Thursday, May 19, 2005


In part one of this article we discussed the upcoming Roth 401k and the existing standard 401k with the hope of helping you to understand that one of these two programs is most likely your best bet to provide for your retirement.

We looked at the low rate of participation among eligible workers in 401k’s in general and younger workers in particular. Then we considered the risk to the future of retirees in this country in light of the question of the solvency of the Social Security System.

With the failure of far too many workers (especially young ones) to save enough to insure their financial security during retirement and the questions of Social Security Solvency you would think that these problems are the major hurtles to be over come.

But you would be wrong. The real dangers to retirement programs and 401k’s in particular are much more serious and have been around since 401k’s first began. Introducing Roth 401k’s hasn’t solved any of the problems that exist within the 401k program.

These problems have been covered up for years by the employers, plain supervisors, managers, insurance companies, brokers, and Federal legislators who are responsible for protecting the investing public. Just as they allowed for junk bond traders and crooked investment advisors to rob us in the past they are allowing unscrupulous tactics and greedy plan providers to do the same to us today under the 401k program.

While these problems have been just under the radar of most investors and basically ignored by the media they are beginning to draw some attention. You can only hide a rotten apple so long in the barrel before it’s found. Let’s hope these problems are solved before it’s too late.

If they aren’t I predict that the resulting scandals and losses for the investing public will make even the Enron and WorldCom frauds look small.

With that in mind lets take a look at these problems and discuss what if anything can be done about them and what you as a participant in a 401k program need to know to protect your investment.

Current 401k participation, vesting, and employer matching fund rules are designed to favor the employer to the detriment of the worker. Many plans won’t allow a new worker to participate for at least 1 year and they allow the employer to take back their matching funds if the worker leaves before having several years of service. Even worse than the 1 year wait are the plans that don’t allow for any new participants or changes except during a very limited time during the year. I’ve seen plans that only allow you to sign up for a one week period twice a year. That means that many workers effectively have more than a 1 year wait to sign on. This is much of the underlying reason for poor plan participation by younger workers. It’s just too easy to forget and fail to take care of starting a plan under this type of limitation. So while Employers promote their 401k programs as a fringe benefit and point with pride to their matching funds portions they know full well that many will never see any of these benefits. They put matching funds in only to get them back in the future when the employee leaves. That’s good for them but bad for the worker and it undermines the future of our retirement system by lowering participation. 401k programs should have an automatic registration and allow the worker to keep any matching funds paid into their account.

Worse many employers aren’t putting in the matching funds that they are required to under their plan. They simply keep the money and the worker is kept unaware that the program is under funded. This should be treated like the criminal action it is but it is seldom punished and this practice has been going on for far too long. Many of the 401k programs ran by troubled industries are under funded and it’s the workers and tax payers that will pay the price for retirement fund failures in the future.

Currently approximately 75% of the plans charge more, many times much more, that they charge for regular individual accounts. 401k plans should get a lower rate not a higher rate. They get away with it because it’s not fully or fairly disclosed to the plan participants what there rates are. So they do less work for more money while hiding the fact from the investors. There are no standards or rules that require a reasonable rate or service charge for 401k programs. That allows for greedy brokers and agents to charge far more than is justified for their services. While I hate legislation in such matters it is the only thing that will solve this problem. These practices hurt fund performance and undermine future value. A fund that has an investment of 500 dollars a month for 25 years and earns 9% interest will be worth approximately 561,000 dollars. If the same investment only earns 8% it will only be worth approximately 476,000 dollars. That’s a difference of 85,000 dollars over only 25 years. That’s an average of 3,400 dollars a year that’s lost to the investor. The worst offenders for over charging for fund management are the plans that are run by the insurance companies. They might not know how to get a good yield for you but they know how to get one for themselves. The resolution of this problem will require that employers have to be more accountable for the fees they negotiate for their plans. Currently they have no incentive to care what is charged as all of the expenses are paid by the investor and the investor has no say in these negotiations. Not the best arrangement to be sure.

And of course the investment advice that is given to investors in 401k programs is very little and lacking in depth. Worse yet investors are removed from the day to day activities of the fund and their investments. They are only receiving quarterly reports and they usually lack detail. So poor performance is the norm with ROI being less than it should be. To compound the problem a lot of the choices given to the investors are overly expensive mutual funds with little or no diversification. The average plan is heavily invested in the sponsor companies stock and has only two or three different funds being held at any one time. Plans should encourage investors to build around low load mutual funds or stock indexing funds that have little overhead and reasonable management fees. Maybe it’s time that the employers have to pay part of the fees so they would have an incentive to keep costs down.

