This is a guest post by Steve who writes Steveark: Slightly Early Retirement. You can find Steve on Twitter @steveark. As with my regular writing, guest posts will cover a variety of topics. If you’re interested in writing a guest post, fill out my form.
A frequent complaint on personal finance blogs is how bad some corporate 401K programs are. Problems like high fees, poor fund choices and wait periods to participate are all excoriated by bloggers for good reason. My perspective is a little different from most. While I participated in my company’s 401K, I also spent years on the management committee that ran our company 401K plan. I literally only had myself to blame for any shortcomings in my 401K.
Why was I selected to be one of the five committee members?
Was it because I had a Human Resources background or a finance degree or Wall Street experience? No, I was a chemical engineer and the very young plant manager of a large chemical plant and my company president felt that it would be good training for me as I moved my way up in the organization. My thoughts were that I loved volunteering for anything new and different and I also loved supporting anything my boss suggested! Plus, who couldn’t use extra knowledge on investing and saving?
Our committee was composed of myself, our company lawyer, an HR department representative, our accounting manager and another engineer. None of us had any previous experience with investing outside of our own personal accounts and we chose a national bank/brokerage firm with a 401 K management division to host our plan. We had a dedicated advisor who would visit us quarterly to review the funds in the plan who would make suggestions as to when we should drop a lagging fund choice and replace it with a better performing option. Like many plans we started with five or six options for our employees and over time expanded the choices to twelve to fifteen funds.
This was before the wide availability of index funds became common but we still were able to get low fee mutual funds because of the size of our 401K plan which was in the $50 million dollar range. We tried to have at least one choice of value and growth aligned funds in large, medium and small cap areas including both US and global funds.
We also had bond funds, a REIT and a money market choice. Initially, we were an opt-in program, meaning that if a new employee did not take the initiative to sign up he was not a participant and would be totally on his own at retirement.
What did I learn from fifteen years of managing a 401K?
People will not sign up on their own. This may surprise readers in this space, after all, we are the financially independent retire early (FIRE) crowd. We understand the magic of compound interest and how money invested early in a career is worth far more than money invested near retirement age. Unfortunately, your average person is still unsure when it comes to how much money they will need in retirement and has no plan to accumulate it.
The retirement crisis is real and I saw the way people did not participate, even to the level of getting the free company matching funds. It was shocking to see people pass up free money while they were buying $40,000 pickup trucks and bass boats on credit.
We did address this by instituting automatic enrollment. We were limited to doing that at a fairly low level but at least it was a start. The same people who would not bother to sign up for the 401K would also not bother to turn off their automatic contributions. I get being lazy sometimes, but this was their future. Wake up!
Not only were many people blissfully ignorant of the need to invest, even those that were smart enough to contribute to the plan often did not invest in a risk-appropriate manner. They seemed to have huge inertia built into their brains. A lot of the biggest savers just put the money in a stable investment fund, which was really just a money market fund. Those things pay 1 to 3% interest while the stock market typically returns closer to 8 to 10%. By being overly conservative they were killing themselves.
I’m not sure everyone is ignorant to the fact of investing on purpose; some may be. Over my career, I’ve found very few people know who to turn to or trust to give them good advice. The more I share the idea of seeking fiduciaries, or just the plain language of how investing works the more people get started immediately. I’ve found most colleagues just want a hand to hold while they open an IRA or other account and for someone to explain in laymens terms what expense rations mean, or front/back end fees.
The lowest income employees participate at the lowest level, most won’t participate at all. That is logical because lower pay means money is tight. However, everyone is going to retire someday and they also forfeited company matching funds that way. Another real problem for higher paid employees was that our plan was perpetually “top heavy”. That meant that too much of the total value of the 401K plan was in the accounts of the “highly compensated employees”. You might think that means the C-suite crowd but it is a pretty broad category that catches senior engineers, middle managers and foremen.
