Wait? Am I really giving advice contrary to everything you have heard from the financial services industry that as soon as you leave a job you must immediately bust a move and roll your 401k (or 403b or 457 or 401a) balance over to an IRA managed by your financial advisor? Well, in many cases it may be more beneficial for you to leave your 401k balance right where it is. So, for now, let’s ignore Young MC’s advice from years gone by and not bust a move with our 401k balances.
I have seen it firsthand how excited advisors get when a client switches jobs or announces they are retiring. There absolutely is happiness for the client because it often means they are moving on to another exciting opportunity in their lives. Sometimes the advisors are more excited because they know it means a pay raise for them. While it may benefit the advisor, it may cost the client much more over the long-term. Why? One simple word – fees!
The vast majority of advisors are paid based on the old-school method of assets under management (AUM). They get paid more based on the assets they manage. So, if you increase their AUM from $500,000 to $1 million and they charge the average fee of 1% you just doubled their pay from $5,000 to $10,000 (we won’t discuss whether their workload just doubled). This AUM model exists whether you are working with an independent advisor or an advisor at a wirehouse firm.
My experience has been most employers do not automatically force a former employee to roll his funds out of the 401k plan. More forward-thinking employers are embracing best practices and forcing former employees who have small balances or have been separated for several years to withdraw their balances. However, the bulk of most employers are not up to speed with these best practices and are fine if you leave your 401k balance there.
If you are not planning to start taking distributions out of your 401k assets and your old employer isn’t forcing you out it may make sense to leave your balance at your old job. The reason is simply because the investment options within a 401k are often much less expensive than rolling it to an IRA. The most recent good data I have seen is from 2013. The average equity mutual fund cost 1.37% while the average cost of an equity mutual fund in a 401k was .58%. Yep, you save more than 50% of expenses by investing within your 401k.
There are several reasons why the costs in a 401k plan are often less expensive. First, you have economies of scale. Let’s say your 401k balance is $500,000 and the overall plan balance is $50 million. The 401k market looks at you like you are a $50 million investor and offers you a lower price point. Additionally, there are more no-load funds inside 401ks which helps keep costs lower because you are not paying upfront or ongoing higher fees typically attached to A and C share funds. Finally, 401k plans are required to disclose the expenses participants pay. Full disclosure of fees tends to move plan administrators to lower cost options.
If you roll your 401k balance to an IRA the odds are you will be working with an old-school AUM advisor. You may return to the world of higher-cost mutual funds and paying your advisor 1% on top of the average fund fee. Let’s just assume you are paying 1% for the mutual funds. Your total annual fee is 2% and over a long period of time it has a huge impact on your performance. I am going to steal a quote directly from John Bogle, founder of Vanguard – “Let’s assume the stock market gives a 7% return over 50 years. If you get to 7%, each $1 goes up $30. If you get to 5% (that would be 7% less the industry typical 2% all-in costs) you get $10.”
In no terms am I recommending people never roll their 401k balances to an IRA. It can be very difficult to keep track of your old 401k balances if you move every 5 years. Plus, your investment choices within an IRA are much larger than were available in your 401k. Additionally, it provides you easier access if you need to withdraw the funds than if the money is still in a 401k. My point with this article is you do not have to automatically follow the conflicted advice and roll your 401k balance into an IRA immediately after you leave your old job. Make sure you are looking at the whole picture and the final decision is in your best interest.