Lots of plans limit drastically the choices of what mutual funds are available for investment. What chance does an investor have when their choice is between two funds that offer little difference in there costs or the rates of return experienced. To encourage workers to have more input and receive good third party advice would go far to alleviate the problems with ROI while encouraging diversification. As we stated in part 1 too many workers have much too large a share of their money in company stock which can be risky if something happens to you employer.

So does that mean that you should avoid 401k programs? Not at all. 401k’s are still one of the best investment options available to you. It just means that you must be careful and take control to prevent these problems from hurting your investment. It is possible to prevent much of the damage once you know the problems. Knowledge and information are power and they can put a stop to most of these problems. So what are the defenses you should be using?


Don’t be over eager to borrow against your 401k program. If you have to leave the company they will close out the loan. That will be treated as a withdrawal from your fund and as such will be taxed and possibly penalized as being an early withdrawal. You will have spent the money and now owe taxes and penalties that you don’t have available. Plus you can’t put the money back in so you lose the tax deferred growth that you had under your 401k program. Believe me over the years I’ve seen many people take a real beating because of 401k loans. Just imagine you’ve lost your job, had your 401k fund reduced by the remaining loan amount, and you get to pay taxes and penalties on the amount of the loan repaid, and you’ve already spent the money. That triple hit hurts.

Don’t take the money and run. When you leave a company roll your 401k over to an IRA. Never cash in a 401k early unless you ABSOLUTELY have no choice or you will take a hit in taxes, penalties, and the inability to replace the money. When it gone it’s gone and so are the tax deferred advantages of having that money earning within a 401k program. So how expensive is it to take money out early. With a 10% early withdrawal penalty, a minimum 10% federal tax, and your state tax (if you have one), you will pay 20 to 30% in taxes plus not have the money growing tax deferred. That means that if you took out 10,000 dollars you would take home about 7,000 dollars. It’s worse still if you are in a Federal tax bracket above 10%. That’s one way to go broke in a hurry. You might as well go to a loan shark at those rates.

And last but not least take charge it’s your money.

Demand to know what you are paying in fees and expenses and if they seem high ask if they can be lowered. Ask questions and don’t stop until you understand the answers as to what your investment choices are. Talk to other workers who are in the plain with you and seek safety in numbers. The more of you involved the more you can fight back against unreasonable charges.

Study your statements and be sure that they are correct. They make mistakes too and you need to watch them. Don’t be one of those people that I get at tax time that hasn’t even opened their statements and couldn’t understand them if they did. If you’re confused or don’t understand seek out an advisor to help you find answers.

Your financial health is much like your physical health. Get a second opinion on anything you don’t understand. Your tax preparer or accountant is a good place to start. They should be willing to take a look and help you with simple questions for little or no cost.

While your 401k is a long term investment don’t get over sold on buy and hold as your method of investment. It’s ok to buy something and sit back and wait just keep watch and bail out if it ends up not working out. Even long term investments need management and no amount of time makes up for sitting for years in a low yield stock or mutual fund just because you think that you aren’t suppose to do anything but buy and hold. Fortunes are lost using that formula.

I watched a person who worked at AT&T buy AT&T stock for years as it climbed higher and higher and split numerous times. The problem was that I then watched as AT&T began its long slide down with the investor holding on all the way. When it was over they didn’t get back their original investment. Stock that at one time was worth almost 200,000 dollars ended up brining only 23,000 dollars. They had invested almost 26,000 dollars so they lost 3000 dollars and because it was in a 401k all of the 23,000 dollars they took out was taxable while the 3,000 dollar lost wasn’t deductible. I just couldn’t ever convenience them that AT&T wasn’t going to come back. They had been so conditioned by the buy and hold philosophy that they just wouldn’t sell. That’s one client that I’ve always felt that I failed even though I preached to them every year when I did their taxes. I still feel that I should have been able to get them to bail out but I never could. I just wish I had another chance at doing that. I don’t know what I could have done that I didn’t do but I’d like the chance anyway.

But that’s a story of another article on another day.

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