At the end of each year the plan is analyzed by a CPA and if it is deemed “top heavy” then the high earners are refunded a chunk of what they intended to invest in the 401K and they then owe taxes on that. Not only does that limit your ability to build your 401K but it always happened just before the tax filing deadline so that if you had filed early you’d have to file an amended return, which is a huge pain. There was a way around it, called a safe harbor plan, but it required a fixed company match and our owners at the time did not want to promise a match ahead of time in case times got tough. We never won that battle.
This is something I never heard about before (I have been in public work for over a decade now, I forget my 401k options years ago in private). That is a bummer if it’s top heavy those get a refund and pay taxes. That limits everyone then.
401k loans are a disaster.
Most plans have a loan provision where you can borrow from yourself and pay yourself back at a set interest rate. It sounds like a great idea, why pay a bank interest when you can keep that by paying yourself? In reality, it is absolute insanity.
Our employees were taking these loans out to buy boats and vacations. When they took out a loan several things happened. They were no longer eligible to contribute to the plan until six months after they repaid the loan so their retirement was basically frozen and no longer growing as before. Since they could not contribute they could not get the company matching funds, free money lost. Third, the interest rate they paid themselves was very low compared to the average return in the stock market; they lose again. And in the case where they retired or were terminated with a loan outstanding, they had to pay it back immediately.
So, if you lost your job you also had to come up with a ton of money overnight to pay the loan. If you didn’t Uncle Sam considered it a withdrawal and hit you with a ten percent penalty and with the taxes on the money. These loans were one reason most people retired from our company with no more than $150,000 in their 401K.
401K plans have hardship withdrawal options that under certain emergency situations, like preventing house foreclosure or serious health issues, allow you to withdraw money from your 401K even if you are many years too young for retirement. However, often you get hit with a 10% penalty and you always have to pay the tax on the money. It is even worse than a 401K loan though because you can never put that money back into the plan. It is just gone forever. I saw this done several times and I never thought it was a wise move. It looked to me like “easy money” in the mind of the employee who was not looking down the road to retirement.
Unfortunately, I have found many people never look down the road to retirement when it comes to finances. They don’t realize the time they have ahead of them helps them get there sooner and easier. We’re in a culture of now, now, NOW! Delayed gratification works miracles as you can see from so many early retirees popping up around the FIRE block.
People buy high and sell low.
Every employee could make a daily election as to where all his money was invested on the hosting company website. We had employees who basically day traded their retirement funds.
It was awkward because most mutual funds only traded at the end of the day so you couldn’t be sure what value a fund would have when it actually made the trade. The worst part was that people would move everything from mutual funds to money market because the market had dropped. They would then sit there until the market had recovered, then they’d go back to mutual funds. They perversely locked in the market drops that way and missed the recoveries.
It is a terrible strategy for amateurs but I saw it happen. If these people had just set it and forgot about it on their portfolios the way I did, then despite the ups and downs they’d have had a big retirement fund eventually.
Employees will not come to informational meetings about the 401k to learn about investing and plan options unless they are forced.
They may have hundreds of thousands of dollars in this plan, maybe it will be their greatest financial asset at retirement and they still won’t come to free meetings with food and refreshments and lots of door prizes. We did have some success when we gave a lot of free stuff away but it amazed me that people showed so very little interest in their future.
People do not keep their beneficiary information current.
Crazy but true. We had an employee die and three women showed up at the same time at our legal department all claiming to be the wife of the deceased employee and all wanting his 401K money. It turned out that “Joe” had never gotten divorced from wife one when he married wife two, and then when he married wife three he still had never divorced wife one or two. So, guess what, only the legal wife, wife one, got the money. It was very lucky for “Joe” he was dead because wives two and three would have killed him! You just can’t make this stuff up!
This is very true. If one does “set it and forget it” they really do forget who they even plan to give it to at the end. Beneficiaries should be a yearly or every X year item to review for sure.
Divorce will shred your 401K.
