Limitations and Risks of 401(k) Plans

401(k) Plans Have Prescribed Investment Strategies

In spite of how popular the investment strategies required for inclusion into 401(k) plans are, this does not mean that we should not closely examine what risks are involved, and take such things into account when deciding where and how much we’re going to put into particular retirement funds.

There are two big reasons to prefer putting money into a 401(k) over anything else, with the first one being the much larger contribution room that a 401(k) offers over an IRA account. This may or may not be an issue with us, and often times the maximum contribution amounts with an IRA will be plenty sufficient for us to contribute all we can afford to or decide to set aside for our retirement.

The big one with 401(k)s is having our contributions matched by our employer. While not all employers offer this, most do, and they have actually set aside part of our compensation for this purpose. To turn this down means that there is money that they are willing to pay us that we are passing up on, and such things should only be done with very careful thought and sufficient justification.

While we certainly are not limited to choosing one type of retirement account exclusively, and many people have both 401(k) accounts and IRA ones, and most people who have IRAs also have access to a 401(k). Within these two main categories, each have a regular and a Roth option, so there are some real choices here that we can make.

Aside from the bigger limits and the ability to have your employer contribute money to your savings plan for you, 401(k)s also have very limited investment options. A 401(k) will generally just offer a few of them, and all involve mutual funds that are committed to being long the market only, and will also stay close to fully invested at all times.

This means that having our money in a 401(k) will always expose us to market risk, and the full measure of it, because there is no hedging here. If the market tanks, we’re stuck with it, and if it takes many years to recover, so will our 401(k) account.

The Effects of Market Risk

Many people lamented, for instance, during the market selloff of 2008, expressing a lot of angst that their retirement plans may be dashed now. As it turned out, the market did recover over the next few years, and now stands much higher than it was before this selloff, but this does not mean that there aren’t risks along the way, even when things recover completely.

Money invested in 2000, for instance, required a full 15 years to see the market return to these levels after adjusting for inflation, and most mutual funds underperform the market, so we would expect a loss even then. Markets have always eventually recovered, but sometimes they take a long time, like it taking 25 years to regain the highs set in 1968.

It is not that uncommon in fact to go through a period of 20 years or more and see the stock market lower than it was 20 years ago when adjusted for inflation, and we should always be looking at inflation adjusted charts since this shows how a constant dollar amount changes over time.

The strict rules and penalties involved with 401(k) plans do have people staying the course a lot more than if they had more latitude, and unless one is skilled enough to effectively manage their own investments, this can be a good thing and a very good one at that. Proper portfolio management requires that we do not let our emotions affect our decisions, and instead make sure that we are acting rationally, which does not mean acting out of sheer fear like so many people do.

If we do have the ability to direct our investments more, and especially to look to have our money in things that have positive prospects in the nearer term, we’re not going to be able to use any of these skills with a 401(k) account, because we are either in or out, there is no in between.

We very often speak of the buy and hold approach as being the safest approach out there, and categorize any attempt to time markets as being riskier and even far riskier, but this arises out of a fundamental misunderstanding about the nature of markets. The risk involved with the buy and hold approach is actually very high, the highest on a per position perspective anyway, because there are no risk controls at all present, nothing to stop us having to endure whatever the market may throw at us.

There is more than market risk out there though, and if we look to manage our own portfolios, there’s also the risk that we’ll screw things up if we don’t know what we are doing, and properly timing markets takes quite a bit of skill and discipline actually. We can do ourselves some real harm here if we are not careful, especially when we let emotions guide our decisions rather than informed market analysis and proper risk management controls.

The Irresistible Appeal of Extra Retirement Money

If we get our contributions matched dollar for dollar, or even at 50%, by our employer, this is going to go a long way to offset the market risk that the funds that they invest in involves. If the risk is seeing our investments lose half their value for instance and we are receiving a 50% premium up front by way of matching contributions, this in itself will handle the risk.

