INSPECT YOUR 401(K)

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Many individuals have access to an employer sponsored retirement plan. Chances are excellent that you are already using some type of employer plan to save for your retirement.

In simpler days of the past, an employer might offer a pension plan or defined benefit plan which promised workers a specific amount of retirement income. The demand of saving and investing rested on the shoulders of the company rather than the employee.

These guarantees are a foregone luxury. Companies typically no longer provide this level of support during employees’ retirements.

Now, your employer may provide a plan in which you are able to save. Chances are high that the majority of the saving and investing will be done by you, not the company.

Employers provide you with a benefits guide or PDF which will describe the plan and its options. You, the employee, are responsible for making any decisions regarding your savings rate and investment strategy.

Your employer may have a set of defaults for any decision you might make. Typically, these default options are intended to appease minimum requirements or compliance regulations rather than suit your specific needs.

You are in control though. As an employee, you can optimize your decisions related to this plan. Since the contributions and investing will be mostly automated, your initial decisions and setup are especially important.

This checklist should help you review your employer retirement plan decisions or set up the plan right from the start!

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Types of Employer Sponsored Plans

For a quick summary or recap, you can review the types of defined contribution, employer sponsored retirement plans below:

1/ The 401(k) plan … This option is typically available to those folks employed by a relatively large company.

2/ The 403(b) plan ... A common option if you work for a public sector employer (a public utility or hospital) or a tax-exempt organization (a church or non-profit).

3/ The 457 plan … This account is used by the employees of state and local governments.

4/ The SIMPLE IRA … This is typically used by small businesses.

There are other options available for retirement plans, but the vast majority of employers will use one of these options. Regardless of the type of employer sponsored plan, the types of decisions you will be required to make are approximately the same.

Employer Match

Many employers incentivize retirement savings by matching your contributions. Although most employers won’t provide a lifelong retirement pension, a match is a worthy consolation prize.

Typically, an employer will match your contributions up to a certain percentage. The description will be something like, “Dollar for dollar up to 3%,” or “Dollar for dollar up to 5%,” or “A 50% match on every dollar up to 6%.” You may have to do a tiny bit of math to determine the dollar amount you will receive each pay period or over the course of the year.

The employer match is free money. When you invest up to the maximum percentage, you immediately receive a 100% ROI on the dollars invested. In a simple sense, it is like your employer giving you a raise or extra salary for prioritizing saving/investing for your retirement and ultimately the future.

Pass ‘Go’ and collect your employer match! It is simple.

Find out two things: 1) if your employer provides a match, and 2) the maximum percentage at which your contributions will be matched.

Once you know this, it becomes the basis of your retirement savings. You cannot optimize your retirement plan without taking advantage of the free money/company contributions.

Vesting Schedule

In some cases, an employer does not guarantee the entirety of the matching contributions immediately. Your contributions will always be yours, but the employer’s contribution may be held back for some period of time.

The funds will become available to you over a “vesting schedule” or period of time. Vest is just another word for the word own.

Your employer will make matching contributions each pay period, but you won’t own the entirety of these matching dollars until you are fully vested. If you leave the company, any of the employer's funds that are not vested will return to the employer.

A vesting schedule may look something like “25% each year for four years.”

If your employer contributes $1 in Year 1, then you’ll receive $0.25 if you stay for one year, $0.50 if you stay for two years, and so on. Essentially, the employer is protecting their interests and dollars by not providing a benefit to an employee who leaves unexpectedly or prematurely.

Once you reach 100%, the employer cannot take it back for any reason.

This is generally a disadvantage to the employee because you won’t receive all of the matching contributions/dollars your employer promised to match. If you work for an employer whose matching contributions vest immediately, consider yourself lucky.

The decision tree becomes a bit more complex when contributions don’t vest immediately. How long will you work for the company? Will you receive the full benefit of the company match? Only you can determine the answer to these questions, and even then the future is rarely what we expect.

In the end, it probably still makes sense to contribute up to the employer match, regardless of your employer’s vesting policy.

Roth Contributions

You are probably familiar with the Roth IRA, the king of investment vehicles. Your dollars are contributed after you pay taxes, and any future withdrawals (including the compound growth) will be tax-free.

This can be an advantage to you as the saver/investor, especially if you are in a low tax bracket. It is almost always better to pay less in taxes!

Although your employer’s contributions will always be pre-tax, you may have the optionality to make Roth contributions in your employer sponsored plan.

