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Sunday, May 19, 2013

Bashing the 401(k)

Lots of 401k bashing as people get near retirement and take stock.  Felix Salmon has a critical articleKaiser Fung jumps in with some reasons he’s not fond of the 401k either.  Kaiser makes some good points that are similar to those of others, but have a bit different spin, so let’s take his four points and expand on them a bit:

Kaiser:  First, it is never a good idea to chop up money into little pockets. ... Imagine you then split the $125 into five or ten investments. It just doesn't make much sense.

Me: "Little pockets". Little pockets are fine so long as your fees don't go up as a percentage. It's the expenses that are a mess with 401k's, depending on how much your employer looks out for your interests.

Fees are deadly: http://wallstreetonparade.com/2013/04/pbs-drops-another-bombshell-wall-street-is-gobbling-up-two-thirds-of-your-401k/ shows with a 2% fee structure two thirds of the money ends up with the management firm, not you. This is simple math, and anyone with Excel can verify Bogle's calculation. There's also no reason for 401k fees to be high, since there's no investment advise being given and the funds used are typically large ones. There are several core Vanguard funds with expense ratios in the .05% to .15% range.

Kaiser: Second, how many of us can truly beat investment professionals at the investment game? Most of us don't have the time or inclination to be monitoring our portfolio 24/7…Is there a study that takes the investment performance of the average Joe and compare them to the average fund manager?

Me: The average Joe typically gets into trouble by buying on history (i.e. buy after the market has gone up, sell when it goes down). Other than that, there's not a lot of evidence that professionals do better for the average investor (because of the fees you pay). Take a look at the "Morningstar" experience in Bogle's famous "buy the haystack" article:http://www.vanguard.com/bogle_site/bogle_speechesequity.html


Kaiser: Third, moving from a defined benefit plan to a 401(k) is to shift risk from institutions to individuals. When we were sold the myth of individual control, we were also gifted the Trojan Horse of financial risk. Now, we are responsible for our own individual bad decisions. This is an important point. More people in the pool lowers the average risk.

Me: no argument with this.

Kaiser: Fourth, the 401(k) is regressive. The lower your salary, the smaller your biweekly contribution. The risk borne by the individual is higher when the principal is smaller.

Me: Not sure regressive is the right term, but it's definitely true that for high income individuals the 401k is likely to be a smaller piece of their total savings, and so they bear less risk. If they bear less risk, lower income individuals bear more.

It certainly is true that loan utilization rates vary, and tend to be used more "for participants in their 40s, those with 10 to 20 years of tenure, those earning $40,000 to $60,000 per year, and those with plan balances between $20,000 and $30,000. For those who have a loan, the loan-balance-to-401(k)-balance ratio declines with age, tenure, compensation, and 401(k) plan balance."http://www.nber.org/papers/w17118


BUT: is this situation better than having a defined benefit plan (such as the Illinois public employee pensions, which are even guaranteed in the Illinois constitution) which the employer (the state) does not fund and now wants to partially renege on?