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Why Do Expensive 401(k) Plans Exist? And What Can You Do About It?

A reader writes in, asking:

“My daughter works for a company that provides relatively high cost investment options in her 401K plan. I’ve encouraged her to speak with senior management to encourage them to add low cost funds (such as Vanguard) so that every employee could realize these potential savings while employed there.

It seems only logical that management would want to have low cost funds available since they probably have 401K savings as well. What I don’t know and understand, is does a business or HR office benefit in various ways by only offering funds that are higher costs?”

There are two primary reasons why an employer might use a 401(k) plan with expensive funds.

First, the decision makers might simply be unaware of the importance of costs when it comes to investment performance. Perhaps they’re choosing funds based on past performance or based on the recommendation of a salesperson.

Second, the decision makers might have chosen to go with a plan that was inexpensive for the employer. In many cases, a plan is inexpensive for the employer precisely because it is expensive for the plan participants. That is, rather than making money by charging the employer, the plan provider charges administrative fees directly to the participants and/or offers funds that have substantial 12(b)-1 fees.

How to Get Less Expensive Funds in Your 401(k)

I’ve heard from many readers who have tried to get big changes made to their 401(k), such as switching from a provider with expensive actively managed funds to a provider such as Vanguard. Unfortunately, such attempts are usually (though not always) unsuccessful. There are several possible reasons why employers might be reluctant to comply with this request:

  • It sounds like a lot of work.
  • It may mean higher costs for the employer.
  • It appears risky. What if they anger a plan participant who likes the current investment options? Would they have to worry about a lawsuit?
  • It may mean having to “fire” a salesperson whom they’ve come to trust (and who, in some cases, may even be a family member or friend).

In addition, if the decision makers are using the current plan provider because they personally subscribe to an investment philosophy that involves using relatively expensive actively managed funds, you would have to convince them that they’ve been making poor decisions with their own money in order for them to see the wisdom of switching. That’s a big barrier to overcome.

Conversely, I’ve heard from several readers who have had success with a much simpler approach: Ask the employer to add one or two low-cost index funds. Phrase the request as a simple favor — a relatively easy way to make an employee happy. Something along the lines of, “I personally really like to use low-cost index funds. Would it be possible to add a stock index fund to the plan, such as Vanguard’s Total Stock Market Index Fund or Fidelity’s Spartan Total Market Index Fund?” Then follow-up as necessary.

With this approach:

  • You’re making a request that’s much easier (i.e., less work) to satisfy.
  • There would (likely) not be any additional costs for the employer.
  • There’s little risk of making any employees unhappy, because they wouldn’t be removing any investment options.
  • There is no need for a discussion in which you have to convince anybody of the merits of your investment philosophy (or the lack of merits of their philosophy).

Unfortunately, even this method isn’t foolproof. For example, in some cases, the plan provider will be unwilling to include lower-cost investment options. And in other cases, the salesperson representing the plan provider may talk management out of adding low-cost funds when asked about doing so.

Investing Blog Roundup: Indexing for High-Net-Worth Investors

Passive investing through index funds or ETFs has been shown time and again to be an excellent way to invest. Some high-net-worth investors, however, are turned off by the plain/common/boring nature of index funds. But as CPA Steve Nelson points out this week, simple, passive investing continues to be an excellent approach, even for very large portfolios.

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Social Security Benefits for Dependent Parents

A reader writes in, asking:

“My mother is financially dependent upon my wife and I. I recently heard something about the possibility that she could receive a Social Security parent’s benefit based on my retirement benefit. I had never heard of this before. Can you explain how it works and how it should factor into my own Social Security decision?”

Parents’ benefits don’t get much coverage, because they’re not very common. And, for reasons we’ll discuss momentarily, the possibility of your parent receiving a parent’s benefit should not affect the decision of when you claim your own Social Security benefit.

In short, a parent’s benefit is a survivor benefit for a parent who was financially dependent upon their now-deceased child.

