EVERYTHING YOU EVER WANTED TO KNOW ABOUT 401(K)s* *BUT WERE AFRAID TO ASK WHAT HAPPENS TO YOUR PLAN IF YOUR COMPANY GETS TAKEN OVER? IF YOU'RE LAID OFF? SUPPOSE YOU GET DIVORCED? AND IS DOLLAR-COST AVERAGING REALLY THE WAY TO GO? HERE ARE ANSWERS FROM THE GUY WHO INVENTED 401(K)s.
(FORTUNE Magazine) – WHERE BETTER to go for answers to the big questions about 401(k) savings plans than to the man who created them? No, this financial innovator isn't a Wall Street rocket scientist, although providing investment management for 401(k) plans is one of the hottest areas in the money business. Nor is he a political type, though the growth of 401(k) plans has led to increased savings and vast amounts of capital formation--major goals of Washington for years. The man who changed the retirement plans of millions of Americans is R. Theodore Benna, 53, a mild-mannered benefits consultant. In 1980, Benna created the first 401(k) savings plan for his own consulting firm, the Johnson Cos. Retirement planning will never be the same.
Ironically, because 401(k) plans are a great idea, and general ideas cannot be patented, Benna has made relatively little money from his brainchild. He lives modestly and works out of Langhorne, Pennsylvania, near Philadelphia. A deeply religious man who serves on the board of a seminary, Benna says 401(k)s were, literally, "a heavenly inspiration" (see box). For his worldly answers to more worldly questions, read on.
Which is better, a good defined-benefits pension plan or a good 401(k)?
A defined-benefits plan guarantees a fixed monthly payment when you retire. Defined-contribution plans, of which 401(k) is the most important, guarantee nothing. What you get when you retire depends on how much you put in and how well you invest it.
The plan that is better for you depends on where you are in your career, and how often you think you will change employers. A defined-benefits plan builds up slowly, and most of its worth comes in the later years of your employment. So it's most valuable to the employee who stays for the long haul. But the value of a 401(k) plan grows according to how your investments do (see chart, "Why 401(k)s Are Better"). Plus, you can take your 401(k) with you when you go to a new company. You can't do that with defined benefits. If you're old and likely to stay put, traditional pensions are good. If you are young and mobile, 401(k)s are superior.
But I've read about rip-offs in 401(k) plans lately. Should I be worried?
No, but be alert. The Department of Labor is investigating some 300 plans out of about 250,000 because some employers are not depositing employee contributions in 401(k) plans quickly enough. Fortunately, this is not a problem at the overwhelming majority of plans. If you're getting your statements on time, you can feel confident that your money is going where it is supposed to. If you are not, ask your employer why.
Is my 401(k) contribution exempt from Social Security taxes?
No. Fast answer. And many local municipalities also tax 401(k) contributions. (Pennsylvania is the only state that does.) So while a 401(k) is a great break on federal taxes, other taxers have their thumbs in the pie.
Is there a way for participants to know what their plan expenses are?
Not as a matter of course, though that may sound astounding. There is no legal requirement that all the plan expenses have to be laid out and clearly identified to the participants. If the 401(k) offers registered mutual funds, you can find out the investment management fee by looking in the fund prospectus. But that's only a piece of what you pay. We get a good many calls from plan participants and subscribers about this issue, and we see a high level of frustration in people trying to find out what the expenses are and who is paying them. Sometimes, larger plan sponsors have a handle on the costs, but there are so many different ways to pack the fees into the plans that it is very difficult for anyone to know exactly what 401(k)s cost.
How much information is my employer required to give me about my 401(k)?
Legally, the employer is required to distribute a summary plan description to each participant. This includes who is covered, what the eligibility requirements are, what the vesting arrangements are, how much employees may contribute, what the company's matching policy is, and details regarding benefits payouts. Companies also provide an annual statement, but there really aren't any detailed rules about what information should be included and how it should be presented. Then there is a requirement to provide a summary annual report, which is a couple pages of information about the plan as a whole--the total amount of money in it, the total amount of contributions, stuff like that, which isn't very useful to individuals.
