Today’s pop quiz: Which would you rather have?
- A 401(k) plan with a big employer match?
- A 401(k) plan with very low expenses?
By the way, the comfort of your retirement may depend on your answer.
The surprising answer is that a low cost plan can do as much for you as a healthy employer match. I learned this while doing research to speak to workers at Texas Instruments.
Texas Instruments changed its 401(k) plan a few years ago.
What did TI do? They replaced a menu of managed funds with a new menu of low-cost index funds. In the process, the company joined a small but growing number of firms that are changing the retirement landscape. In that single step— cutting the cost of the plan— they increased the odds that TI employees would accumulate enough money to fund a good retirement.
Texas Instruments isn’t alone in taking this step. Business Week lauded IBM last year for “Reinventing the 401(k).” Exxon Mobil made the change years earlier. Indeed, one of the oldest low cost 401(k) plans in America is the Federal Thrift Savings Plan. Its expenses are 0.03 percent a year, an amount that has virtually no impact on how much employees accumulate over their years of saving.
The typical fund in the Texas Instruments plan has an expense ratio of 0.15 percent and represents one of the major asset classes. As a consequence, an employee who saves 6 percent of income for 35 years and invests in a balanced portfolio that has a gross return of 8 percent a year will accumulate about 5.3 years of final income with their own contributions. The loss to expenses is a piddling 3 percent. The employer match will increase the accumulation further. (These figures assume inflation averages 3 percent and the worker only receives wage increases equal to inflation.)
So how does a low expense plan compare to plans with higher expenses?
According to 401ksource.com, a typical large company (at least 5,000 employees) 401(k) has expenses of about 1 percent a year. Investing the same amount in the same way in a plan with those expenses would reduce the accumulation to 4.47 years of income. That’s a reduction of 18 percent, more than the 15 percent tax rate paid by most workers.
Many small company plans have expenses of nearly 1.5 percent. When you subtract that from the gross return, the accumulation drops to 4.05 years of final income, a reduction of 26 percent.
If you have an insurance product based plan— as thousands of schoolteachers’ do— annual expenses of 2.25 percent will reduce your accumulation to only 3.50 years of final income. That’s a reduction of 36 percent, right up there with the 35 percent tax rate currently paid by workers with taxable income over $372,950.
Workers in these expensive plans would need to have a 50 percent employer match just to bring them back to the 5.3 years of final income that workers in low cost plans like the TI plan will accumulate. In a typical large plan with expenses of 1 percent a year, it would take about a 20 percent match just to make the accumulation equal what employees in low cost plans can accumulate.
But what about brilliant asset management from the best minds on Wall Street? Surely the pros will compensate for the fees they charge?
Sure they will. And you can add that to all the other wonderful things this crew has done for you lately. According to the most recent Standard and Poor’s Indices versus Active funds Scorecard (This PDF report, known as SPIVA, can be found with a simple Google search.), a large majority of actively managed funds failed to beat their index benchmark over the last five years— the same years that Wall Street often claimed could only be handled with smart stock and bond picking.
What are the specifics? Over the last 5 years 60 to 80 percent of all actively managed domestic funds failed to beat their index; 85 percent of all actively managed international and emerging market funds failed to beat their index; and 62 to 97 percent of all actively managed fixed income funds failed to beat their index. The only bright spots for active management were emerging market debt funds where 50 percent of active managers beat their index and international small cap funds where 70 percent of active managers beat their index.
On the web:
IBM Reinvents the 401(k): Business Week, 7/09/2009
http://www.businessweek.com/magazine/content/09_28/b4139058355275.htm
The Payoff for Low-Cost Index Investing, May 22, 2009
Standard and Poors’ SPIVA Report for June 30, 2010
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Photo credit by Pixabay
(c) A. M. Universal, 2010