If we are unhappy with the particular funds that are offered by our 401(k) plan and would prefer to select from a wider range of funds, the fact that we’re getting this premium will be way more valuable than any advantage we may have with fund selection, which will be rather small actually.

It is going to take a lot to have us wanting to do something else with our money that does not involve receiving this contribution matching, and while we may imagine a more liberal structure like that used with IRAs, where employers contribute the funds to us directly and we then direct them toward a much wider range of investment choices, this could provide the best of both worlds, but this isn’t the way that this is done presently.

One of the reasons why we do see these limitations is that the IRS passes on most of the administrative work to the employers, which lowers the cost to the government, and this has thus far been the preferred option. If enough people complain, then we might see changes here, but presently, few people care enough about such things and there just isn’t much interest in lobbying for any of this.

The scheme of 401(k) accounts with their risks and limitations mirrors pretty close what the vast majority of investors would be doing anyway, especially if index funds are offered within their 401(k). Given all this, even if we are able and willing to play a more active role in our investments, the great appeal of the matching contributions will simply win out in the great majority of cases and people will not choose to give this up to pursue other strategies, nor should they.

This does not mean that we should not look to mix this up a little, for instance setting aside some of our contribution amounts and putting them in an IRA, which gains the additional flexibility but loses the matching benefits.

Hedging Strategies for 401(k)s

If we aren’t receiving matching from our employer at all though, this will change things and in this case there’s no upside to the 401(k) beyond the greater contribution limits. We should then prefer to max out our IRA contributions first, and then use the 401(k) only for excess amounts if we have any interest at all in taking advantage of the extra flexibility that IRAs provide.

If you switch jobs, you can roll over 401(k) money into an IRA, and if we roll over to a traditional IRA, we can keep the money tax deferred while opening up more options to us to hedge.

IRAs allow us to not only invest in a wider range of mutual funds, a fact that really isn’t that significant actually since mutual funds do tend to be pretty similar in nature, they also allow us to invest in ETFs and even hedge our positions with options.

Hedging with options is a fairly complex situation that does require some real knowledge about how to do this properly though, and really should be left up to those who really know what they are doing, but hedging with ETFs is something that average investors can gain a good understanding of without a great deal of difficulty.

IRAs also allow us to invest in single stocks, even though for the great majority of investors this is not something we should get into without the requisite skill, and even those who are highly skilled and are very successful traders will often choose to trade indexes over specific stocks due to the higher liquidity and lower volatility of indexes.

One of the real beauties about the emergence of ETFs is that it allows everyday investors access to index-based securities or baskets of them without having to delve in the futures market or purchase them individually. We also don’t have to just go long with these as inverse ETFs allow us to bet on markets declining and profit from bear markets, even within an IRA.

This is all well beyond what you can do with a 401(k) though, and if you stand to benefit from matched contributions from them, you’re going to need a big advantage to want to choose to direct your investments more with an IRA, as the benefits of matched contributions are significant indeed.

This does not mean that there isn’t a time and place for this strategy even with matched contributions, where we may look to hedge our main investments at various times by having certain amounts in an IRA which we can look to reduce our risk by using inverse ETFs.

If we can roll over amounts from a 401(k) to an IRA, money that our employer has contributed to but we are now with a new employer, it makes perfect sense to do so, instead of just having all of this money go into a new 401(k) account.

Once we retire, the benefits of employer contributions completely go away, and at this point, an IRA is going to be clearly the way to go if we are looking to tinker with things. We may not care about such things though and have no preference here, and most investors do not, but there are other reasons why we still may want to roll over the money into a Roth IRA as soon as we can after we retire.

While 401(k)s have certain limitations and risks, the sheer benefit of the matching will be more than enough to compensate for this. Once the contributions stop though, the game changes, and when the native inferiority of the 401(k) structure becomes the only real difference, we are then freed to explore other options as appropriate.