I’ve based my life strategy around fierce independence. If at all possible, I try to avoid moving with the crowds. Of course I like the same music, TV shows, sports, movies, clothes, soap, cars, books, podcasts, food, housing, pet options and sleep schedule as just about every other American. But what does a libertarian have if he doesn’t believe he is an individualist?
Anyway, one of my actual independent actions is my complete disregard for 401k plans. There are too many better options for my money and I’m way too claustrophobic to hold my money in an account that I won’t be able to use for 35 years.
Unfortunately, as I’ve written ad infinitum, ‘How should I invest my 401k?’ is the most common question I am asked as soon as I identify myself as a former financial wunderkind and a current boring bank employee with an investing website. So I’ve spent a lot of time thinking about the pros and cons of 401k plans, which we will look at in this article. Stay tuned next week for the riveting article on how to invest your 401k if you have to do it.
Pro: Employer Match
Perhaps the most obvious pro is when your employer matches your contribution in any form. At a previous job my employer matched 50% up to 8%, so by contributing 8% I immediately had a 50% return. It takes a lot of potential from alternative investments to beat 50% on day one.
Of course, employer matches aren’t all roses. Many, if not most, employers require employees to work for a certain amount of time before they get the match. This can be ten years or more in some instances. If you’re passing up a 20% increase in income by getting another job or a 3,000% increase by starting a small business for a 4% match, you’re doing it wrong.
Con: Dearth of Investment Options
In a discount brokerage account that takes 15 minutes to setup, the individual investor gets more investment options than there are second rate hot sauce selections in that one aisle in the grocery store. You can shift from a S&P 500 ETF to Euros one day and into oil stocks the next. Wherever there is a value or momentum, you can go.
Typically, a 401k plan will have an S&P 500 fund, small, large and mid-cap funds, a growth fund, maybe a value fund, an international fund and, if you’re lucky, a real estate fund. Don’t forget the 7 bond choices that all have higher fees than their current yield-to-maturity*.
Though there are ways to work around this scarcity, this set-up drastically reduces investors’ ability to invest in the best performing instruments.
*If you don’t know what Yield-to-Maturity is, subscribe to my newsletter! We have an investing glossary where we talk about finance terms every week. Fun shit!
Pro: Tax Advantages
Though you do eventually have to pay taxes on your 401k, pre-tax income is used. This either reduces the amount you need to withhold every paycheck or increases the refund at the end of the year.
If you want more freedom and the same tax advantages, a traditional IRA functions in the same way.
Con: High fees
The scarcity we talked about above leads to a movie theatre popcorn affect. Many 401k mutual funds will charge 1-2% per year in addition to a front-end load (front-end loads are like the cover charge you have to pay to be allowed into the shitty fund) because they know you have no other options. In a normal discount brokerage account, you can avoid overpriced mutual funds run by a hoity toity brokerage and choose to invest in only ETFs with fees below 0.20%.
Pro: Forced Savings
One of the keys to effective personal finance that I discuss in my new book, is setting up ways to force yourself to save. This can be accomplished with automatic transfers into a savings account, by building equity in your house or by utilizing a whole life insurance policy.
Because 401k plans pull out of your paycheck before you see it, there is no psychological issue each month with the saving. There is no fear that you will need the money and no ability to utilize it for better rims on your car or adding a fourth pet to the ever-expanding herd of animals thundering through your house at 2 am.
Con: The Mutual Funds Probably Are Bad
There are tons of studies that I won’t go through the trouble of finding and linking that show the vast majority of mutual fund managers lose out to the market every year (if you want to find these studies check out this book, this one and this one) and almost every single one loses out when you increase the term to three, five or ten years.
This happens for a variety of reasons. Like 401k plans, mutual funds have limits on where they can invest. Most can only invest in US stocks above a certain size and they cannot focus too much into one stock. This, combined with the biases and emotions of human management, spells poor returns.
Guess what? Most of the time these losers are the funds you have to choose from.
The good news is almost all 401ks have some sort of S&P index you can invest in that has sub-1% fees. This takes away the human error.
Also, when you can, skip the age based funds that invest based on what year you hope to retire. These funds are managed based on the inane idea that only age should determine asset allocation and almost certainly have way too high of an allocation in bonds.
Pro: You Can’t Touch the Money for a Long Time
Many investors, myself included, screw themselves over with high turnover. We sell out of a stock that has gained 80% to “secure the gain,” and then watch it increase 400% over the next 3 years. Or we watch the stock fall 15% in three weeks and rage quit so hard on our cell phone screen when we’re selling it that it creates a tiny dent right before the stock rebounds back past the buy price and up 5,000% over the next decade.
401ks have restrictions on how often you can trade and most providers make it so damn difficult that the best you can do is pick an allocation and then check the performance seven months later when you finally get around to opening one of the statements in an inevitably brutal exercise sure to breed malcontent with investing and the universe.
This annoyance can lead to a positive outcome. Keeping your wits together, or simply not being able to sell out, during drawdowns is imperative for long-term success in investing.
Con: You Can’t Touch the Money for a Long Time
Because we aim for doublespeak on this site, I’m now going contradict the last point. In almost all forms of intelligent asset allocation, periodic rebalancing is a must. Rebalancing is what creates the diversification into uncorrelated assets that gives you a free lunch. It keeps you from dedicating 40% of your portfolio to resource stocks after a run-up and keeps you from having just 2% of your portfolio in resource stocks right before a run-up.
It’s likely that intelligent asset allocation is not much of an option anyway in most 401k plans. But the difficulty in rebalancing and moving to cash makes it that much worse to have your money stuck in investing purgatory until you finally turn 59.5.
As with almost everything, the choice on whether or not to use the 401k plan offered by your employer depends entirely on each person’s unique situation.
For people like me with delusions of future business success grandeur or the appetite for actively trading and investing in real estate, 401k plans are a prison that require a fee creeping toward 50% for any withdrawal of our hard-earned cash.
For people who will use their 401k, equity in their residence and various savings accounts as retirement savings, 401k plans are perfect. They give you an opportunity to invest in stocks that likely would not have arisen otherwise. And even if the returns are worse than you could manage by spending a lot of time on investing, they’re still better than that the four cents per year you’d get in a savings account.
The hard choice is for those in-between. You don’t have to daydream about being a featured mogul on CNBC to understand asset allocation and the benefit to diversifying your savings or even creating new income sources. But this doesn’t mean you have to 4(01k)sake your 401k either. You can reduce the percentage allocated to it and use its investments as part of a greater asset allocation plan wherein outside accounts are used to diversify into international stocks, commodities, real estate, bitcoin, fine art, baseball cards, a towel that Aaron Rodgers once wiped his face off with, sports gambling, a local car wash business, etc.