For this episode of Motley Fool Answers, Robert Brokamp and Alison Southwick do a deep dive into perhaps the most popular form of retirement account in America: the 401(k). Between that and similar defined-contribution plans, we were holding $7.7 trillion at the end of 2017 -- a remarkable sum, and yet most people still aren't saving enough. But our contributions are only one piece of the puzzle. The other big one is return on investment, and in this area, there's wide divergence.
In this segment, our hosts cut to the chase with straightforward advice on determining the quality of your 401(k) plan.
A full transcript follows the video.
This video was recorded on May 22, 2018.
Robert Brokamp: Here's what you should do to figure out whether you have a good, bad, or awesome 401(k) plan. It all starts, No. 1, with the fees. It does cost money to run a 401(k). It costs more to have a 401(k) than compared to just a regular old brokerage account or an IRA. Part of it is because there are a lot of regulations required by the Department of Labor and IRS. 401(k) plans every year have to go through what's called nondiscrimination testing.
They can't benefit more people who are known as "highly compensated employees." The people who are considered highly compensated or 5% owners of the companies can't be benefiting more than the rank and file. There are cases where if the people who are making more money contribute more than everyone else, either the company has to throw more money into everyone's account just to throw it in there, or the highly compensated employees who put money in have to get their money taken back out. They have to go through that test each and every year.
Alison Southwick: But if your company doesn't match, and it's based on your income, how would you ever pass that, because people who are making more money are always going to naturally be making more contributions?
Brokamp: It's done on a percentage basis. The company gets around it partially by just throwing money into everyone's accounts.
Southwick: I'm sorry. I feel like this episode is now devolving into "Alison throws random 401(k) questions at Bro and sees if he has an answer." And, so far, you do.
Brokamp: So far, I do. This is one example of something that a 401(k) has to pay for that a regular old account doesn't. And in about 80% of the plans, those costs are at least partially or fully covered by the employee, not the employer. Those are costs that you are paying.
There's also, of course, the cost of the mutual funds in the 401(k). There's the expense ratio. For most people it's just a percentage of annual assets. But anywhere from up to 20% of funds in 401(k)s charge commissions or some other ongoing marketing fee, even though it's already in 401(k) plans.
Southwick: I don't like marketing fees.
Brokamp: Exactly. As to all-in costs for the average plan, according to a report from the Investment Company Institute and BrightScope [which is a company that rates 401(k) plans], a participant pays about 0.51% a year to be in a 401(k). It's not horrible, but there's a lot of variation around that often based on plan size. The bigger the plan, the more those costs are spread out, and the more bargaining power the plan has to get lower-cost funds. Those are the lowest cost.
But for the smaller plans [when you look at plans that have anywhere from $1 million to $10 million in assets], the average cost is 1.14% a year...
Southwick: That's no joke...
Brokamp: No joke, exactly, so there's a lot of variety. What determines a big part of those costs? The No. 1 cost is the investments. The average 401(k) has a little over 20 funds in it. The vast majority are actively managed funds, which means they have higher costs. About a quarter of the assets invested in 401(k)s are in index funds.
Index funds, as we all know, historically outperform actively managed funds, so according to Standard & Poor's, only 16.3% of actively managed funds outperformed the market over the trailing 15 years. That means many of those funds trailed the market, but if you're in a 401(k) you had no choice. You can only choose from among the choices within the plan. Fortunately, most plans have a couple of index funds, but they don't have a good index fund for each category.
I'm not saying that all actively managed funds are bad. We have several in The Motley Fool's 401(k). I helped select them. But if you look at 401(k) assets as one big portfolio, you're probably seeing a lot of investments that are not keeping up with their benchmarks.
There's another thing that's been going on with 401(k) plans [and this is where some of these lawsuits have come from] and that's where companies are putting investment options in the plan that aren't necessarily the best ones for the employees, but they're good for the plan provider. The most famous example of this was employees and former employees of Fidelity suing Fidelity because the Fidelity 401(k) had too many Fidelity funds in there. There were Fidelity funds. Some of them were high-cost funds. Some of the funds did not have a long history, but Fidelity put them in anyhow. According to this report from the Center for Retirement Research, up to 40 firms have been sued or are in the middle of being sued for what is called "self-dealing," basically putting funds in the 401(k) that are not the best for employees but they're being put in there for the good of the plan provider.
Southwick: Talk about not eating your own cooking.
Brokamp: Exactly. I'll just add one other thing. I keep talking about 401(k)s. I'm including in that all kinds of employer-sponsored plans, but probably the ones with the highest expenses are 403(b)s. According to a report from Plan Sponsor Council of America, up to 72% of the assets in 403(b)s are annuities.
Southwick: 403(b)s are charitable organizations? Non-profits?
Brokamp: Right, they're non-profit, so a lot of teachers. Charitable organizations. Annuities, on average, have much higher expenses, so all these stats I'm giving you about the average expense of a plan, it's generally a 401(k). You could probably double those costs...
Southwick: Just assume it's worse if you're in a 403(b).
Southwick: The people who are doing the kindest non-profit work in our nation; sorry. You get the worst option.
Brokamp: Right, exactly. In fact, that's pretty much what Ron Lieber wrote in The New York Times, recently. The people who are doing the best work and not getting much money in return also have the worst retirement plans. There you go.
