Rating Your 401(k): Is Your Employer's Retirement Plan Good, Bad, or Ugly?

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.

They discuss how you can determine whether your employer is making an effort to get you a solid plan, what you can do if they aren't, as well as fees, fund types, strange regulations, and more. But first, in this week's "What's Up, Allison" segment, our Foolish duo detour across the pond to run some budget numbers on the wedding of the year between Prince Harry and Meghan Markle.

A full transcript follows the video.

This video was recorded on May 22, 2018.

Alison Southwick: This is Motley Fool Answers! I'm Alison Southwick and I'm joined, as always, by Robert Brokamp, personal finance expert here at The Motley Fool. Hey, Bro!

Robert Brokamp: Hey, Alison!

Southwick: Today we're going to talk about how to tell if your 401(k) is A-OK and what to do if it isn't. All that and more on this week's episode of Motley Fool Answers.

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Brokamp: So, Alison, what's up?

Southwick: Hey, that's right. I'm the person who's what's up today, not Bro. It's exciting!

Brokamp: It is!

Southwick: So, Bro, two people got married this weekend [maybe you heard] and now that we're all done partying, it's time to take a look at the cheque, by which I mean, of course, Harry and Meghan Markle.

Brokamp: Yes. And cheque is spelled with a "que" at the end, I suppose.

Southwick: Absolutely.

Brokamp: That's right.

Southwick: According to the England-based luxury wedding planner, Aimee Dunne, a woman most qualified to make outrageous guesses, the wedding of Prince Harry and Meghan Markle will end up costing £2 million, which is roughly $2.7 million. Let's break it down, shall we?

Brokamp: Let's do that.

Southwick: Well, they're having a humble affair at home, albeit the home is Windsor Castle in this case. At $75 a pop they spent $45,000 on invites. These are all estimates. I mean, no one knows for sure.

Brokamp: Just on invites?

Southwick: Yes, just on invites. Again, these are all just best estimates, so these could be totally off, but let's just enjoy it, huh? Estimates for a wedding dress are coming in at around $270,000. You can buy a house to live in for that and it's a dress. All right, whatever. Flowers, a $150,000-300,000 budget. They invited 600 guests, so let's talk about food, wine, and all that good stuff. The guests get lunch and dinner and another 2,640 commoners will get tea and a snack, so the estimates are that food and beverage will come in at about $680,000. I think that sounds like a deal if the dress is already $270,000. I don't know. It's all relative. So, $2.7 million. That's an expensive wedding. Still not as expensive as Prince Charles and Lady Diana's wedding. That apparently cost $48 million in 1981... or $110 million when adjusted for inflation. Well, here's the thing. This so-called expert lady when she was estimating...

Brokamp: [Laughs] Expert lady!

Southwick: ... the cost of the wedding, she was only looking at the fun stuff [the dress, the food]. She left out the largest part of the bill, which is... Do you want to guess?

Brokamp: Security?

Southwick: Yes!

Brokamp: Really?

Southwick: Yes, that's it. You've got to have your wedding snipers.

Brokamp: What?

Southwick: You've got to have your wedding policemen. Escorts. All of that security is estimated to cost up to $40 million for this wedding. And guess who gets stuck with the bill?

Brokamp: The taxpayers.

Southwick: Yes, that's right! The taxpayers!

Brokamp: Was there such a thing as a wedding sniper?

Southwick: No, it wasn't like what wedding sniper did you get for your wedding. He was the best. Let me give you my recommendation. No, you've got to have snipers. They just happen to be at a wedding. Here's a side note, though. For security for Kate and William's 2011 wedding, it only cost £6.35 million. And Harry is the spare [not the heir], so I don't know why there's such a massive difference and why they're saying it's going to be so much more for his wedding than the others.

So, $40 million. That is a small price to pay considering what a windfall this wedding is going to be for the U.K. economy according to some. Britain's very serious-sounding [Office for National Statistics] reports that the royal wedding could generate as much as £550 million or roughly $680 million and this is because of tourists coming in for the festivities, trinkets, souvenirs sold, and all of that.

PwC is skeptical that royal weddings really are such a boom to the U.K.'s economy. William and Kate's wedding generated about £107 million, but in perspective, that's less than 4% of the spending in the U.K. for Black Friday. There's maybe some more money to be squeezed out of that royal commemorative tea towel.

Brand Finance, a company that sounds way less serious than the [Office for National Statistics] thinks the wedding could create a boost of £1 billion, but they assigned an eye-roll inducing £300 million to something called PR value for the U.K., as if you're going to be like, "There's a royal wedding. Now I want to go to the U.K. and spend all my money."

And they compared it to, let's say, £50 million in merchandise that will be sold.

