Source: The Economist/Morningstar )
Put another way, over those same 20 years, the rest of the stock market gained an average of 9.3% (Source: DQYDJ.com.)
If you were invested in the average mutual fund within your 401k, your 401ks gains were 17% lower than if you had just invested in a broad market index fund.
It gets worse with mutual funds. They are expensive. Many people don’t realize that these funds (which, remember, underperform the broad market) cost a ton of money to buy, sell, and hold. The expense ratio, which can be found on the prospectus of your mutual fund, is just part of the cost. There may be a load fee (these can be as much as 5 or 6%), and plenty of other hidden costs, like transaction fees and the fact that many charge you just to hold cash. All told, it’s estimated that the average mutual fund is going to cost you 3.56% every year to own (Source: Forbes).
Beyond crappy mutual funds, your 401k itself costs money to run. Generally this cost is a fixed fee for the whole plan, which means the larger your company is, the smaller your administrative fee will be, because it’s spread among more people. I’ll err on the side of caution and say that you work for a larger company and your administrative fee for your plan is 0.5%. If your company is smaller, it could be over 1%. Check your 401k statement.
Let’s apply real numbers to these fees. Say you make $60,000 a year and your employer matches 50% of your contribution to your 401k up to 3%.
I’ll even give your mutual fund within your 401k the benefit of the doubt and say it’s performing better than the average mutual fund and has lower than average fees. We’ll say your cost of ownership totals 3%, which includes the expense ratio, load fees, and transaction fees. We’ll also say that your mutual fund is only underperforming the market by 1%, including the lower returns for blended target date funds (commonly found in 401ks), and the 0% return on the cash it holds. There may be a bit of overlap in the data I found, so this leaves some room for error as well. We will use .5% for your 401k’s administrative fees, but yours could certainly be higher. We won’t mess with periodic salary raises, but we also won’t mess with inflation.
If we use the 100 year average annual return of the S&P 500, which is around 10% with reinvested dividends, this brings us to a total return of 5.5% in your 401k account.
After your annual contribution of $1800 plus your employer’s match of $900, your total nest egg comes to $392,910.
That’s…something. Not enough to retire early or even at all, but hopefully social security will still be around for you, or your spouse is also saving for retirement.
Now let’s say since you’re eager to build wealth, you’ve been contributing 3% extra, above the 3% you contributed for your match, for a total of 6%. After your annual contribution of $3600 plus your company’s match of $900, your nest egg after 40 years is $654,850.
Better. After inflation and taxes (which I’ll be ripping to shreds in my next post), you’ll be left with a fraction of this, but it’s more than some people will have, certainly.
Now: my favorite part. Or maybe my least favorite, I’m not even sure.
What if, instead of putting that extra 3%, or $1800 per year, into your sad performing, fee-filled 401k, you put it into an IRA, which stands for individual retirement account, all on your own? If you know nothing about investing and choosing your own stocks makes you nervous, you could buy a broad market ETF, which statistically outperforms mutual funds and costs less than 5/100th of 1% to own?
Caution: you may die a little when you see this. I sat blinking and speechless when I ran these numbers. I checked and double checked them. I knew the fees were awful; just how awful, I did not realize. I’m going to lay these numbers out for you. This is the wealth that is lost by using only your 401k to build your future.
The dollars in the IRA are used to purchase ETF shares quarterly rather than monthly like I did with the 401k. The ETF expense ratio is calculated at 0.05%, but there are a few ETFs that are even less expensive. These numbers also reflect a $5 quarterly trading fee, which is the low fee you’ll pay if you opened the Trade King Roth IRA featured in my tutorial. Other brokerages will probably cost more per trade.
That $150 a month in your IRA, all by itself, including a quarterly purchase of very low cost ETFs with just average performance, grows to $938,919 over 40 years.
If you chose to contribute to get the match to your 401k, then put that extra 3% in your IRA instead of your 401k, you end up with a handsome $1,331,829 between both accounts.
But really look at this: you took just that 3%, or $1800, per year extra that you were contributing to your retirement over and above your match, put it into an IRA, and only bought a basic, average ETF with a basic, average return of 10%, and your total over 40 years just in the IRA is almost $300,000 more than contributing 3%, your employer’s 50% match of your 3%, plus an additional 3%.
This is $676,979 of your wealth that was distributed to Wall Street if you kept that same amount of money in your 401k.
These fees are not a joke.
Mutual funds are, dare I say, the devil.
You’re paying an enormous amount of money to hang on to an investment that is inefficient at best. Your inefficient investment is being held in an equally inefficient account.
401ks are where dreams go to die.
They know this.
They know that you do not know to look for these fees.
Most people don’t even take the time to compare their 401k investments’ performance to the rest of the market. They’re aware of this too.
Tweaking your retirement strategy in this way is not stock picking; this is not even selecting the best quality companies, this is just buying a large cap ETF with a low expense ratio quarterly, and getting average returns.
So after all of these different scenarios and losing hundreds of thousands of dollars to Wall Street just in these seemingly small fees and poor performance, I can’t help but wonder: is your employer’s match in your 401k even worth it at all?
I don’t want to get in trouble, so I’m not even going to compare the difference between skipping the 401k altogether and simply maxing out an IRA…yet. Knowing myself, I probably will soon. Just know that when I’m done here, I will be logging into my husband’s 401k account to make some changes myself.
Here’s what I want you to do now: I want you to actually open your 401k statement, and look for these fees. Look at the performance of your holdings. Look at how much your company matches. Look at other options within the plan, and their cost and performance. I am not telling you to cancel your 401k contributions, but rather, encouraging you not to just trust your 401k to be everything you need for retirement. You have options. Your 401k is about the least attractive one.
Do not, under any circumstances, rely on your employer to provide you with a comfortable retirement.
Next up: you’re going to be horrified at what your traditional 401k is costing you in taxes as well.
Need an IRA? I already did all the research for you.
This is an example only, based on the data available. Your investments could be perform better or worse than the examples given. Do not make changes to your retirement accounts without researching to see what your current fees and returns are, and how they compare to other options.