The 401(k)-retirement plan was introduced with the hope of solving the retirement benefits problem in the country, but despite being in existence for more than 30 years, the plan has failed to serve its purpose. Brady studied the effectivity of the 401 (K) plan on the retirement benefits of employees and successfully concluded that the 401 (K) is a complete disappointment (1). Using a Monte Carlo simulation, Brady could prove that an individual can have more benefits in retirement (around 20%) from alternative investment than from investment in the 401 (K) retirement plan (33). In an interview, Teresa Ghilarducci- the director of the Schwartz Center for Economic Policy Analysis, assert very distinctively that 401 (k) is such a product that is not designed according to the need of the middle-class Americans. Yet American people invest in the 401 (K) without knowing the actual cost of the investment, as a result, people receive lower retirement income from the investment (Breslow). Various writings on the 401(K) retirement plan benefits identified that the main economic cause for the 401 (K) failure is the information asymmetry. The 401 (K) policy is not instructive and not easily fathomable for the people who are supposed to receive the benefit from the program. On the other hand, the policy has a positive impact on the employer’s income. Another important fact is, the 401 (K) plan requires a higher expense ratio than the regular pension plan and this information is not clearly shared with the people who are supposed to be the actual beneficiaries of the plan. The providers of the 401 (K) retirement plan are also responsible for the failure of the plan, by concealing significant information and providing falsified information to the employees and to the organization the 401 (K) providers create information asymmetry which is a reason for the drastic failure of 401 (K) plan.
Another thing that could be a reason for the failure of the 401 (K) plan is the plan itself the plan offers fewer options for the investors whereas mutual funds offer more options for the investors. The traditional theory of economics suggests that more options are beneficial for an investor, but the paradox of choice suggests that sometimes more options have negative effects on the decision-making process. For many pension participants, it is difficult to decide between many investment options, and several studies proved that number of default investment options aid the decision-making process (Turner & Klein, 5). The study further discussed that offering fewer options than too many options is better for some people. Turner and Klein assumed that probably for this particular reason 401 (K) plan offers limited options for the pension participants (5). But these limited investment options could be an economic reason for the investment plan to experience a higher cost of management and therefore the reason for the loss of investment value. Curtis and Ayres successfully proved that investors of directed 401 (K) plans suffer the loss of investment value due to the decisions made by the fund manager as well as for the suboptimal choices of the investors (2). Besides that, the expense of the 401 (K) plan is a decisive thing to consider as the pension return of an employee is heavily affected by the fees associated with the employee’s 401 (K) plan fees. A booklet published by the US department of labor publications named “A Look at 401 (K) fees” delivers a seamless description of the fees associated with the plan, and generally, the plan involves three different types of fees. The investor of the 401 (K) plan pays administration fees, investment fees, and individual service fees (A Look at 401 (K) fees, 8-9). The booklet of the US department of labor shows that an increase in one percent of the fees in the 401 (K) plans can reduce the retirement income to twenty-eight percent (A Look at 401 (k) fees, 7-8). The investor has to pay the administration fee for receiving various management services from the fund management company, but the administration fees may vary from company to company. Usually, if the fund size is big then the administration expense would be at a lower percentage, and for the small size funds, the investors should be paying a higher administration fee. The investment fee is the major part of the fees in the 401 (K) plan; it is the fee that the investors pay for managing their investment fund. Investment fees depend on the expense ratios of all the selected mutual fund in the 401 (K) portfolio.
To calculate the expense of the mutual fund in an investor’s portfolio multiply the expense ratio by the final balance in that fund. For example, if the investor has $1000 in a fund and the expense ratio of the fund is.45% then the investor would have to pay $4.5 per year as the investment fee for the fund. Numerous financial advisors suggest that an expense ratio less than 1% is the reasonable expense for a mutual fund, but if it exceeds the percentage then investors should reconsider their investment; because the higher expense ratio would reduce the retirement benefit of the participants to a great extent. Another type of fees an investor might need to pay is the personal service fees; it is charged when the investor receives any personal service from the company such as receiving investment consultancy services. The investment consultancy service fees may be charged to the mutual fund if it receives the portfolio construction services from the experts. The most alarming issue related to the fees is the hidden costs; The 401 (K) plan have some hidden costs that are not disclosed to the pension participants, or these costs are explained in such a way that are not understandable to the investors.
To illustrate the effect of the compounded fees let’s consider two different investors who invested their money in two separate mutual funds under 401 (K) plan. Both the investor invests $15,000 yearly and they will be saving the amount for next 30 years, the annual inflation rate is 2%, rate of return is also same 8.15% for both the fund but Mr. A’s fund has an expense ratio of.15% and Mr. B’s fund has an expense ratio of.65%. If we calculate the present value of the payment then we will find that present value of the growing annuity of Mr. A is $204,997 and present value of the investment of Mr. B is $216,301, calculation shows Mr. B pays more than Mr. A due to the higher expense associated with his investment (“Present Value of a Growing Annuity”). According to the “Present Value of Growing Annuity”, the initial payment for both the investor are 15000, the growth rate is the inflation rate of 2%, and rate of return for Mr. A (8.15-.15=8%), and for Mr. B (8.15-.65=7.5%). Consequently, if the investors want to benefit from the 401 (K) plan, then the investors will need to come up with a solution to all the problems with 401 (K) plan. Muller and Turner show that many 401 (K) investors do not change their investment plan when they really should roll over their money into a lower cost pension fund (5-7). It is strongly recommended to the retirement plan holders to roll over the investments if their pension fund has a high expense ratio. The employee and the employer should be aware of all the issues related to the 401 (K) plan, which includes, but are not limited to- understanding of mutual fund, rate of return, costs of the fund, dynamicity of the fund manager, and issues that changes the retirement benefits of the employee of the 401 (K) plan.
Works Cited
United States, Department of Labor, Employee Benefits security Administration. “A Look At 401 (K) Fees”. EBSA Resource Center, Aug 2013. Web.
Brady, Peter J. “Can 401 (k) Plans Provide Adequate Retirement Resources?” Public Finance Review 40.2 (2012): 177-206. Web.
Breslow, Jason M. “Teresa Ghilarducci: Why The 401(K) Is A “Failed Experiment””. FRONTLINE. N.p., 2017. Web.
Curtis, Quinn, and Ian Ayres. “Measuring Fiduciary and Investor Losses in 401 (k) Plans.” 7th Annual Conference on Empirical Legal Studies Paper, 2012, Web.
Muller, Leslie A., and John A. Turner. “The Persistence of Employee 401 (k) Contributions Over a Major Stock Market Cycle: The Limited Power of Inertia.” Benefits Quarterly 29.3 (2013): 51-65. Web.
Turner, John A., and Bruce W. Klein. “Retirement Savings Flows and Financial Advice: Should You Roll Over Your 401 (k) Plan?.” Benefits Quarterly 30.4 (2014): 42-54. Web.
“Present Value of a Growing Annuity.” Present Value of a Growing Annuity – Formula and Calculator. Finance Formulas, Web.