My topic this week centers on 401(k) plans. These plans were introduced in 1974 as part of ERISA – the Employee Retirement Income Security Act. Individual Retirement Accounts, or IRAs, were also part of this legislation. Congress created these savings programs for small businesses (401(k)s) and self-employed people (IRAs) who were not covered by traditional defined benefit plans. However, as time went on, many larger employers which had defined benefit plans decided to replace those plans with a 401(k) plan. Why did they do that?
1. The funding of a defined benefit plan was virtually all with the employer’s money; a 401(k) plan is predominantly funded by the employee through payroll deduction.
2. The investment risk of a defined benefit plan is borne by the employer. However, if the value of a 401(k) plan account falls, it is the employee who suffers.
3. The longevity risk (how long you live) is borne by a defined benefit plan – if people live longer, it costs the employer more. In a 401(k) plan, the employee bears the longevity risk alone.
Since their introduction, 401(k) plans have become the most common retirement plans in America and traditional defined benefit plans have faded away in the private sector and are starting to be challenged in the public sector as well. One of the criticisms of 401(k) plans is that many have high fees and these are not disclosed to the plan participants (the employees who contribute). That is about to change. A rule that was part of the recent financial reform legislation is being implemented which requires plan administrators (the company which manages the plan) and plan sponsors (the employer) to disclose the fees being charged. As the first linked article below suggests, this could be good for plan participants although I believe many will be shocked by the level of fees they have been paying. The second linked article below speaks to managing the 401(k) from a fees perspective.
A number of the people I meet express disappointment in the performance of their 401(k) plans. Once they learn more about the fees, their disappointment may rise. I help many of my clients manage their 401(k) plan choices to improve their performance, however, many 401(k) plans just don’t offer many attractive options. That is why we often ladder our retirement savings using a combination of 401(k) plans, traditional or Roth IRAs and after-tax savings to maximize performance, reduce fees and create lifetime income structures. If that concept has appeal, give me a call.