Rowling & Associates Blog

Employer Plans: Avoiding Costly Mistakes

by Josh Clavell

Most workers have a significant portion of their assets in their employer plans. It is great to see so many people saving from every paycheck for their future, but there could be some costly mistakes that could derail your worry-free retirement. Here’s what to watch out for.

Forgetting about the free money

Did you know that over half of the employees who were automatically enrolled in their plan are not contributing enough to receive a full match? In other words, don’t just assume that the default contribution settings are maximizing your benefits. You should never leave free money on the table. If your employer offers a match, you should be contributing, at the very least, the minimum to get the maximum match. There are a bunch of possible pitfalls with maxing your match, so we will refer you to this well-crafted Forbes article which should cover most of the ways people miss out on their match.

Assuming you don’t have to make decisions

One of your most important decisions is in the investment of your assets. Until 2006, most default investment options were into Money Market Funds which meant retirement accounts were just sitting in cash! ERISA, the Employee Retirement Income Security Act which regulates employer plans, requires the managers of these plans to be fiduciaries. Prior to 2007, these managers were liable for negative investment outcomes when the participant failed to select the investments, so naturally, to avoid legal risk, they invested in the safest vehicle they could. The Pension Protection Act in 2006 relieved this responsibility so long as the participant was invested into a qualified default investment alternative (QDIA). Although this is much better for investors than before, the majority of QDIAs today are Target Date Funds (TDFs), which come with their own flaws.

Investing in Target Date Funds

JP Morgan estimates that 88% of new retirement plan contributions are expected to flow into TDFs this year. TDFs ask the investor to pick the closest 5-year retirement date: 2020, 2025, 2030, etc. This simplicity is clearly the reason for their popularity. The good news is that a TDF is a diversified vehicle that will scale back the risk/reward as you approach retirement. You set it and forget it, and the fund managers do the rest. However, there are numerous reasons why they might not be as great as they seem. For one, their inherent assumptions are tailored to a generalized population, which means they will probably not be in line with your personal risk appetite at a certain point. Additionally, there is not a set standard for how a TDF is managed. Two TDFs with the same retirement date might have completely different levels of risk and potential growth based on the opinion of the management team. Furthermore, there are many fund managers who can only select the underlying investments from a single mutual fund family, some of which might be historically underperforming. Finally, the underlying fees you are paying to the management team might be significantly higher than alternative investment options within your plan.

Trying to beat the market

Two-thirds of all investments in employer plans are in mutual funds, but some people get the idea that they can grow their retirement accounts and beat the market by picking stocks. There are many articles out there about failproof plans to grow your 401(k) and beat the market. If it sounds too good to be true, it is. Individual investors rarely outperform the market because we are all wired to be emotional investors who sell low and buy high. Investing in low cost mutual funds in your retirement accounts is the way to go. If you don’t know where to start or are not the do-it-all-alone type, get some unbiased help with the investments from a professional.

Tapping into your retirement early

Since employer plans are often such a big part of the modern household’s portfolio, it’s imperative that they grow with the power of compounding throughout your career. There are very few instances in which you should ever need to take an early withdrawal from your retirement plan (before 59 ½). By doing this, you are not only depleting your future nest egg – you are passing up future tax-deferred gains and will pay immediate taxes and a 10% penalty on top of that (if you don’t qualify for a hardship or other penalty-free reason). We encourage everyone to establish an emergency fund, so that you never have to fund the present at the cost of your future.

Overlooking the risks of loan utilization

According to an employer plan loan study conducted in 2015 by the National Bureau of Economic Research, at any given time, 20% of participants had an outstanding loan and during the entire study, almost 40% of all participants utilized a loan. Clearly, many people tap into their employer plan when they lack a better option for a loan. Here’s how it works. Imagine you moved to San Francisco last year to take a higher paying tech job. In order to move there, you used all your equity in your old home to put a hefty down payment on a Bay Area fixer upper. You rolled your old 401(k) over to your new employer plan and your current balance is $250,000. You need $50,000 to remodel part of your home and you no longer have home equity to secure a bank loan. You decide to take a loan against your 401(k). $50,000 is sold out of your investments and given to you. You will automatically pay yourself back in 5 years with interest. Although your investments were cashed out, as you pay off the loan your assets are growing with the interest and reinvestments. Additionally, your plan allows you to continue to make your normal 401(k) contributions (not all plans allow this while you have an outstanding loan). You even continue to receive your generous employer match along the way. Everything is working out perfectly. But what happens if you’re a casualty of a job cut? Prior to the Tax Cut and Jobs Act, you would only have 60 days to repay the loan. Now, you have until your next tax filing to repay the loan or it is considered a taxable distribution subject to a penalty if you are under 59 ½. The same study mentioned above found that an astounding 86% of all borrowers who left their firm with an outstanding loan balance defaulted. Although the new law is a little more lenient on the repayment period, it might still be incredibly tough to pay off a sizeable loan in such a short window, especially if you just lost your job. You need to consider these risks.

Not having an exit strategy

Mistakes can happen when you leave a company. Many people don’t think about what to do with their retirement assets and just leave them in the employer plan. Unfortunately, once you are terminated, your employer can start charging you administration and management fees that you might not have been paying while an employee. These can add up over time. Additionally, if you had limited investment options or the account was automatically managed for all employees, you will be stuck with either these limited options or the lack of investment control. A better option might be to roll the assets into your new employer’s 401(k) if the investment options are better. You get the benefit of increasing your vested balance if you’d like to take a 401(k) loan at some point. Additionally, the assets stay in an employer plan which is better protected against bankruptcy, creditors, or lawsuits compared with an IRA. If the legal protection is less of a concern and you don’t think you might take a 401(k) loan, the most preferable option would be to open an IRA and invest these assets either by yourself or with a fee-only advisor. You will have access to many more low-cost options, maintain complete control over your account, and be ready to perform a Roth conversion should an opportunity present itself. If you decide to rollover your employer plan to an IRA, we recommend doing so via direct rollover so you will not face any time constraints in the handling of the assets.

Asking for help

As you can see, there are a lot of potential pitfalls when it comes to your employer plans. Each plan has a unique set of rules, matches, fees, investment options, loan arrangements, etc. Sometimes it is hard enough just starting a new job and you might not have the time or mental energy to set up your contributions or pick your investment options. If you want to do yourself a favor, schedule a meeting with a fee-only advisor and let them worry about the complications of your employee benefits.