Do people really understand their 401(k) plans? The answer, according to certified financial planner Robert Braglia, is — in two words — “absolutely not.”
But that’s not, for the most part, their own fault, said Braglia, president of American Financial & Tax Strategies.
“People want to know more and understand, but most of the information they can access is from the vendors who have a single point of view at best and a vested interest at worst,” he said.
A few of the misunderstood 401(k) plan aspects Braglia cited include:
- The “automatic” option: People often assume that it must be a good choice for them because it was developed by someone with expertise.
- Expenses: While an employer may have chosen a high-cost plan, the fund options often have a wide range of expenses, and sometimes employees are swayed by higher-cost funds with fancy names.
- Available options: Employees don’t realize that plans often have a ‘self-directed brokerage option’ through which they can buy, for example, low-cost index exchange-traded funds.
- Employer stock: Not a good idea, because typically they will be over-concentrated in this from programs such as stock options, restricted stock grants, payroll-deduction stock purchase plans, etc.
Leon LaBrecque, CFP and managing partner and CEO of LJPR Financial Advisors, pointed to a “universality of financial ignorance.”
“I can assure you that for the most part, people clearly don’t understand their plans,” said LaBrecque, who is also an attorney and certified public accountant. “This knowledge gap starts at the simplest level and goes to the complex.”
He said he uses tax analogies to explain certain 401(k) plan benefits to plan participants.
“Everyone doesn’t understand that a pretax contribution is a write-off to yourself,” LaBrecque said. “It’s the world’s greatest tax shelter.
“Unlike a mortgage, where you pay the principal and write off the interest, with a 401(k), you’re paying yourself and also writing it off your taxes.”
“I’ve also heard people say, ‘I started late, so now I need to invest aggressively. This sounds good on the surface, but the closer you are to retirement, the less volatility you should have.”
Instead of over-withholding to get a refund, LaBrecque advises clients to take more exemptions and put the excess in their paychecks into the 401(k) plan. In this way, they are giving their money directly to themselves instead of waiting for it to be returned to them in the form of tax refunds.
Daniel Galli, CFP and principal of Daniel J. Galli & Associates, has found that a high number of participants in larger companies do understand the benefits and do utilize the plans. However, he still sees participants making common mistakes related to loans and withdrawals.
The key is education, he said. There are two concepts employees find especially challenging: 401(k) plans as savings vehicles and how they should invest in them.
Employees often look at the market as savers who want complete safety, instead of investors with a longer view and willing to accept market fluctuations, Galli said.
He said he has frequently observed employee misunderstandings, such as not realizing they don’t have to roll over their 401(k) plans when they leave a given company; thinking they’re maxing out their plans when all they’re doing is just matching the employer’s contribution and not putting in the maximum allowed; and putting more emphasis on fees than on the investment value of a fund option.
“I’ve also heard people say, ‘I started late, so now I need to invest aggressively,'” Galli said. “This sounds good on the surface, but the closer you are to retirement, the less volatility you should have.”
Most people understand the basic need for saving toward retirement and the basic logistics of contributing to a 401(k) plan, said Roy Janse, CFP and managing partner at DeHollander & Janse Financial Group.
Employees often miss all the details, he said, such as automatic rebalancing, brokerage account options and whether to use the tax-deferred or Roth 401(k) option.
Janse believes there is not enough proper participant education, especially during the sign-up period, when participants are flooded with a stack of paperwork or canned presentations. Frequently, they either do not have the time or do not make the time to review the information properly.
In addition, there’s too much financial jargon and not enough personalized information available, he said.
Many companies understandably employ a lot of automated services to streamline their processes and leverage economies of scale, Janse said. But every participant has a unique situation and specific information needs.