Are 401(k)s worth it anymore?

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Hanna Horvath, CFP®

Hanna Horvath, CFP®

Managing Editor & Certified Financial Planner™

Hanna Horvath, CFP®, is a certified financial planner and former managing editor at Policygenius. Her work has also been featured in NBC News, Business Insider, Inc. Magazine, CNBC, Best Company, and HerMoney.

Published September 10, 2020 | 5 min read

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Featured Image Are 401(k)s worth it anymore?

Most workers today have the option to join a 401(k) plan, a do-it-yourself approach to retirement saving. These retirement plans have been popular for the past 40 years, but some experts say there are better ways to save.

Wondering if 401(k)s are still worth it? Here’s what you need to know.

An extremely brief history of the 401(k)

The 401(k) retirement plan was established in 1978, gaining popularity in the 1980s. Over the years, these plans replaced many chronically underfunded pension plans, which paid a predefined retirement benefit when workers retired. Unlike pension plans, 401(k)s have no defined benefit. The responsibility is on the worker to save. Employers work with financial institutions to manage the funds, and can contribute a “match” of their own to employee savings.

“Pension plans became just too challenging for employers to manage,” said Donn Hess, senior vice president at Lockton Retirement Services.

There are two primary benefits of 401(k)s: long-term tax savings and potential employer matching. Contributions reduce your income, decreasing your tax burden. Earnings in 401(k)s can build up exponentially, thanks to compound interest. You also won’t pay taxes on the investment gains.

Savers can meet their retirement goals with the help of employer matching. Experts recommend saving 15% or more of your pre-tax income for retirement, and the average employer 401(k) match reached 4.7% of an employee’s salary last year, according to Fidelity.

If you’ve been lagging behind the savings benchmark, a match can make up the difference, said Dann Ryan, certified financial planner and managing partner at Sincerus Advisory. Around 10% of employers cut matching during the pandemic, but many plan to reinstate it as soon as financially possible, based on a report by Fidelity.

But some experts still think 401(k)s are overrated.

Is the 401(k) dead?

The main argument against 401(k)s is that they don’t adequately prepare workers for retirement, given so many are behind on savings. A 2019 study found 75% of 401(k) savers won't have enough to maintain their lifestyles when they retire.

401(k)s also aren’t free: Most come with administrative fees or service charges. The average 401(k) plan fees total 1% of assets held, according to data from the Center for American Progress. Like savings, costs compound over time. The Department of Labor offers this example:

Let’s say you have 35 years until retirement and a 401(k) account balance of $25,000 with 7% returns and 0.5% in fees. Your account balance will grow to $227,000 at retirement, without any additional contributions. If your fees are 1.5%, however, your balance will grow to only $163,000. The 1% difference in fees reduces your account balance at retirement by 28%.

Some experts, including Aaron Brown of Bloomberg, argue zero-cost index funds are a smarter option. These passive funds track a broader diversified market, and have minimal fees because they aren’t actively managed. While you can invest your 401(k) in index funds, not every employer will offer the most affordable option with the highest return. Investing in through a brokerage or individual retirement account can mean lower fees, a wider selection of investments and potentially higher yields.

Why 401(k)s are still smart

It’s not fair to blame the 401(k) for the larger problem of Americans chronically under-saving for retirement, said Hess. In fact, 401(k)s could be the only thing helping them save anything at all. He argues plan features like automatic enrollment, automatic saving increases and default investment into diversified portfolios set savers up for retirement better than going at it alone.

“None of those features 401(k)s offer are proactively available on do-it-yourself savings platforms unless the investor independently seeks them out, in which case, he or she was probably already on the way to healthy savings behaviors anyway,” he said.

There are additional benefits to 401(k)s. Employers have a fiduciary duty — a legal responsibility to maximize their employee’s returns, said Hess. Withdrawal fees reduce the temptation to withdraw savings for something else.

“401(ks) are a great place to save, because you lose access and lose control of your savings,” he said. “People are often challenged by having too many investment choices, and those who make their own selections tend to underperform. You want your money locked up and growing, undisturbed, for retirement.”

How to get the most out of your 401(k)

Stock market volatility can erode retirement savings. If you’re close to retirement age, consider shifting your assets away from stocks to less volatile investments like bonds to protect your money from additional fluctuations. Younger savers have time to recover from losses.

While it may be tempting to stop contributing to your retirement during times of financial stress (or even taking a withdrawal), resist the urge. You could miss out on valuable future gains if you stop putting money in. If you’re able, contribute more: Just boosting contributions a percentage point can lead to big gains over time. And if your employer offers 401(k) matching, take advantage of it, or else you’re leaving money on the table.

Other ways to maximize your retirement plan? Avoid withdrawing funds early (and let compounding interest do its thing). If your employer offers multiple investment options for your 401(k), pick funds with low fees.

If you leave your job, don’t forget to roll over your 401(k) into an IRA — you’ll have more investment options and lower fees. We have a guide here.

Some experts, like Ryan, suggest rebalancing your account, a way to manage risk by changing the makeup of your portfolio. Let’s say your retirement plan contained 60% stocks and 40% bonds. If the recent bear market shrunk the stock portion of your account to 50%, you should consider rebalancing by buying equities and selling bonds, he said.

Hess isn’t so sure.

“Should you rebalance as part of your regular savings plan? Yes. Should you rebalance in response to the market? No,” he said. “Don’t change your strategy based on emotion, when the historical data shows differently.”

Image: Serhat Beyazkayah