Friday, July 06, 2007

The 401K System Makes No Sense

This is the fifth and final post in my 401K week series. In my previous posts this week I covered everything from ROTH 401K, to company matching funds, to some of the new features in my company’s new 401K plan. However, today I want to take three steps back and make a general comment: the entire 401K system is flawed.

The 401K system creates bad outcomes, discrimination and strange tax consequences. Simply put, the system should be scrapped and rebuilt from the ground up. Here are some of the main problems I see with the 401K system, and how I propose to solve them:

Lack of Expertise – here is the biggest problem with the 401K system: in most companies, and certainly in all the small and mid-sized companies that I have ever worked for, or that my wife has ever worked for, 401K plans are managed by the HR team. With all due respect, the vast majority of HR professionals do not have the first clue about retirement planning, investment options or even basic financial concepts. They view 401K plans as something to be administered while keeping company costs to a minimum.

Concepts such as diversification, return and investment cost reductions are completely foreign to many HR professionals. Many of them are actually afraid of these topics and are paralyzed by their fear. I know very few people who wake up in the morning thinking: “I have some money I would like to invest for retirement. I should talk to a human resources specialist…”, but ironically this is exactly the group that controls a large portion of American’s retirement plans.

Lack of Choice – if your company does not offer a self directed 401K plan, you can invest your retirement assets in only a limited number of often poorly selected and expensive funds. Your company is deciding for you how you may invest your retirement savings. Why is this a good idea? Even if your company offers a self directed 401K 30% of your funds must still go into the company selected funds. The 70% you can invest yourself are, in all likelihood, subject to trading and investment fees that you would probably consider excessive in an online brokerage account.

High Cost – 401K’s are an expensive investment vehicle. The new 401K we are adopting will have an expense ratio of 1.14%. My personal portfolio, built around multiple Vanguard index funds, carries an average expense ratio of around 0.3%. The high cost of 401K plans is one of the reasons we invited a Vanguard representative to bid for our 401K business. However, while Vanguard offered us a fund line-up with an average expense ratio of 0.22%, they also required a plethora of fees that when factored in would increase the cost of the proposed plan to approximately 0.6% - 0.7% of assets per year, and the level of service which they offered us was not adequate for our corporate needs. It seems that even Vanguard, the champion of low cost investing, finds it difficult to offer truly low cost 401K plans.

Needless Complications – 401K plans are subject to a wide range of regulatory requirements and administrative costs. The person that deals with the administration of our 401K plan can be constantly seen running around the corridors with various forms that need to be signed, filed or returned. It’s a mess. That’s one of the reasons 401K plans are so expensive.

Strange Tax Outcomes - Do you find it strange that if your company offers a 401K you can contribute $15,500 this year towards your retirement, while if it doesn’t offer a plan you are basically stuck with the much lower $4,000 contribution level of an IRA? Do you find it amusing that if your household income is above $166,000 per year you cannot contribute to a ROTH IRA, but if your company offers a ROTH 401K you can contribute $15,500 to it, even if you make a cool million every year? What is the justification for such asinine outcomes?

With these and many other problems plaguing the vary concept of company managed, defined contribution retirement plans, I would like to suggest a much simpler, and less expensive option. Hell, this would be good for everyone: employees, companies and government: let’s completely eliminate 401K’s and instead allow everyone to invest the full amount of $15,500 in either a ROTH IRA or a traditional IRA as they choose. Companies could still match employee contributions in exactly the same way, only they would do so by means of direct deposit to the employee’s IRA rather than into a cumbersome and expensive 401K plan.

While we’re at it, let’s allow everyone to make such contributions, whether or not they are employed. Why does it make sense to prevent the unemployed or the under-employed from saving for retirement?

What do you think? Am I making too much sense? Given my “high degree of confidence” in Congress (and the IRS), I am not holding my breath for such common sense changes to occur.


TFB said...

I agree. It makes no sense to tether retirement savings to the employer. Canadian's RRSP system works much better. Everyone is free to choose any provider. Unused tax deductions can be carried forward.

SouthernBread said...

I have to second that. I work for an organization that has an "in-house" investment firm. 80% of our options are Mutual Funds they manage. That's well and good, but the only other options are the standard money market, the company stock, one international fund, and one poorly performing other fund.

I wrote our HR group and, luckily, they happen to be in the middle of choosing options for next year. They said they would consider a target-date fund and an index fund.
I wish we had an employee board with well-informed people on it.

J at IHB and HFF said...

Hello. I agree and I have an article underway with more points. How do you explain the widespread cheerleading for the 401k? Meanwhile, feel free to nominate the 401k in my “Best Con Artist” article.

Shadox said...

Thanks for the comments guys.

Southernbread - the one thing you have going for you is that 401K committes are always worried about getting sued by unhappy employees. I would actually keep writing them (professionally) and offer some specific funds you know your 401K provider offers. I would actually push for 3 Index funds: S&P; Small Cap and International.

Compounding said...

My biggest gripe is simply that the government is "allowing" you to have a special account for retirement investing. If we switched to the Fair Tax, that would be a thing of the past.

KMull said...

Interesting thoughts. I've actually been going through my entire 401k plan my company offers and looking at the investment options on my blog ( We have a lot of high priced funds. Ugh.

Armchair Fiduciary said...

I agree that it is nuts that you have to count on your employer to set up a 401k to contribute $15,500 per year while someone whose employer doesn't set one up is limited to a $4000 IRA contribution. Everybody should at least have access to the same contribution limits regardless. If you are interested here is how I recommend investing a 401k if you have one.

Anonymous said...

Absolutely right on. Also, here's anothere idea: change the IRS code to allow employees to "roll" their 401k into a Roth IRA without having to leave their current job! Why is the IRS effectively "incentivizing" you to leave your employer? It kills me that I can't match my taxable investment returns with the proprietary index funds choices in the 401k.