Is the 401(k) plan a fraud?

A recent article claims that saving for a comfortable retirement with a 401(k) plan is impossible. There are pitfalls, including hidden fees, but just because saving for retirement can be tricky doesn't mean it's a scam. 

Over the last two weeks, quite a few readers have passed along a link to Helaine Olen’s article at Salon entitled 401(k)s are a sham: Duped by a DIY retirement dream, the elderly now face staggeringly low living standards and have asked for my thoughts on it. Are 401(k) plans really a scam?

I think the article, like all articles along these lines, makes some good points and some bad points.

First of all, the point I disagreed with the most was that the article completely excuses people from any level of personal responsibility for their retirement. The article is filled with statements like “It was a fraud because to expect people to save up enough money to see themselves through a 20- or 30-year retirement was a dubious proposition in the best of circumstances.”

Well, I’ve used a 403(b) plan in the past (basically the same thing as a 401(k)) and I’m currently looking at (ideally) 40 years in “retirement” ahead of me. Twenty or thirty years should be pretty straightforward.

Why? For one, I started saving young. I contributed from the first day I was employed after college. For another, I contributed a lot. At the minimum, I always contributed up to the match. I also have a Roth IRA and a Traditional IRA.

I took responsibility for my own retirement and because of that, I’m going to be able to retire on my own terms. I don’t feel that someone else is to blame if people choose not to save in advance for their own retirement. If you’re choosing not to save, that’s your choice, but it doesn’t mean that retirement plans are evil. It just means you’re choosing to spend now in exchange for working later in life.

So, what did I agree with? I agree that many 401(k) plans are fairly unscrupulous when it comes to the fees that they charge. Olen does a great job taking on the specifics of some target retirement funds here:

“While the average fee for any mutual fund is .80 percent, the number for target date funds is a hefty 1.08 percent annually. Some funds are much, much worse. Legg Mason’s Target Retirement Series charges 1.47 percent expense ration for the privilege of taking your money. How do they get away with it? Well, the industry promotes them as “set-it-and-forget-it” funds, thereby attracting the sort of investors most likely not to ask many questions.

And while these numbers sound like peanuts, they are anything but. As the Department of Labor reveals:

Assume that you are an employee with 35 years to retirement and a current 401(k) balance of $25,000. If returns on your investment in your account over the next 35 years average 7 percent, and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to the account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.”

Quite a few 401(k) plans out there are littered with awful investments. A 1.47% expense ratio is pretty awful and should be avoided.

Having said that, there’s still some measure of personal responsibility at work here. A person who signs up for a 401(k) plan knowing that the success of this plan will have a lot to do with the success of their retirement owes it to themselves to study the options available to them and ask a lot of questions.

If you’re just tossing money blindly into anything without knowing what it is, you’re asking to be scammed.

Yes, there are hucksters out there. Yes, there probably should be regulations putting some limits on some of the shadier things. That doesn’t change the fact that you should be educated about what you’re doing and responsible for your choices.

For one, expense ratios are useful, but they’re not the be-all end-all of how you should judge an investment. If you have two roughly equivalent investments, an expense ratio can be the difference maker between them, but if you have something returning 8% a year on average with a 1% expense ratio versus something returning 5% a year with a 0.5% expense ratio, the choice is still pretty clear for someone making a long term investment. The author quotes the horrible expense ratio on that Legg Mason investment – and I fully agree, it’s atrocious – but the author doesn’t go on to compare the returns of that fund to others of similar type.

But what if I’m stuck with an awful 401(k) at work? If that’s the case, open up a Roth IRA yourself with an investment firm that offers good investments with strong expense ratios. I use Vanguard, which offers expense ratios on many index funds that are below 0.1%. If your employer offers matching funds, you should contribute to your 401(k) up to the peak of their matching funds, but after that, you should be utilizing other investment opportunities.

I could go on and on with specific advice about retirement savings, but instead I’ll simply point you to a great book on the topic – The Bogleheads’ Guide to Retirement Planning. If you’re saving for retirement, you owe it to yourself to read this book (or one similar to it) and apply the ideas to what you’re doing for retirement.

There are sharks in the water every time you spend your money. Investments aren’t any different. If you’re going to invest your money, you owe it to yourself to spend the time to understand what’s going on with it. The fact that many people choose not to do this doesn’t mean that the idea of saving for your own retirement is a scam.

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