Southwick: For listeners out there, I am making a sad, disgusted face.
Brokamp: Yes, exactly. Those are the things you should know about 401(k)s and other defined contribution plans. How do you find out what you pay? Fortunately, ever since 2012, the Department of Labor has required that employers provide a fee disclosure document. It's several pages long. It's a lot of legalese. It's boring. But at least if you look through there, you will see what you're paying for administrative fees. It might be a flat fee. It could be you're paying $100 a year, or something like that, or it could be a percentage of assets. Or it could be folded into the mutual funds themselves in something called revenue sharing.
One example that I found online is of a CPA looking at his own 401(k). He has a fund that we have in The Motley Fool 401(k). We have the Vanguard 500. We pay four basis points. In his plan he's paying 25 basis points. That's because some of the costs running the plan had been folded into a mutual fund. You'll see this in the disclosure that you look at, but it's also an important thing to keep in mind because let's say you have a mutual fund in your 401(k), and you're like, "I wonder if that's a good fund. I'm going to go to Morningstar and check it out." Morningstar is not going to have whether other fees have been added to that. You have to rely on the information that is provided by your plan to make a judgment about the performance of those investments.
Southwick: If they do roll the fees into the cost of the mutual fund, I assume they do that across the board, and all the mutual funds have bumped-up fees. Or no? No? They only pick out different ones?
Brokamp: That is a very fascinating point that you're making, and we didn't plan that. It may not be in every single fund.
Southwick: But that's not fair.
Brokamp: It's not fair.
Southwick: I thought the whole point of it was it's supposed to be fair.
Brokamp: It's not fair, because the people who are choosing some funds are paying more fees than people who are choosing other funds, so it's important to figure that out. You definitely want to look at the document, by the way. You can ask your HR people.
Southwick: What's it called again? What's the form called again?
Brokamp: It's called 404a5, I think. It's just your annual fee disclosure document that has to be sent. Some will send it quarterly, too, especially if your provider is on top of things. You can ask the people in your HR department. I trust the people in my HR department, but my anecdotal experience of talking to people in HR departments is that they're not investment professionals. They're not investment experts. They have to know a lot about a lot of things [their healthcare plan, their flexible spending account plan], so they may not know the details of the 401(k). They might have hired a company to do all the work for them. You definitely have to dig into the document.
Southwick: You also mentioned BrightScope earlier. Can't I just go there and see how my 401(k) is rated? And excuse me while I also head to BrightScope and look up our 401(k).
Brokamp: Yes. What BrightScope does is pulls data from the filings that plans have to make every year. It's called a Form 5500. It pulls the data. It's very useful. Very helpful. It gives your plan a rating. Compares it to other plans within your peer group [so other plans within your industry].
The one thing I will say is it's often delayed. For example, the information on The Motley Fool plan is as of 2016. There haven't been many changes to our plan since then, so it's still pretty accurate, but just know that if there's been a change to your plan in the last year or two, it may not be reflected in BrightScope's data.
Southwick: Do you know your rating? Do you take this personally?
Southwick: Yes! You must take it personally.
Brokamp: Yes, and I think the top rating for our industry is 87.
Brokamp: It's not like a grade where you're looking for that 100, although you ideally could hit that point. They're pretty picky, and a big part of BrightScope's formula is costs. We, on our committee, have reached out to BrightScope and asked what you have to do to get the 100. We're pretty comfortable with our plan. We do have some higher costs because of the actively managed funds we have in our 401(k), but because we feel good about those funds and we're on top of them, we're OK with the higher costs.
But that does bring up a point that everyone should ask about their 401(k), and that is who's choosing the investments. Do you have an investment committee at your company and do you trust them? Or are the investments being chosen by the company providing the plan and why are they doing it? If they are a company that's offering a lot of funds of their own, make sure that those are still really good funds. If I had a plan offered by, say, Vanguard and all my funds were from Vanguard, I'd feel pretty comfortable with that. If I were with a plan that was offered by a full-service broker, and all the funds came from that company, I'd probably feel less comfortable.
Very quickly, let me go over some things about why you would stay with your plan, because the bottom line is there are plenty of good plans out there. First of all, you might have super low-cost funds. If you look at the average expense ratio on mutual funds and 401(k)s, it's actually lower than what you get out in the marketplace, because if you work for an employer you have some bargaining power. You might have great funds that you couldn't get elsewhere, and you want to stay there.
You might trust the investment company to stay on top of the funds to make sure that the funds in there are pretty good. It might be that your employer covers all the administrative costs, as they do here at The Motley Fool...
Southwick: Oh, thanks!
Brokamp: ... oh, you're welcome, so you don't have any extra costs other than the cost of the mutual fund. Another one could be that your plan offers attractive investments not available outside of the plan. So, in some plans, there are these funds that have been created just for that plan, and you couldn't get it elsewhere. You might want to stick with it. Another example is some funds have basically cash-like investments that have higher yields than regular, old cash. You might stick with your plan for that, too.
Alison Southwick has no position in any of the stocks mentioned. Robert Brokamp, CFP has no position in any of the stocks mentioned. The Motley Fool recommends The New York Times. The Motley Fool has a disclosure policy.