Without a doubt, participation in a 401-K plan could be a good option for employees to participate in. For some, however, there may be better options.
So what is a 401-K plan?
According to Wikipedia, a 401-K plans is:
“In the United States, a 401(k) plan is the tax-qualified, defined-contribution pension account defined in subsection 401(k) of the Internal Revenue Code. Under the plan, retirement savings contributions are provided (and sometimes proportionately matched) by an employer, deducted from the employee’s paycheck before taxation (therefore tax-deferred until withdrawn after retirement or as otherwise permitted by applicable law), and limited to a maximum pre-tax annual contribution of $18,000 (as of 2015).”
Boy, that’s a mouth-full, isn’t it?
Sometimes, it is also referred to as an Qualified Employer Sponsored Retirement Plan. Is that good. Maybe?
Well let’s break down my description above, namely, Qualified Employer Sponsored Retirement Plan.
Retirement Plan – A plan of Retirement- a savings account for retirement.
Employer Sponsored – meaning the plan is offered by the employer, to all eligible employees. It’s his plan.
Qualified – a government program that offers tax advantages to the plan participants (employees), usually where employee contributions are “pre-tax” meaning that they do not show up as income in the year contributions are made. Also, employer contributions are not shown in reportable income either for the tax year contributions are made to the plan. All funds earn with no taxes due on the earning each year. Taxes are due, however, when funds are withdrawn. Like all government plans, there are “strings” attached as to when you can access your funds.
In my view, there are two things that participation in a 401-K plan accomplishes for the employee that is seemingly good.
- Employer Match – generally the employer will match a percentage of money, up to a limit, that the employee puts in. Say the employee puts in 3% of his income. The employer may put in a “matching” amount of say 3%. This “matched” amount is additional money the the employee would not have received if he did contributed to the company retirement plan. Some call this “free money”. But, is it?
- Encourages Employees to save money for retirement. With 96% of the population reaching age 65 with not enough money saved to retire, 401-K plans may help more have something for retirement because of the “free money” and because of the taxes saved on their contributions. It is an enticement to save. A good thing I think.
Look’s hard to beat, right? But what about the “Drag”?
What is Drag? It is anything that takes money away from the retirement saver’s retirement savings efforts. Namely, there are three. They are:
Types of Drag
- Lost Money due to Market Declines
- Lost Money Due to Taxes
- Lost Money due to plan Fees
In my Retirement Planning business, it is common for me to hear the words, “I already have a retirement plan at work”. The way that these words are spoken by those who have those plans reminds me of a Vampire Movies where the “Cross” is show to the vampire and he has no choice but to retreat… it’s like a “trump card”, a nuclear bomb or something. Those words are spoken as if they are suppose to “stop me in my tracks”… that there is nothing I can do to help those who have these 401-K plans. Nothing could be further from the truth. See, the real test is revealed with their answer to the “important question”. What is the important questions? “How much will that provide you in retirement income when you reach age 65?”
This is about the time I see eyeballs rolling up in the back of people’s heads… the “cross” doesn’t work with this vampire, they think… he must be a “Day Walker” or something like that.
Retirement is serious business, yet almost no one can answer the important question… “how much retirement income will my plan yield”. And if the retirement saver can’t answer this question, then how can they know it will meet their retirement needs or not? They can’t.
The purpose of this article is not to analyze retirement needs. Rather, to show how “drag” could affect their current retirement efforts over the years. So, let’s get to it.
Retirement #1 Drag – Market Losses
We hear all the time when the market is doing well. Almost daily, they news reports the daily gain for the Down Jones Industrial Average, S &P 500 Index and the NASDAQ. Market trends typically affect all three exchanges in similar fashion. We’ll look at the S & P 500. The S & P 500 Index represents the 500 most widely held stocks held in the U.S., and represents almost all industries from manufacturing, retail and the service industry. It makes up about 70% of the American Economy. So it is a broad representation of the market. So how has it done?
If you will add up the annual gains for 10 years and divide by the number 10, it will give you the Average Return. Here are those numbers.
So our Money has had an average return of 6.05%. Hold on, not so fast. The Average Return is Not the same as Actual Return. Actual Return? Yep, Actual Return. Well what does that mean?
Well if you were in the market for this 10 year period, I think you could hardly count the gains in 2009 through 2011 as gains and couldn’t count most of 2012 either. If you add up these number for this 4 year period, almost all of those gains would be “gobbled up” by the 2008 loss of -37.47%. So to include them as a positive number in computing an Average Return is ludicrous. Yet, that is how the average is calculated.
These four years would have only actually increased your pre 2008 holdings by 2.28%. But the Average Return reflects a gain of 39.75%. Of which 37.47% of those gains you had earned previously… they in no way represented an additional gain over this 10 year period. You have already counted them once. You were just getting your money back. The numbers average well but in actuality, this was money you already had earned. You can’t count it twice, can you? So, how much did you actually make after paying for market losses?
To get a true picture, you have to look as Actual Return and to do that is to measure Return on Investment. You take a starting point, and ending point and a ROI calculator and Voilà; you get your Actual Return. You can see our results below.
What you wind up with is an actual return of 3.9% instead of 6.05%.
That’s a loss of more than 1/3 of your earnings and represents Drag #1 – Market Losses. They have to be paid for and guess what… they are coming directly our of your retirement savings, in real time, and the way you pay for them, is by having to earn them back. (twice)
Retirement #2 Drag – Taxes
The second drag is easy to explain because everyone understands taxes. They are going to have pay taxes some day. Would it be unreasonable to assume that might be 33% or better. So, the retirement saver is losing 1/3 of their earning to taxes. And on that note, wouldn’t it be better to pay that tax on “the seed” rather than “the harvest”? Rather than deducting $100,000 in contributions over a thirty year period and having to pay taxes on $500,000 in retirement savings, why not receive the whole $500,000 tax free? Can you do that? Maybe. All I can tell you is that many of our clients don’t pay taxes… ever!
Retirement #3 Drag – Fees
The third type of drag is hard for the retirement saver to see. It is almost hidden. It takes a number of calculation to figure out the real cost of fees. In the chart below, we show the results over a 30 year period for a typical 3%-3% Match 401-K plan for an high income earner earning $100,000 annually in all years, earning 8% on their money and 3% in fees annually.
Can you believe that fees come to 40.59% of what the retirement saver wound up with. Here the broker and plan administer have almost half as much as the retirement saver and employer have and they didn’t put a dime into the plan. Wouldn’t you rather keep most of these fees for yourself?
Now fees can’t be avoided all together. After all, the financial industry doesn’t work for nothing. But what if we could save half of those fees and have those add to you’re plan’s retirement values each year and add compound growth on top of that? That could make a big difference.
Can we save fees for our clients. Probably. Most time, we can save our clients fee expense)
To know for sure, we have to analyze that on a case by case basis.
So there you have it. The retirement saver is:
Losing 1/3 of their money due to market declines (Drag #1)
Losing 1/3 of their money in taxes (Drag # 2) and
Losing 1/3 or more in fees (Drag #3)
So, that Begs the Question:
“How can the retirement saver ever hope to retire losing this much of their money to Drag”?
I invite you to find out if there is a better way.