What's wrong with 401(k) plans » PRINT

By Paul Merriman
December, 2005

Most 401(k) plans are far from perfect, and chances are good (actually this is bad) that yours falls far short of what it could be. In this article Paul Merriman describes the ideal 401(k) plan, discusses real-life plans we have studied and tells how you may be able to improve your own plan.

If you are working and accumulating money toward retirement, your 401(k) or similar retirement plan is a critical tool. Along with your IRA (which is subject to low annual contribution limits), the 401(k) may be your most important tool because you have more control over it than any pension or Social Security.

To help you understand why so many plans leave so much to be desired, I'd like to start by describing a theoretically ideal plan, within the limits of current laws of course. I can think of seven attributes of a "perfect" 401(k) plan.

The perfect 401(k) plan: Asset classes

First - and this is by far the most important on this list - workers would be able to put their money into the asset classes most likely to make their money work hard for them over the long run. I believe the menu of choices should include nine equity asset classes plus a short-term bond fund.

The nine impmortant asset classes are U.S. large-cap stocks, U.S. large-cap value stocks, U.S. small-cap stocks, U.S. small-cap value stocks, international large-cap stocks, international large-cap value stocks, international small-cap stocks, international small-cap value stocks and emerging markets stocks.

Whenever possible, 401(k) participants should have access to these asset classes through low-cost index funds. My own company's 401(k) plan lets employees invest in what we consider the best mutual funds, the institutional asset class funds offered by Dimensional Fund Advisors. These DFA funds are available to retirement plans, but few plan trustees take the time and trouble to make them available.

No added fees

Second, employers would treat the 401(k) plan as an employee benefit and would not pass the costs of administration through to workers. This might seem pretty obvious, but many employee plans make the participants pay for plan administration in the form of higher fees for the investment funds they choose. Some plans levy a direct charge to participants.

Matching contributions

Third, employers should match at least half of what each worker contributes. Ideally, the match would be 100 percent, but I know that would be hard for many employers to stomach. One option would be to promise a 50-percent match no matter what, with higher percentage matches after particularly profitable years. Executives routinely get such profit-based bonuses, and the rank and file should have that incentive as well.

Default options

Fourth, the plan's default options would automatically enroll new employees as soon as they became eligible to participate in the plan, unless they took the initiative to decline. This would combat the inertia that sometimes stalls participation for years.

I'd also like to see a default asset allocation that's likely to make sense for most participants. I think it's a shame that the default option in many retirement plans is a stable value fund, which virtually guarantees many employees will gradually lose some of the purchasing power of their savings.

In my view, the default should be a 60/40 percentage mix of stock funds and fixed-income funds. Although this may not be right for every investor's individual situation, it's a big improvement over a stable value fund. Over long periods of time, I believe a 60/40 mix should provide adequate protection from the swings of the market while it gives ample opportunity for long-term growth.

Education and encouragement

Fifth, employers would actively encourage their employees to contribute to the plan and to learn about investing and the most effective ways to use their plan options. I believe employers could do this by hiring outside experts to provide education to the participants.

Rollovers at age 59 1/2

Sixth, employers would allow workers who reach age 59 to move all or part of their 401(k) balances into a rollover IRA while continuing to contribute to the company plan. This would give employees virtually unlimited investment choices. Federal law allows employers to offer this option, but few do so. Perhaps 401(k) administrators don't want to lose the asset-based fees they collect on the larger accounts typical of older workers.

Company stock

Seventh, in my opinion the perfect corporate retirement plan would prohibit employees from loading up heavily on company stock. There's probably no way to make this happen short of a federal law, because employers with publicly traded stock love the steady market that's created for their shares every payday. I have nothing against corporate loyalty, but it's too easy for employees and employers alike to gloss over the very real added risk that goes along with owning an individual stock, especially stock in a company they are already counting on for wages and benefits.

Back to the real world

Now let's look at what I believe is a typical cross-section of actual 401(k) plans. My company has created a web site, 401khelp.com, where we analyze the investment options offered in retirement plans and make recommendations on how participants can make the best use of what they have.

As I write this, we have reviewed the investment options of more than 50 plans. These include large national companies like IBM, Bank of America and ChevronTexaco. Many are Northwest companies like Costco, Nike and Alaska Airlines. Some are government and non-profit employers including the State of Washington, the City of Seattle and Kaiser Permanente. You'll find the complete list on the front page of 401khelp.com.

Grading the plans: Most get a "D"

Most of these plans do a poor job of giving participants the investment options they need most. As we reported in a news release that has been ignored by every news media outlet to which we offered it, our analysis found that employers significantly shortchange plan participants by featuring unnecessarily expensive mutual funds and failing to give ready access to many important asset classes.

Those employers who do offer broad fund choices typically do an inadequate job of helping participants choose the best options. Even though the asset classes we recommend are readily available in low-cost funds that retirement plan trustees could choose to offer, we found only one plan that offers them all.

Instead, most plans are loaded with funds that concentrate on U.S. large-company stocks and growth stock, which over the long term (and over the past six years as well) have performed relatively poorly for investors.

It's rare to find retirement plans offering broad-based, low-cost funds that invest in U.S. value stocks or U.S. small-cap stocks. It's rarer still to find international funds that go beyond large-cap stocks.