Speaking of merch, according to racked.com, the must-have item is Harry and Meghan themed china. You can get a plate for $49. You can get a mug. There's even an official commemorative plate which is a lovely cornflower blue and has initials, and plenty of doodads and whirligigs. That goes for $67. You can also buy some weird stuff, like commemorative sweet ginger and American mustard-flavored pork sausages.

You can get coloring books and condoms [or, as the Brits say, kawn-domms] named "crown jewels." That's not really how Brits say condoms, but they say it in such a way that just is so weird to American ears. You know what I'm talking about.

Brokamp: I don't think I've had this conversation with many English folks, but I should now, I guess.

Rick Engdahl: How many Brits have you known through the years?

Brokamp: I don't know. I was just saying...

Southwick: I went to school in England for a while, so...

Engdahl: So, you have experience. OK.

Southwick: My mom listens to this show, Rick, so let's just walk it back a little. So, you're not, unfortunately, going to make a ton of money off your Harry and Meghan sparkle-flavored bag of parsnip crisps [again, that's a commemorative thing you can buy], but you could maybe make some lucrative bets.

Yes, that's right. Something called Paddy Power, one of the largest sports gambling houses in the world has more than a dozen prop bets around the wedding including what tiara Meghan will wear [because she has many options, now]. What dish will be the main course? What color hat will the Queen wear? Will it rain? Will Harry shave? Maybe you went a little crazy and made the bet that Donald Trump will walk Markle down the aisle. It had 500 to 1 odds. Man, how awesome would that have been if it hit? But, of course, as they say, unlucky in gambling, lucky in love, and that, Bro, is what's up this week.

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Brokamp: The No. 1 goal of investors is retirement and for 55 million Americans, they plan to fund that goal by saving money in a defined contribution plan. If you add up the amount of money in 401(k)s, 403(b)s, 457s, and all of that, you would have $7.7 trillion as of the end of 2017 according to the Investment Company Institute, and that's up from $3 trillion in 2000. So, that's a lot of money.

Southwick: That's not bad.

Brokamp: That's not bad. And if you're one of those Americans, I have some good news for you. 401(k)s have gotten better thanks, in part, to lawsuits filed by your fellow workers, and that's a conclusion of a recent report from the Center for Retirement Research at Boston College, which found that fees have been declining for several years, in part due to litigation initiated by workers in not-so-awesome plans. That's the good news.

However, the truth is that many 401(k)s are still mediocre and some are just horrible, and you might be better off investing at least more of your retirement money elsewhere.

Southwick: It's interesting that you can sue your employer if your 401(k) isn't great, because isn't that like a benefit? You'd think it would be "you get what you get and you don't get upset."

Brokamp: It's interesting you say that. When you offer a 401(k), you have automatically made yourself a fiduciary, which means you are legally required to act in the best interest of the people you are serving. Even though, that was a good point.

Southwick: I didn't realize that. So, because The Motley Fool provides a 401(k), here, to us they are my fiduciary?

Brokamp: Right, as well as the people on the 401(k) committee...

Southwick: That's you!

Brokamp: ... which includes me. I am a fiduciary...

Southwick: To me!

Brokamp: To you! And to everyone else here at The Motley Fool.

Southwick: So, I could sue you!

Brokamp: You could sue me. Please don't do that. It's actually an interesting point, because it requires a good bit of work to offer a 401(k). It does require a good bit of risk to offer a 401(k). So, on one hand we should be grateful to our employers for doing it. On the other hand, if they're going to be doing it, they are required to act in our best interest.

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.

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).

Brokamp: Exactly.

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?

Brokamp: 86.

Southwick: Yes! You must take it personally.

Brokamp: Yes, and I think the top rating for our industry is 87.

Southwick: Yes.

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.

Now, what to do if your 401(k) is not A-OK. Some standard advice is to take advantage of the match, contribute up to that point, and then move money to an IRA. I think that's good advice, but it is important to realize a couple of things. In the vast majority of plans, the match does not vest immediately. In other words, it doesn't become yours immediately. You have to work there for a certain number of years. It might be you have to work there for three years and then you're automatically invested. It might be [which is more typical], you have to work there for five years and it gradually vests.

However, the average person stays at a company for just four years, so if you don't think you're going to be staying with that company long enough for the match to vest, it may not be worth contributing to a bad 401(k) just to get a match because you're going to leave anyhow. But if you're going to be there and it's a good match, go ahead and stay.

By the way, the average match is 3%. Generally, it's 50 cents on the dollar up to 6%. But as I think I've mentioned in previous episodes, at Vanguard they have more than 200 different matching formulas, so matches are all over the place. But if you're getting a match of 3%, you're getting about average. If you're getting a match higher than that, you actually have an above-average plan.