You won’t receive any current year tax benefits, but the tax advantages in the future are immense.

Not everyone will opt for making Roth contributions. Many people (typically those with high earnings) will prefer lowering their taxable income in the current year rather than waiting until retirement.

Because of its usefulness, you should always take time to consider whether to make Roth contributions instead of the default, Traditional (pre-tax) contributions.

Default Investment

Retirement plans have evolved with time. At some point in the past, the company typically deposited any contributions directly into a money market fund as the default investment. This is the ultimate safety play - there is essentially no risk associated with this type of mutual fund.

Now, companies will invest in a slightly better default option on behalf of the employee. It will still be a conservative choice (probably a balanced fund or a target date fund), but it will actually have exposure to the equity market and its risk/return profile.

You don’t want a risk-averse, compliance-focused company choosing your investment strategy. In order to optimize your retirement plan, you will select mutual funds more aligned with your specific situation and best interest.

Your specific strategy will be based on a few factors, mostly your age or years until retirement.

One of the biggest risks in investing is departing from a predetermined investment strategy when the market is down. You might be tempted to sell while markets are down or unnecessarily modify your strategy

Since withdrawing from an employer retirement plan is a hassle, this temptation to sell out in a down market is mitigated to a degree. Because of this, you might take on more exposure to equities (a typically higher risk and higher reward asset class) and ride the market regardless of its relative position.

Allocation and Expense Ratios

Since you want to optimize your contributions, you will be responsible for modifying the default investment option and choosing a strategy better suited for your goals.

You will be provided with a list of mutual funds. After this, you must decide the fund(s) to use and the percentage of your contribution to allocate to each fund.

The mutual fund options available will be something like “Large Cap Growth/Value,” “Mid Cap Growth/Value,” “International - Large Blend,” or “Total Bond Index Fund,” etc. The specific options may change from employer plan to employer plan, but companies will have the same general options.

If you need help interpreting your retirement plan options and allocating your retirement assets, reach out to a financial advisor. What might take you a few hours to research/put in action will take a few minutes for a good financial planner. They will also help place your employer retirement plan in the greater context of your financial plan.

Each mutual fund available to you will have an expense ratio. The fund company collects a small fee for managing the assets. The fee is expressed in basis points. (A basis point is equal to 1/100 or .01 of 1%. It can also be expressed as true decimal .0001 or percentage .01%)

For the available mutual funds, you will probably see expense ratios from 5 basis points (0.05%) to 150 or so basis points (1.5%). It is difficult to determine an “average” expense ratio because each individual mutual fund has a different management style. Generally speaking, the majority of funds will fall between 0.35% and 0.75%.

Generally speaking, you should select investments with a low expense ratio. The fund’s performance is negatively correlated with the expense ratio (i.e., higher returns with lower expense ratios and lower returns with higher expense ratios).

Contribution Rate

One of the decisions you’ll be required to make is your contribution rate. This is the amount or percentage you will contribute each pay period.

Because you read The Wealth Span, you know to contribute up to the percentage with an employer match, but what about saving/investing beyond it?

At this stage of investing, we must rely on a system or order of operations to determine the optimal decision.

There are many parameters to consider in regards to the quality of your employer sponsored plan.

1/ What is the vesting schedule?2/ What investment options are available to you?3/ What is the quality of the investment options?

If you are restricted in any of these ways, you will probably be better off saving/investing in another vehicle.

There are other parameters specific to your financial circumstances which creates more to consider.

1/ Is it easy or hard for you to save?2/ Are you maxing out a Roth IRA?3/ Do you enjoy making investment decisions?

Once you understand all of these elements, you will have a rough idea of whether to contribute beyond the employer matching percentage or save/invest elsewhere. Only you can know for sure what is best.

If you struggle to save and invest, the automated nature of your employer retirement plan can be especially beneficial. If saving/investing comes more naturally, you may appreciate the flexibility of saving in an IRA or elsewhere.

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TL;DR

When you have access to an employer sponsored retirement plan, it is wise to carefully make selections and decisions.

Automation is a powerful tool and even an advantage under normal circumstances but can work against a saver/investor if improper decisions are made initially.

In the end, a large percentage of your retirement assets will be stored in this type of account. Be sure that you are making the optimal decisions.

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Is your employer sponsored retirement plan optimized and ready to support you in retirement? Take a look at your benefits guide/summary to review your options and compare to this checklist.