Why don't employers give employees more advice?
Employers are afraid employees could misinterpret or misapply information they provide, and that they could end up in a lawsuit. The Department of Labor is supposed to issue guidelines about when education becomes advice, which would help employers deal with this problem. Those guidelines are due out in January. Personally, I am skeptical of when we will get them. There are some 20 million plan participants. They range from rookies just starting out to people at, or close to, retirement who have six- and seven-figure account balances. Writing guidelines to cover that spectrum will be very difficult.
Suppose my employer and I disagree about the balance in my 401(k) account.
Under Erisa every plan must have a formal claims procedure, which doesn't get utilized very often. The claims process does, by the way, have to be included in the summary plan description. You have a right to ask about your balance--or anything else--and if you have a legitimate issue, the company has to respond. There's also an appeals process.
What happens to my 401(k) account if my company gets taken over?
There are a number of possibilities. The plan may be continued without any change at all. The acquiring company may have you transfer your account into their plan. Or the plan may be terminated. You just don't know.
What if my plan gets terminated?
If the plan is terminated, everyone has to become fully vested. Typically the accounts are distributed to the employees as if they were leaving the company.
Does that mean I have to pay taxes?
No. You can roll the account over into an IRA, which is what you would do if you left the company.
Is there a way I can contribute more than the maximum?
The maximum for 1995 is $9,240. Most plans don't permit after-tax contributions because it's a pain administratively. One option is to contribute to an IRA, which may or may not be deductible. You can still put money away and enjoy financial benefits similar to those of an after-tax contribution to a 401(k). And of course there is nothing wrong with investing money after-tax in mutual funds or elsewhere.
How much can I borrow from my 401(k)?
Generally, you can borrow up to 50% of your vested account balance, up to a maximum of $50,000.
What happens to the interest I pay on a loan taken from my 401(k)?
Most commonly it goes back into your own account. So you are paying interest to yourself. Keep in mind, however, that if you borrow, you are also cashing money out of one of the investments you have in the plan. Let's say you have $10,000 in the growth fund and want to borrow $5,000. What happens is that $5,000 in the growth fund is liquidated, and your plan account now owns $5,000 of the growth fund and a $5,000 loan that you must repay to the plan.
Does it make sense to borrow from a 401(k) and invest the proceeds in, say, an international stock fund outside the plan?
Possibly. If the investment performance has been really rotten, or if you don't like the choices, you could take out a loan and reinvest the borrowed money where you are comfortable, say, in that international stock fund. You could accomplish much the same thing by investing your after-tax funds, but it's going to take you longer to get a lump sum together. If the market is screaming "Buy!" you may lose out. There are advantages to investing lump sums.
Are you saying that dollar-cost averaging is not always the way to go?
No, it's not. When you dollar-cost average, you contribute a set amount of money at regular intervals over a period of time. Because stock prices move up and down, and because you are investing the same number of dollars each time, you buy more shares when the price is low and fewer shares when the price is high. So you know from basic arithmetic that your average cost per share will be less than the simple average of the prices over the period. It sounds like a sure winner. But look at it this way. There are three possible scenarios after you invest in a stock or a fund. Its price can trend upwards over time, in which case you would have been better off putting all your money into the stock on day one. Or the price can trend downward, in which case you would have done better not putting any money in the stock. Or the price can go up and down, and go nowhere. In that case you would have been better off in Treasury bills or a bank CD. So why dollar-cost average?
There is a psychological appeal, of course. People don't like the idea of risking all their capital at once. And dollar-cost averaging seems like a way to diversify that risk. But the truth of the matter is that once you buy the stock, your entire investment is on the line, regardless of what your average cost per share is. If the market dives 30%, you lose 30% of your investment.
But since 401(k) contributions are deducted from each paycheck, I have to dollar-cost average, don't I?