The other reason why you would contribute to the 401(k) and then go to an IRA [ideally a Roth IRA] is because it may be the only way you can get a Roth. At this point about 65% of plans offer a Roth option, but a lot don't, and for many people the Roth is the way to go, especially with tax rates being historically low right now. So, if you think of the Roth as best for you, that might be another reason why you would just put a certain amount in your 401(k), but then max out a Roth IRA.

Another thing to do with your plan is even if you have a very mediocre plan, chances are you might have one or two good funds. Just choose those funds in those asset classes, and then use your other accounts for the other asset classes. Generally speaking that means most funds have at least an S&P 500 index fund. If you have a bad plan with bad options other than that, just choose that. Use that for your U.S. large-cap allocation, but then use other accounts for international, small-cap, real estate, and whatever else you want to put into your portfolio.

A minority of plans do offer the brokerage option, which allows you to buy individual stocks as well as probably choose from thousands of other mutual funds and ETFs. That's also something to consider if the mutual funds in your plan are not very good. The problem with that is that many of these side brokerages within 401(k)s are more expensive than a traditional brokerage, so either the commissions on the trades are higher, or you have to pay an asset management fee underneath that.

Even at The Motley Fool we have to do that with the side brokerage in our 401(k). We have to pay a certain amount on top of the trade. So, it's a good alternative if that's your only choice, but it's still not a better deal than just opening a discount broker somewhere else.

The other thing to do, of course, is to advocate for a better plan. Bring all these facts up to the people who offer the plan at your office. Chances are they also are participating in the plan, so they have an incentive to do a better job. Don't go in there with guns blazing. Go in there with some research. BrightScope is a great resource as is the Investment Company Institute in terms of research on how much the average 401(k) costs. It's great to just bring in some facts and say, "Hey, this is what the average is. We're paying more. Is there a way to get a better deal?"

Lastly, another possibility is to transfer the money to an IRA. Generally speaking, once you're in a plan, you have to stay in a plan, but for some plans you can do something called an in-service distribution. The plan has to allow that and generally you have to be 59 and a half; but if you are still working, you can move some of the money out of the plan to an IRA and get some lower costs and better investment options.

Then, of course, there's always money with old plans. If you have any money in a 401(k) or 403(b) or 457 with an old employer, you can always roll that money out of that plan either into an IRA or into your current plan if it's a good one.

Southwick: There you go. How to tell if your 401(k) is A-OK and what to do about it courtesy of Bro.

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Southwick: We've got some housekeeping and some announcements. I think some of them are exciting, but we'll see what you think.

If you are coming to FoolFest or if you just happen to be in the D.C. area on May 30th, we are hosting a Podcast Listener Meetup. Fun!

Brokamp: That is fun!

Southwick: If you want to hang out with me... I don't know if Bro will be able to make it. Probably not.

Brokamp: I'll try my best.

Southwick: I'll try. That's a no. You still get me and probably Rick. Rick, are you coming? Rick's coming, and other podcast people like, of course, Chris Hill, and all those guys. E-mail us at [email protected] and I'll send you the details. Again, if you're going to be in the D.C. area [maybe you live here, or maybe you're coming in for FoolFest on May 30th], join us at the Podcast Listener Meetup. It's going to be downtown at a bar. It will be fun. E-mail us at [email protected].

Also, for my FoolFesters, if you're attending and might be interested in joining us on the show, we're looking for a few people who might be willing to come on the show and share their investing story for an upcoming episode. Pretty please? Usually when I ask for stuff, you guys are good enough to oblige. I really hope this comes through.

So, if you're coming to FoolFest, we want to hear your investing story and have you on the show. Won't you please come join us? Again, email me at [email protected]. That's always going to be the email.

And you can tell summer's around the corner because postcards are starting to come in. Kenneth and Aaron sent an amazingly bizarre postcard from Monaco. It's a bunch of posh people sitting at a table eating snails, but their heads are hedgehog heads.

Brokamp: Crazy!

Southwick: I love it!

Brokamp: But it's in French, so I don't know if there's any explanation for why that is.

Southwick: The title of the picture is Tea Time. That doesn't help. Rich sent us a card from Tombstone, Arizona and one from Mount Rushmore. Thanks are also in order because you listeners keep leaving reviews on iTunes and I really appreciate it, so I want to thank jsv1969, hotsoupcookin, wgnj, newerwriter, (unclear: 27:27), ldennis, and jhop88. Thank you so much. I'm going to start planting bad reviews on iTunes just so then I can circle back to you guys and be like, "Someone said something mean again," then you guys will be awesome and jump to our defense, because you are awesome!

That's the show. It's edited drearily by Rick Engdahl. It's so rainy here in D.C. this week, it is miserable. Again, our email is [email protected]. E-mail me if you want details on the Podcast Listener Meetup. E-mail me if you're up for coming on the show. I really hope you are. For Robert Brokamp, I'm Alison Southwick. Stay Foolish everybody!