How many employers are wasting the money they spend on employee match contributions? How much can a cost efficient plan add to your retirement security?
Those questions came to mind as I spent more time examining “The 401(k) Averages Book.” That’s the publication I discussed last week. I likened it to a “map” of the world of smaller 401(k) plans. The book clearly shows that expenses decline as plans get larger. It also reveals a wide range of expenses for plans of the same size.
Average plan costs, for instance, decline from 1.9 percent to 0.9 percent as the assets in the plan climb from $500,000 to $100 million. Costs for a plan with 50 participants and $2.5 million in assets range from 1.98 percent down to 0.38 percent. These cost figures are significantly higher than those in a recently released Investment Company Institute report. The ICI report includes much larger plans and uses an asset-weighted average expense level for mutual funds rather than an un-weighted average expense level.
Cost differences have a big impact on how much you accumulate for retirement. To explore this I built an Excel model. It allows me to compare lifetime accumulations for different assumptions about lifetime earnings, inflation, savings, employer matches and pre-expense investment returns. While the model measures in dollars, it also converts the amounts accumulated into years of final income— the basis for most retirement planning.
The years-of-final-income figure may sound abstract, but it is a lot more useful than large future dollar figures that can be entirely misleading. If you are 30 today and earning $50,000, your income at age 67 will likely be around $150,000 — assuming a 3 percent annual raise that reflects 2 percent inflation and 1 percent for productivity and experience.
Typical contribution rates to 401(k) plans average about 6 percent of wages. Most people have 60 to 70 percent of their contributions in stocks, a mix that historically could be expected to grow at an annualized rate of about 8 percent.
So, lets see how your location on the 401(k) map affects long-term accumulations:
- If you are a member of the Federal Thrift Savings Plan, with expenses of 0.03 percent, you will accumulate 9.26 years of final income.
- If you invest in Vanguard Balanced Index Admiral shares, with expenses of 0.09 percent, with an IRA you’ll accumulate 9.14 years of final income.
- If you invest through the lowest cost small 401(k) plan with expenses of 0.38 percent, you’ll accumulate 8.56 years of final income.
- If you invest through a large plan with expenses of 0.90 percent, you’ll accumulate 7.63 years of final income.
- If you invest through a small plan with high expenses of 1.98 percent, you’ll accumulate only 6.04 years of final income.
As you can see, as expenses rise, your accumulation drops from 9.26 years of final income to 6.04 years. That’s a loss of 3 years of income, a drop of 35 percent.
There are several really important implications here:
- If your employer has an expensive plan and doesn’t offer a significant match, you’ll be better off dropping the 401(k) plan and investing through a low-cost IRA.
- While the Big Dogs need 401(k) plans for their substantially higher contribution limits, the vast majority of employees aren’t so limited. Saving 6 to 10 percent of their earnings in an IRA won’t exceed the contribution limits for IRAs.
- An employer offering an expensive 1.98 percent cost plan would need to offer a 40 percent match just to bring your final accumulation to the level it would be in a low cost 0.38 percent plan. In other words, the employer may be wasting most of his matching dollars on the financial services industry.
- In most small plans— such as small medical groups, legal firms, etc.— the big dogs have the largest investment accumulations. This means they will benefit significantly if they pay close attention to the cost of the plans they choose.
What’s the bottom line here? If you work for a small company with an expensive 401(k) plan, you’ll benefit by moving to an inexpensive IRA unless there is a strong employer match. And if you are a big dog, seeking a lower cost plan will demonstrate enlightened self-interest, as well as concern for your employees.