With the continued decline of traditional pension plans, the burden for retirement saving falls clearly on the individual. Since its creation in the Revenue Act of 1978, the 401(K) has become the prevalent retirement plan for private employees. There are over 630,000 defined contribution plans (of which 513,000 are 401(k) plans) with over 88 million participants and $3.8 trillion in assets.
A traditional pension is a “defined benefit” plan which bases pension payments on a formula that typically considers salary level, years of employment and age. The benefit is earned regardless of how much money has been put into the plan or how the plan’s investments perform. A 401(k) is a “defined contribution” plan that is entirely dependent on the money added to the plan during the worker’s career and how that money is invested, with no guarantees. The plan provides a lump sum at retirement and the worker is on his own to manage and spend the money in retirement.
The 401(k) offers generous contribution limits. An employee can contribute up to $18,000 of his own money in 2015 (workers over age 50 can contribute an additional “catch-up” amount of $6,000) and the employer can contribute up to 25% of the worker’s compensation, with the combined total not exceeding $53,000 ($59,000 for workers over 50). The employer contribution usually comes in the form of a “match” of the employee’s contribution but can also include profit-sharing and other contributions.
In most 401(k) plans participation is voluntary, so actual savings is far below the allowed maximums. Around 20% of eligible employees don’t participate at all and the average participating employee saves between 5.5% and 7% of his income. Fewer than 10% of participants save the allowed maximum and the typical employer contribution is only 3% of the employee’s income. As a result, the average 401(k) balance at age 65 is $228,000 according to AARP, and the average balance for all participants over age 55 is $150,000 according to Fidelity Investments and The Vanguard Group. The $228,000 figure may seem significant, but by a common rule of thumb of retirement planning it would only provide around $10,000 a year to support retirement. No wonder there is a mounting chorus of the retirement crisis facing American workers.
Aside from insufficient retirement savings (which is also due to individual behavior), 401(k)’s have come under scrutiny on several other fronts. The Department of Labor (DOL) released a proposal requiring financial professionals to put clients’ interests ahead of personal gain when they make recommendations for retirement accounts. The government claims investors lose as much as $17 billion annually due to excessive fees and conflicted advice. The securities industry disputes that estimate and warns that the rules may make it uneconomical for advisors to serve lower-balance accounts.
At the same time, the Supreme Court unanimously ruled that companies administering 401(k) plans must continue “to monitor trust investments and remove imprudent ones. This continuing duty exists separate and apart from the trustee’s duty to exercise prudence in selecting investments at the outset.” Similar to the DOL’s concerns, this ruling involved “retail” mutual funds with higher fees than nearly identical products with lower institutional fees. While the ruling established principles that plan administrators must act with “care, skill, prudence and diligence” as fiduciaries, lower courts will have to sort out what that means in practice.
Small employers, already faced with the higher administrative costs of a 401(k) plan compared to alternative retirement plans, may now decide not to offer a savings plan with these stricter rules. The other small company retirement plans, such as a SEP-IRA or a SIMPLE IRA, either require higher employer contributions every year that may be difficult to maintain or lower employee contribution limits which are a disadvantage for conscientious savers who want to maximize their retirement savings.
Another unintended consequence of the ruling could be that plan costs are simply shifted from investments directly to plan participants. There are many legitimate costs involved with a 401(k) plan, including employee education and support, recordkeeping each employee’s account and fulfilling regulatory requirements to ensure that plans are not disproportionately benefiting higher paid workers. Higher investment fees are often shared among providers of these services, defraying costs to the employer and the employees. While greater disclosure and transparency are always worthy goals, the reduction of investment fees that are available to pay plan expenses will probably mean more direct participant fees.
There are a couple of easy fixes for small companies that want to offer employees the maximum employee contribution but avoid the costs of a traditional 401(K). The contribution limits for the more easily administered SIMPLE IRA ($12,500 in 2015) could be increased to the 401(k) level. The retirement savings plan for federal workers, known as TSP, could be made available to small employers. The TSP is a straightforward 401(k)-type plan with four low-cost index funds, a government-guaranteed fund and a series of “Lifecycle” funds that are invested in the five other options in differing allocations. The Lifecycle funds have a “target” year and automatically become more conservative over time.
For individuals who are concerned about the costs of their 401(k), the first step is to ask the plan administrator for full disclosure of fees in a way that can be understood; this information is required but is often buried in complicated language. If the 401(k) fees seem high, or if there are other low-cost investment options that are not found in the 401(k), an employee can participate in the 401(k) to receive all the employer’s contributions, including any “match” for money contributed by the employee. A match is sort of “free money” and it should not be overlooked just because of high fees.
After securing the maximum match, an individual can then contribute to an IRA if income is within limits based on filing status. This strategy (which can also employ a Roth IRA instead of a traditional IRA) can support high levels of retirement saving with lower cost and greater flexibility.
As with many saving and investment issues, the commitment to make funds available for long-term saving is the first and most critical objective. Once that commitment is in place, take the next step to invest in the most effective way available.