401(k) – Did Dave get it wrong?

As many know I am a former instructor in Financial Peace University, the Dave Ramsey Course that has led thousands to a better life through financial discipline.  The FPU program is often held by churches but has been customized for students, military and business audiences.  It teaches budgeting as a family, agreement on spending, planning and saving for emergencies, getting and staying out of debt and retirement savings.

In the past couple of years Dave has been criticized by the investment community for his “simple” approach to choosing mutual funds.  The investment folks would prefer a more diverse portfolio for their clients than Dave advocates in FPU.

Yesterday a newsletter from Dave’s organization addressed retirement savings and 401(k) programs.  Dave stated that employees should NOT participate in their company 401(k) program if the firm did not offer a match, did not have a good diverse platform of investment choices and if the fees were high.

I cannot argue with the need for a good diverse set of investment options nor in making sure the 401(k) plan is providing the lowest possible fees for the fund choices.  These are excellent benchmarks for all employee benefit plans as well as personal portfolios.  What I do cringe at is the idea that an employee would forgo participation in a company 401(k) plan that does not provide a match.

To be fair what Dave Ramsey advised in a no-match plan was that you should first contribute the maximum amount allowable to a Roth IRA ($5,500 if you are under 55 and $6,500 over 55.)  His logic is that you will have more investment options and saving with after tax dollars in a Roth IRA eliminates income taxes on the use of the money in retirement.  If the family had additional money available for retirement savings, then Dave suggests you participate in the unmatched company 401(k).

What Dave does not touch on are the benefits of a payroll deduction to maintain investing discipline, the availability of Roth 401(k) options with many employers and cost of a Roth IRA handled through an investment advisor.  I am a strong believer that payroll deductions are the least painful way for employees to save for retirement.  It is just too easy to let the money go for something else if you can get to it.  Savings into a Roth IRA can be set up through payroll deductions, but it is not as streamlined as a contribution into a 401(k).

I also advocate that firms should include a Roth option in their 401(k) program.  This can often be done by the administrator at minimal additional cost.  Employees should choose a Roth 401(k) if they younger, currently in a low tax bracket and if they believe they could be in a higher tax bracket in retirement.

There is a strong movement among the investment community and its regulators to increase the transparency of fees in all plans.  One tool being promoted is a zero revenue sharing model.  Using this choice, the 401(k) plan would eliminate most 12(b)1 fees that are buried in the mutual fund performance and instead charge the participants a fee that is shown on their performance statement.  Fees today are reported to the IRS and Department of Labor but rarely fully disclosed to participants.  Today the participants see a net return on an investment that has been reduced by 12(b)1 fees.  The 12(b)1 fees are legitimately directed to cover the plan expenses including employee education.

The Department of Labor has been encouraging firms to not only offer strong investment portfolios for their participants with the lowest possible fees, but also to consider automatically enrolling non-participants (forcing them to un-enroll if they choose not to participant) and automatically escalating the employee’s deduction to force increased savings.  The Department is deeply concerned that individuals are not saving enough to fund their retirement and they want employers to help educate the employees to improve the current retirement savings patterns.

While I am a believer in the benefits of Financial Peace University, I have to differ with Dave Ramsey on avoiding a no-match 401(k) plan in favor of first investing in a Roth IRA.  There are costs to investing through an investment manager.  It is important that the investor compare the fee structure in both cases AND the benefits of payroll deductions before opting out of a company 401(k).

photo credit: 401k via photopin (license)

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