When 401(k) Plans Fail

The 401(k) Question

Last week’s column measured the net advantage provided by tax-sheltered accounts. It compared the aftertax outcomes for two portfolios that were held for 40 years. Each investment gained 8% annualized while making the same amount of income distributions, but one was placed in a taxable account while the other went into either an IRA or 401(k) plan.

Broadly speaking, the tax-sheltered accounts made their owners 35% wealthier. (The amount varies according to the portfolio characteristics.) Their investors eventually paid more taxes than did the owners of the taxable accounts, because their IRS bills were assessed at the higher ordinary-income rate rather than the lower capital gains rate. But because they were tax-protected, those accounts had so handsomely outgained their taxable rivals that they easily won the contest, despite their IRS obligations.

That was plenty of material for a single column. As readers reminded me, though, it was hardly the last word about the benefits—and potential drawbacks—of tax-sheltered accounts. Among the many topics they raised was the effect of 401(k) expenses. (Another common refrain was that I had ignored legacy issues, because assets from 401(k) plans don’t receive a step-up in cost basis upon the retiree’s death. Both are true: I did choose not to address inheritances, and 401(k) assets are indeed unattractive for that purpose.)

My example assumed identical returns for the taxable and tax-sheltered portfolios. That’s an appropriate premise for IRA accounts, which are routinely offered for free. But most 401(k) plans have additional costs. At what point do those fees negate the plans’ tax benefits?

The Starting Point

To address that question, I revised my model. Instead of considering a single investment with a 40-year time horizon, it assesses the ongoing actions of a worker, a single filer who contributes 7% of her income into a 401(k) plan from ages 25 through 34 before increasing that rate to 10% from ages 35 through 64. Her rate of investment return, as before, is 8% annualized.

Our subject’s income ranks in the 90th percentile, which means a beginning salary of $81,818 and a peak salary of $160,000. (All figures are expressed in current dollars.) Early in her career, she places in the 22% tax bracket, then graduates to the 24% bracket. Her long-term capital gains tax rate is 15%.

The calculations assume that she remains in the 24% tax bracket while in retirement. As that bracket covers single incomes ranging from $95,376 to $182,100, which translates to 59%-114% of her final income, that is a highly likely outcome. (Of course, the tax code will surely change during those four decades, but nobody can model the IRS’ future.)

The base case makes two further stipulations. First, the 401(k) plan is unusually cheap. The company absorbs the plan’s recordkeeping fees, and the investment lineup—the other component of 401(k) costs—consists of institutionally priced index funds. Thanks to these features, the 401(k) plan’s portfolio costs the same as the taxable account. The second premise cuts in the opposite direction. Unlike most plan sponsors, the company offers no 401(k) match. The participant receives only the fruits of her labors.

The chart below shows the aftertax benefit conferred by the 401(k) plan under these conditions, for 1) a stock market index fund and 2) a low-turnover balanced fund. The chart’s figures represent the percentage of improvement. For example, after all taxes are paid, the 401(k) account that holds the balanced fund is worth $2,205,971, as opposed to $1,691,177 if that fund had been held in a taxable account. That makes for a 30% improvement.

As expected, these figures are lower than those cited in last week’s article. The gain from a one-time, 40-year investment in the balanced fund was 44% and the stock market index fund 30%, as opposed to today’s findings of 30% and 22%, respectively. (The increase with the balanced fund is larger because it is less tax-efficient than the stock fund, and so it therefore benefits more from tax protection.) That said, the 401(k) structure remains very useful.

Test 1: With 401(k) Fees

As 401(k) plans typically have higher costs than self-directed brokerage accounts—financial advisory fees are another matter, but they lie outside the scope of this article—this exercise overstates the plans’ benefits. A realistic comparison would dock 401(k) plans by 0.50% per year, the median participant price. That, of course, is merely an average. Small plans may charge as much as 1%, while multinationals’ plans can be as low as 0.25%.

The following exhibit plots that range, showing the advantage (or not) for 401(k) plans assuming their annual expenses are 0.25%, 0.50%, 0.75%, and 1% higher than those of a taxable account.

That’s less pleasant. Once costs rise above the norm, as represented by the yellow and red bars, the 401(k) benefit for a low-turnover equity investor pretty much disappears. Although the threshold for the balanced-fund investor is higher, at the 1% red bar, many smaller plans charge that much. The good news for such participants is that the 401(k) structure makes saving easy and automatic. The bad news is that while they might believe they are receiving a tax benefit, they really are not, once expenses are considered.

Test 2: With 401(k) Fees and Employer Matches

Fortunately, this analysis is incomplete. I addressed the dark cloud of 401(k) plans but not the silver lining of employer matches. According to the Investment Company Institute, 90% of 401(k) participants receive some level of company contribution. Determining the match size is difficult, but the largest 401(k) provider, Vanguard, reports an average amount of 4.4%.

Less than that is required for 401(k) plans to earn their stripes. The next chart shows the aftertax advantages for 401(k) plans with 1% costs, assuming employer-match programs that range from 1% to 4%, with the original no-match situation shown in red. Even these relatively small matches, each of which is below the national average, restore the 401(k) plan’s advantage.

One slightly worrisome note is that although 90% of overall participants are eligible for a company match, that figure drops to 68% for small companies—which are also the likeliest to offer plans with high expenses.

Conclusion

The claim that the additional expenses of 401(k) plans consume their tax benefits is more theoretical than actual. Although it’s true that an extra 1% per year changes the math, it also holds that in most cases 401(k) participants receive more money from their employer than they forfeit in plan costs.

Another way of phrasing the issue is that US companies spend about $250 billion per year on their 401(k) plans, while the federal government forgoes a similar amount in tax revenue. Admittedly, some of that $500 billion is spent on plan fees, but most lands in the pockets of 401(k) participants. The industry creates far more successful outcomes than failures.