How to Qualify for a Parent’s Benefit

In order for a parent to be able to claim a benefit on the work record of their child (including a stepchild and adoptive child in some cases):

  • The child must be deceased and have had sufficient Social Security work credits to be considered “fully insured,”
  • The parent must be at least age 62,
  • The parent must not have gotten married since their child died (though it’s OK if the parent was married at the time of death and is still married),
  • The parent must not be entitled to a retirement benefit that is greater than or equal to their benefit as a parent, and
  • The deceased child must have been contributing at least 50% of the parent’s support.**

How This Affects Social Security Planning

The fact that your parent is financially dependent upon you (and may therefore someday receive a benefit based on your work record if he/she outlives you) should not play any role in your own Social Security claiming decision, for two reasons.

First, the age at which you claim your own retirement benefit doesn’t affect the time at which your parent can start receiving a parent’s benefit. (It is your date of death that determines that.)

Second, the age at which you claim your retirement benefit doesn’t affect the amount of your parent’s benefit based on your work record. The amount of a parent’s benefit is 82.5% of the deceased person’s primary insurance amount if there is one eligible parent. If there are two eligible parents, each parent’s benefit as a parent is 75% of the deceased person’s primary insurance amount. (If the parent is already receiving a different Social Security benefit — such as their own retirement benefit — then the total amount they will receive is the greater of the two benefits.)

**To meet the “contributing 50% of support” requirement:

  • The deceased child must have been making regular contributions for the parent’s ordinary living costs, and those contributions equaled or exceeded 50% of the parent’s ordinary living costs, and
  • The parent’s income (from sources other than the child) that is available for support purposes is 50% or less of the parent’s ordinary living costs.

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Investing Blog Roundup: IRS Data Breach

The IRS announced this week that identity thieves used the online “Get Transcript” application to successfully obtain tax return information of more than 100,000 taxpayers. Kelly Phillips Erb has more information:

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Does Including International Stocks Really Make You More Diversified?

A reader writes in, asking:

“I’ve read that Mr. Bogle doesn’t think investors should use an international allocation. His argument makes sense to me. With our globalized economy, it seems that the performance of companies here in the United States would be dependent on what is going on in other countries anyway, allowing for international diversification without an international fund. What do you think?”

This is one topic where, despite my immense respect for Jack Bogle, I do not agree with his position. I strongly prefer to have international stocks in my portfolio.

My line of thinking is perhaps best explained with an analogy.

Imagine that your current portfolio consists solely of four different stocks. Now imagine that you have the option to add a fifth stock to the portfolio. Would you do it?

How would your answer change if you found that, historically, that fifth stock is so closely correlated to the other four stocks that, based on historical backtests, adding that fifth stock does literally nothing to improve the volatility or returns of the portfolio? Would you still add the fifth stock to the portfolio?

For me, the answer would be an emphatic “yes.” By adding a fifth stock, I’m less dependent on the performance of the other four stocks. And while the stocks have historically been highly correlated, that could change at any time. One of the stocks could experience a significant decline that is specific to that one business, while the other stocks continue to perform just fine. And in such a case, I would be very happy to have more stocks in the portfolio so that my losses are minimized.

In other words, I would be eager to add additional stocks to the portfolio, even if a historical backtest showed that doing so offered little benefit.

For me, a similar line of thinking applies when considering whether to hold international stocks or not. That is, my desire to hold them isn’t based on historical backtests. (That said, historical tests do suggest that an international allocation provides a modest improvement.) And my desire to hold international stocks is not diminished by the fact that the U.S. stock market and developed markets abroad tend to be fairly highly correlated. I own international stocks primarily because I’m concerned about a scenario in which, due to some unforeseen event, that high correlation breaks down and the U.S. market performs significantly worse than other markets.

In short, I would argue that you are more diversified with more stocks (or more industries, or more countries) in your portfolio, even if that doesn’t show up in the form of dramatically improved back-tested results.

Investing Blog Roundup: Rick Ferri Launches Robo-Advisory

This week, well-known author/advisor Rick Ferri announced that he will soon be launching a robo-advisory service, targeted toward younger investors. Cinthia Murphy of ETF.com has the scoop:

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