We were constantly processing Qualified Domestic Relations Orders from a judge that split our employees’ retirement assets into two halves and gave half to their ex-spouse. In more cases than I’d care to remember this didn’t just happen one time but often twice to the same employees.
The math is pretty simple, if you have a nice $200,000 nest egg in your 401K and you give half to ex-spouse number one, you only have $100,000 left. Then if you get married and divorce again and give half of the $100,000 to ex-spouse number two, what’s left? Only $50,000. You saved $200,000 and gave $150,000 of it away to people you don’t even like anymore. It is the law and it is a fair law but you are still stuck with very little to retire on and not a lot of time to earn compound growth on your investments.
Your plan needs low-cost index funds and you need to pick the best of the breed and not be shackled to funds that are owned by the company that you are paying to host your 401K plan.
We started with a big national financial company and at first, were invested in their own mutual funds. Over time we moved away from those to index funds and best of breed funds.
Ironically that financial company’s own employees sued over the way their own 401K plan was limited to in-house funds! Needless to say, after that most hosting companies became very good at offering best of breed funds and index funds and stopped trying to sell their own funds into the 401K plans they hosted.
This is the reason I haven’t invested in various public options for 403(b) plans over the years. They usually are very expensive funds and limited to company choices that benefit the company and employer. In addition, 403(b) plans offer no match, so the expenses really hit hard without that “company match” buffer 401(k) plans offer.
There were battles we could not win. Safe harbor, self-directed accounts (where every employee could pick from any fund in the world) and offering a ROTH 401K were all things that the committee was still working on after I left. But I felt we did the best we could to maintain low fees and good options.
We also never won the battle to get everyone to participate or to get them to participate at high levels. I did take special pride in one thing though.
When our privately held company was bought by a big fancy Fortune 500 corporation they compared their 401K to ours and decided that ours was better. They ditched the plan that their 6000 employees had been under and switched everyone to the plan we had set up for our 500 employees. That felt pretty good!
The main thing I learned from managing a 401K plan for my fellow employees for 15 years?
The 401k plan was the most underutilized benefit at our company. Because it had the ability to make most people a millionaire if they would only contribute heavily to it.
How do I know that? I was only in the plan for 28 years and I early retired with well over a million dollars in my 401K. My other employees probably averaged about $50,000 in their accounts and most retired with less than $150,000. All I did was invest the maximum I was allowed in the plan and put that mostly into index funds or low fee mutual funds spread across domestic and international stocks.
With a company match, it makes a lot of sense to put in the maximum to get the benefit as well as the tax break. We don’t get any match for 403(b) plans, so it’s more costly for us at this time than investing in taxable funds we can control.
As I approached my slightly early retirement I started to move more money into bonds and REIT’s but for most of my career, I was virtually 100 percent equities. The “top heavy” problem meant I was limited to less than the federal contribution limits for most of my career but even at that and even though I only was in a 401K for 28 years I still became a 401K millionaire.
I accumulated considerably more than that in separate non-401K accounts. I never missed the extra money because it was deducted from my paycheck and I never made allocation changes in my investments due to the market soaring high or crashing low.
I just set it and forgot it and now I’m a very comfortably slightly early retired guy. I hope my insights from inside the trenches of running a 401K help you decide how you will utilize your plan.
This was a lot of good information Steve! I hope others find it useful when looking at their retirement savings options no matter public or private employment. Knowing a little more about how it all comes together and the pitfalls of these types of accounts is useful.
Do you contribute to at least the level that your company matches in your 401K?
We do not currently, as we have 403(b) options in our primary careers that offer no match and high-cost funds. In Chris’ second job, he receives a match, so we contribute to the lowest index-fund option (luckily a Vanguard one!) up to the company’s match until we pay off our mortgage with that income.
Do you contribute to a ROTH 401K or a separate ROTH outside of your company 401K?
We both have ROTH IRAs and have been able to start maxing them out the past few years which feels great!