Yes, and payroll deductions are one of the great advantages of 401(k)s. They help reverse the cycle of earn and spend. And I'm not advising people to try to time the market. What I am advising is that 401(k) participants--most of whom must dollar-cost average--think differently about their investments. Ordinarily, you would expect a fund with a higher ten-year rate of return to produce the most dollars for you. But that's not necessarily the way it works out when you dollar-cost average. An example: If you had invested $100 a month for the last ten years in the Putnam Vista fund, which had a 346% total return over the period, you would have ended up with $27,274, according to Morningstar. But if you followed the same program investing in the Twentieth Century Growth fund, which had a 358% ten-year total return--12 percentage points higher--you would have ended up with just $24,835. Why the $1,400 difference? Twentieth Century Growth was much more volatile than Putnam Vista. Volatility can really hurt when you dollar-cost average. I think you should favor funds with consistent good performance, even if they give up a few points in the rate of return. You could well end up with more dollars at the end of the day.
Here's a change of subject. I've got a big balance in my 401(k), but I decide to leave my company. What happens?
If your 401(k) is over $3,500, your employer has to allow you to maintain your account. That isn't publicized by employers because many would rather cash you out. Or you can roll over the 401(k) into an IRA. If you have company stock, you can set up a self-directed IRA with a broker so you can continue to hold the shares. You can also take the company stock without putting it in an IRA, but you will have to pay taxes on it.
Can my husband empty my 401(k) account without my knowing it?
Not legally. But the potential is there because of those telephone voice response systems. If your spouse knows your PIN, he or she can take out a loan, forge your signature, and cash the check. That would be against the law, but so is robbing banks.
Can my wife leave her 401(k) account to her personal trainer? Yes, if you are not careful. Ordinarily, your spouse would have to get your consent to name anyone other than you as beneficiary of a 401(k). But when you roll over a 401(k) into an IRA, that requirement goes away. You can name anyone you want to be the beneficiary of an IRA. So your wife could leave her company, roll a $250,000 401(k) account into an IRA, and designate her trainer as the beneficiary. You're still married. She kicks off, and her boyfriend gets the quarter of a million dollars. It could happen. One plan participant that we know had her husband sign an agreement saying that he could not change the beneficiaries of his IRA without her approval.
What happens to my 401(k) plan if I get divorced?
There is something called a Qualified Domestic Relation Order, known as a QDRO, that is part of a divorce settlement. QDROs assign benefits to someone other than the plan participants. In a divorce, this might be an ex-spouse, children, or other dependents. It's a complex area of the law, and a lot of divorce lawyers aren't familiar with it. Plans must have written procedures for determining the qualified status of domestic-relation orders. Make sure your lawyer knows those rules cold.
What happens to my 401(k) if I remarry?
This is a big issue for single parents. Say you're a single mom with a 401(k), and you've named your child your beneficiary. You get struck with the love bug and re-marry. Your spouse automatically becomes the beneficiary, regardless of what's on file with your employer. So after the marriage the stepparent must consent to having the child named as the beneficiary. It's unclear whether a prenuptial waiver is valid. Legislation that would allow prenuptial designations of 401(k) beneficiaries is pending.
Is my 401(k) account protected from creditors if I file for bankruptcy?
Yes. In fact, the protection that a 401(k) has from creditors is the only real advantage of leaving your money in a 401(k) rather than transferring it when you leave or retire from your company. If you declare bankruptcy, your 401(k) is harder to get at than an IRA.
What happens to my 401(k) account when I retire?
You may be able to leave it in your company plan. It varies. Companies can require that you take it out. You could roll the whole amount into an IRA. Then you could direct your investments anyway you want. Take particular care to allocate your money wisely in retirement. Conventional wisdom has been that as you approach retirement, you should convert your stocks into fixed-income investments because you need an income stream. But that's a dangerous strategy now that people are living 20 years and more after retirement. I normally recommend rolling 401(k)s into a few mutual funds that allow monthly withdrawals. Most people aren't aware that they can take a regular monthly check out and still be diversified.
REPORTER ASSOCIATE Ani Hadjian