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A few weeks ago, you guys shared a list of things you wanted learn more about. Several of you posed questions about how to think about your 401ks, which we’ll address in this post.
New readers, if you have questions you’d also like answered, feel free to leave a comment on the thread here. I go through it regularly for post ideas and for Reader Mailbag questions.
The 401k Landscape
What’s the deal with 401k investing options? How can I get more control over what I can invest in through my 401k?
So here’s the deal: For most of us who are working a steady job at someone else’s company, we will be offered an opportunity to invest in a 401k. This is a tax-deferred account with a maximum contribution of $18,000 for the year 2017 if you are under 50, and $24,000 if you are 50 or over.
Your company engages a plan administrator for the 401k they offer you. They go somewhere – Fidelity, American Funds, etc. – some existing broker who has a retirement plan administrator arm and sign a contract wherein that company serves as the administrator for all 401ks for the company. Your company and the plan administrator talk through a slate of funds they can offer employees, select a few, and that is the slate that is presented to you.
Sometimes the options they offer you are pretty darn good. Often, for smaller companies, the options they offer to you are lackluster across the board. Being a plan administrator involves a lot of paperwork and resources. When you have a question and call a hotline, someone needs to answer your questions. One of the main reasons folks like Fidelity and American Funds set up an entire division to administer retirement plans is because they want to be able to funnel all those dollars into products they own or get a cut of. So if you’re a tiny company looking for a plan administrator, the big guys with really nice 401k offerings for employees might turn you away. It may just be the guys who offer funds that charge 5% on all money coming in or going out that will take a small company’s call. This explains why your 401k offerings might suck compared to your friend’s. While I stayed at the same company for all seven years of my career, my husband has changed jobs four times and I’ve seen the entire spectrum of awesome to total suck. It was heavily tied to size and prosperity of the company he was working for.
So what happens if you don’t like any of the options offered to you?
Tough luck. You either choose to invest in something offered, or you choose not to invest in your 401k.
What To Look For In a 401k
What should I look for in a 401k offering?
We could create an entire miniseries on this one topic, but there are three simple steps that will put you in a pretty strong initial position.
Find a Benchmark
This is the cornerstone of the three. When deciding whether to pull the trigger on an opportunity in your 401k program, you want to have a benchmark to compare this option to. You want a Next Best Alternative. For most of us, a good Next Best Alternative is that any fund we invest in should do at least as good as a brainless monkey could do; investing in a low cost index fund. A low cost index fund such as VTSAX (a Vanguard fund) says “I have no idea which stock is better than another.” Instead, it buy shares of every stock in the market in proportion to their market cap, and their whole job is just to mirror movements in the market. Buying a low cost index fund is saying tthat you are betting on the broad, long-term prosperity of all US-traded companies.
Once you have a benchmark in place, comparison becomes easy because you just line the new option up against the benchmark on all fronts and see which one comes out on top.
Compare Performance to Benchmark
You will want to take the performance data of the option you’re considering, and line it up against index fund performance. You can use VTSAX as an index fund benchmark, or you can choose something like the S&P 500. These are both reasonable. Now look at the 1 year, 5 year, and 10 year performance at least. Did the fund you’re considering at least keep up with investing brainlessly in an index? How much was the overperformance/shortfall?
Compare Expenses and Fees to Benchmark
You will want to check out the cost of this new fund. Cost comes in two flavors.
Almost every fund shows you an expense ratio, which is the percent they charge of total assets under management in order to keep the lights on and do their jobs. In a low cost index fund like VTSAX, you are paying something like 0.05%. I have seen expense ratios as high as 1-2%. A high expense ratio is not necessarily a deal killer, but you have to ask what you’re getting for that high expense ratio.
Say VTSAX generated a 10% return last year just blindly mirroring the market. After their expense ratio of 0.05%, you see a net return of 9.95%. Fund A has a 2% expense ratio. You’d better expect Fund A to be generating 11.95% or more – at least 1.95% more than your benchmark. Otherwise, you will net see a lower return on your money than parking it in VTSAX.
Some funds also charge fees when you enter the fund. These are called load funds. My husband worked for a tiny company that had American Funds as their plan administrator. All their options were American Fund Mutual Funds, and they all had a 5% charge on entering the fund. That meant if we invested $100 into the 401k, they would put $5 in their pocket and only invest $95 for us. You should know that there are plenty of no-load mutual fund and index fund options out there. Just because your plan doesn’t offer them doesn’t mean they don’t exist, but they may not be available to you while you are with this company and this plan administrator.
Yes or No to the 401k
My 401k Options Suck: What Now?
Say you do this comparison and all the plans suck. Should you eschew investment in a 401k?