Another frequent problem is unnecessarily high expenses inside the funds themselves. The equity funds in plans we reviewed typically charge shareholders 0.7 to 0.9 percent annually. Equity fund expenses in the Amazon.com plan average 1.14 percent. Compare that with the 0.27 percent average expense ratio in the readily available alternative funds that we recommend in the same asset classes.

The worst: washington mutual

Washington Mutual, a huge Seattle-based thrift with more than 2,400 offices across the country, gives those employees one of the worst plans we've seen. This is in spite of the fact that the company owns a brokerage subsidiary and thus has the in-house ability to offer the best of everything.

Maybe Washington Mutual's brokerage subsidiary itself is the problem. The options in the company's plan don't include even one U.S. small-company value fund or any international small-cap options. The featured funds, all with Washington Mutual's own brand name, have average operating expenses of 1.12 percent a year, and most have greatly under-performed their peers, according to data from Morningstar.com.

Washington Mutual for decades marketed itself as "the friend of the family" and built up a loyal customer base. This is a nice image, and Washington Mutual is a very good company in many ways. But a "friend" it's not, at least not to its approximately 52,000 employees. A true friend would offer its knowledge to those who could benefit it instead of trying to exploit people (in this case the captive audience of its own employees) to bolster its overpriced in-house mutual funds.

To be fair, I must mention that Washington Mutual offers access to other mutual funds through Fidelity. But Washington Mutual neither emphasizes this option nor provides any guidance in using it. As Tom Cock, managing editor of 401khelp.com, said: "Of all employers, Washington Mutual should know better."

Of the "10 essential" asset classes we would like to see in a plan, Washington Mutual offers only three.

The best: IBM

At the other end of the spectrum, IBM's plan is a model in terms of offering an excellent lineup of investment options. Participants who meet certain minimum balance requirements can have their 401(k) balances managed at Schwab, with access to DFA funds in every asset class we recommend except short-term bonds. A Schwab fund is available to fill that gap.

The rest of the pack: disappointing

On the most important attribute, giving employees access to what we consider the vital asset classes, most plans get a failing grade. The IBM plan was the only one with funds in more than six of the nine equity asset classes we want to see.

Three plans - those of American Airlines, British Petroleum and Raytheon - offered six of those nine. Four plans (ChevronTexaco, the City of Seattle, HSBC and Target) offered five. Eleven plans feature only four of the nine equity asset classes, including Amazon.com, Comcast, Honeywell and Safeco.

Participants in 17 plans have access to only three of the nine. These include Alaska Airlines, Bank of America, Cisco Systems, Home Depot, Merck, Nordstrom and Starbucks.

I would give a grade of "D-" to the dozen plans that offer only two of the recommended asset classes. These include Costco Wholesale, Kaiser Permanente, Lowe's, Nike, The Seattle Times and Weyerhaeuser. I could dispense only an "F" to the plans of Qwest Communications and Cardinal Health; each only one of the recommended asset classes.

Kudos go to the plans of American Airlines and Target, both of which offer emerging markets funds (as does the IBM plan).

Finally, a dozen plans include funds that charge 12b-1 marketing fees. In my mind this is an outrage. There is absolutely no justification for requiring a captive audience such as a group of employees to pay for the costs of selling funds. Plans with this flaw include Amazon.com, American Airlines, ChevronTexaco, the City of Seattle, Group Health Cooperative, Nordstrom, Verizon and Raytheon.

What employees can do

If you're stuck in an imperfect 401(k) plan, you are not out of luck. At 401khelp.com we have posted a sample letter you can send to your plan administrator lobbying for better investment options.

I also recommend you read and heed an article called "Successful 401(k) investing in 12 easy steps." (And while you're at it, do your coworkers a favor by giving them copies of that article, too.) I'd like to take this opportunity to touch on a few of the most important points in that article.

It should be glaringly obvious that you'll never make the most of a retirement plan unless you contribute to it and invest in the right things. But contributing the maximum allowed might not be in your best interests.

No matter what investment options your plan is missing, be sure to contribute as much as it takes to maximize any match from your employer. That match is most likely the biggest one-day return you will ever achieve. But should you contribute money that won't be matched?

I believe you'll do better to first maximize your contribution to a Roth IRA. For most people, the maximum contributions are $4,000 to $4,500 for 2005 and $4,000 to $5,000 for 2006. The Roth IRA has some great features. Though there's no immediate tax deduction, the earnings are tax-free after you've had a Roth for five years. Even better, an IRA gives you virtually unlimited investment options, so you can make up for the deficiencies in your 401(k).

Only after you have maximized your Roth IRA should you consider putting money into a 401(k) without a match.

Even if your 401(k) allows you to invest in company stock, don't do it. As noted earlier, that involves too much risk. Ditto for taking a loan from the account unless you have an emergency and no other option. If for any reason you stop working for your employer, including layoffs or disability, any outstanding loan from your 401(k) is due and payable immediately. If you don't repay it (and this is a time when it probably will be hard), the whole amount of the loan will be treated as taxable income. And if you're under age 59 , you'll pay a 10 percent penalty as well. Ouch!

You'll find more details on these points - and some other excellent suggestions - in the article I mentioned above.

If it's used right, your 401(k) can be a terrific tool toward your retirement savings. Just make sure you are the master of how that tool is used.

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