Investing PART 11: The dreaded 401(K), what good is it?

Like the song says: “Don’t it always seem to go that you don't know what you got've ’til it’s gone”

Investing PART 6 of this series stated: “These comments should provide a hint at how I suggest you incorporate your 401(k) into your portfolio, but that’s a topic by itself.” Yet, other postings have mentioned a dislike of mutual funds. One summarized my thinking with the statement “The only thing that is more dangerous than advice is letting someone else manage your money.” But, you say: “401(k)s pretty much limit the options to mutual funds and add a layer of someone else managing your money in the form of the plan administrator.” So, it is quite legitimate to ask how I square that circle with the defense of 401(k)s in PART 6.

Some people view 401(k)s as investment vehicles; I don’t. They are an excellent accumulation vehicle. As explained in PART 6, the 401(k) is an almost unbelievably good deal as an accumulation vehicle. It follows that absent some important offsetting consideration, one should “max out” one’s 401(k) contribution. That’s not to say they’re a substitute for all other savings and investment vehicles. One needs some “money in the bank,” and the Roth IRA is a good enough deal to rival a 401(k).

Schwab just published some interesting data in ON INVESTING, “factoids” if you will. The factoids are from a study of Schwab clients. Seems the portion of 401(k) participants who reported changing their contribution rates after receiving professional advice was 70% and the average increase was 100%. Now, the sample isn’t scientific and the study was far from a double blind experiment. Nevertheless, it strongly hints that people underestimate what they need to save, and once they realize they need to save more, they recognize how valuable a 401(k) is as a method of saving. I only wish it showed that people were realizing that whether one is saving enough for retirement is irrelevant; a 401(k) is too good of a deal to pass up.

An interesting side issue is how to treat a 401(k) if you also have a pension and have access to a 401(k)-type program. I’d just reiterate that a 401(k) is a good deal, period. That’s true regardless of what anyone else promises you. Further, pensions have some major drawbacks. It seems to me that turning your money over to a Wall Street pension manager because someone on a committee believed him when he said "trust me" (or if it's a public sector pension, got their palm greased with a campaign contribution) is foolish. Plus, an employer-sponsored pension increases risk since both employment and retirement are dependent on a single organization’s management judgment. That’s a level of concentration that is worth worrying about.

Give me a 401(k) where I have some control any day. If one has a pension, great, but it’s no excuse for ignoring a good deal like a 401(k). The big advantage of pensions is they're mandatory. They're great if they're funded, but they're seldom adequately funded because everyone involved has an interest in keeping funding cost down. Thus, they become a crap shoot, a Ponzi scheme if you will. Not what I want for retirement.

There is an important implication of viewing a 401(k) as an accumulation vehicle rather than as an investment vehicle. Once contributions are over (e.g., one is laid off, switches jobs, or retires), a rollover out of the 401(k) into an IRA should be the default. There can be offsetting considerations that could be decisive, but the 401(k) doesn’t get the benefit of the doubt.

The 401(k) could offer some compelling investment options not available or replicable in an IRA. That’s rare, but possible. The other two more common justifications for staying in the 401(k) are things that counter balance its inferiority as an investment vehicle. The 401(k) could offer some major tax advantages like a markedly different tax basis. If the exit from employment is into retirement, the tax basis could matter to someone with both a 401(k) and an IRA. Finally, the difference between how IRAs and 401(k)s are treated in a litigation could mater. But, generally IRAs are the default purely from the perspective of which is the better investment vehicle.