401k Rollover to IRA: Keep in mind that when you leave your current employer, you will be allowed to roll all that 401k money into a self-directed IRA. At that point, you can invest the money in anything you want. Depending on how long you plan to be there, it may still be worth it to park so many dollars in a tax advantaged account.
Company Match: Some companies provide a 401k match, meaning for whatever amount you put in your 401k, they contribute an equal amount up to a certain threshold. This is a strong incentive to invest in a 401k. Say the company has a 5% 401k match – for every dollar you invest, the same amount up to 5% of your total salary. So for a $50k salary, the first $2,500 or 5% of your salary that you contribute, the company will contribute the same amount dollar for dollar. That’s a guaranteed 100% return for that first year on the first $2,500 you invest! Employer contributions do not count towards the maximum amount you are allowed to contribute annually to a 401k. Depending on how much the 401k options trail your benchmark, you may want to invest to essentially capture “free” dollars offered by your company.
What You Invest In With Your Taxable Money: What do you invest in with your taxable money today? The advantage of parking your money in a 401k is that it is allowed to grow tax-free. If you sell some of one thing and buy another, you don’t need to pay taxes on the gains, at least not until you draw money out of the actual account. If you are going to be bouncing between different kinds of investments, this tax deferral component is very valuable. If you are going to park your money in a low cost index fund and leave it untouched for 40 years, the tax deferred status is basiallyworthless to you. So if you were 100% certain you weren’t going to touch the money and leave it in a low cost index fund, you would accept absolutely no offering that was in any way inferior to your benchmark, the low cost index fund.
Reading a Prospectus – Case Study
I pulled the very first prospectus from the American Fund website. The fund is called Amcap fund. You can see the summary prospectus here to follow along.
Investment Approach: This is what the prospectus has to say about the fund’s approach.
“Principal investment strategies The fund invests primarily in common stocks of U.S. companies that have solid long-term growth records and the potential for good future growth. The fund may invest in common stocks and other securities of issuers domiciled outside the United States to a limited extent.”
Cool. So you know the fund is going to be looking for growth-oriented stocks. Some funds are focus on undervalued stocks, or stocks that pay the most in dividends. Oftentimes the prospectus uses broad language. This is because the fund managers don’t want to limit themselves when they know they have to manage to the written prospectus for 10+ years.
Say they said specifically that they only invested in companies that were growing 10% or more and 50% of the portfolio would be in technology companies. The market changes, and the best opportunities are elsewhere. Do they shut the fund down? Do they keep going after sectors they know are going to do poorly? Thus the broad language. If the fund has been in existence for a while, I like to visit Morningstar and look up the ticker symbol to check out what the mix of the portfolio looks like.
I’m pretty suspicious as I get to this page. Annual fund operating expenses are a total of 0.67% vs 0.05% at my Next Best Alternative benchmark, Vanguard’s total stock market index fund. It’s certainly not the worst expense ratio I’ve ever seen (we discussed how they can be anywhere from near zero to 2%). I can accept this expense ratio if I see performance numbers that beat my benchmark, meaning since it costs 0.62% more each year in expenses, I expect to see performance numbers that show me they will outperform Vanguard’s fund by at least 0.62%.
The shareholder fees section, however, is one giant red flag, waving gaily in the wind. The sales charge load imposed on purchases is 5.75%. That means if I invest $100, they take $5.75 and only invest $94.25 on my behalf. Furthermore, when I sell, I may also be subjected to a “deferred sales charge” of up to 1%, depending on certain conditions. Let’s assume we meet the exit requirements and are only charge the on purchases. That is a huge number!
The below are two charts from the prospectus. Luckily this prospectus shows you performance taking into account those massive purchase fees we saw above. Take a look.
Which lines should you compare on? Well we are trying for the best apples to apples comparison, so since they indicate their S&P index fund is before taxes, you should compare it to the before taxes line for the fund.
Blech. This fund underperforms significantly in the 1, 5, and 10 yr horizons. You will notice the 1 year performance lags a full 6+ percentage points. This is undoubtedly because of that high initial purchase fee. No matter how you spin it, this option looks like a whole lot of bad. Keep in mind that the S&P 500 figures don’t include sales charges and expenses while the American Funds returns do, but the expense charges at VTSAX are 0.05% – near zero – so it will not really affect the gap you see.
If you see a prospectus like this, the answer is generally pretty clear. It’s a bad deal compared to investing it long term on your own in an index fund. The only reason you’d consider doing it is if you highly valued having dollars in a tax deferred fund for different investments in the future or you receive a company match, which we covered earlier. But strictly on fund overall return during your hold, it’s a subpar option to doing things in a taxable account on your own.
401ks can be an excellent component to your early retirement plan. With just a few simple guideposts, you will be able to determine whether the options afforded to you in your program worth taking.