Since the documentary The Retirement Gamble aired on PBS earlier this year, people are more aware of fees in 401k-type plans. In this article, I quantify the effect of a high-cost 401k plan. The result may be quite surprising to you.
First let’s look at a worker with a median income and a median savings rate. Suppose you earn $50k a year and you contribute 6% of your salary to your 401k plan. Your employer matches another 3% of your salary. You plan to work there for five years, which is the median tenure at an employer these days.
Suppose your employer’s 401k plan has a very high cost. Your all-in expense ratio is 3%. How much worse off are you in this high-cost plan versus a very low-cost plan with an expense ratio of 0.1%?
I calculate the dollar impact as the additional money that must be contributed into the high-cost plan every year to make you whole as someone else in a low-cost plan. I do my calculation in today’s dollars, adjusting for inflation.
The answer: $342 per year in today’s dollars. If the employer contributes additional $342 per year for each of the five years you work for it, you will have the same amount of money in your 401k plan with an all-in cost of 3% versus a nearly perfect plan with an all-in cost of 0.1%.
When someone with a median income and a median savings rate is choosing between two employers, the difference between one employer with a high-cost 401k plan and another one with a low-cost 401k plan comes down to just $342 a year. I’m sure other factors such as salary, career growth, job stress, commute time, cost and quality of health coverage, etc. etc. play a much bigger role.
Now we look at a higher-paid employee. Suppose you earn $200k a year and you contribute the maximum to the 401k plan, $17,500 in 2013. Your employer matches another 5% of your salary. You also plan to work there for five years. How much worse off are you in a high-cost plan with 3% cost versus a low-cost plan with a 0.1% cost?
The difference is much larger: $2,090 per year in today’s dollars. It’s something, but still, when you are looking at a $200k job, I’m sure other factors, again, career growth, salary, bonus, vacation time, job stress, commute time, company culture, etc. etc. are worth much more than $2,090 a year. If I’m choosing between one job that pays $200k a year and another that pays $198k a year, I may very well pick the one that pays $198k for those other reasons.
I’m all for lower cost in 401k plans. However, this exercise tells us we shouldn’t fret about it, especially when these days employees typically don’t stay at an employer for that long. As long as you remember to take the money out of a high-cost plan when you leave, the cost of a high-cost plan isn’t really that high. Whether the cost is 3% or 0.1%, contribute anyway. Don’t let the high cost scare you away.
The cost of a bad 401k plan goes sharply up if you are going to work for the same employer for 10, 20, or 30 years. If you are going to work there for a long time, there must be some good reasons; otherwise you would go somewhere else. Those good reasons make you stay. The bad 401k plan just becomes part of the tradeoff for those good reasons. No job is perfect. Remember the good reasons.
If you’d like to double-check my calculation or play with other scenarios, you can use my spreadsheet: how bad is a bad 401k.
[Photo credit: Flickr user deeplifequotes]