Personal Finance

The Biggest Red Flags Lurking in Americans' 401(k) Plans

Chris MacDonald

Published: December 4, 2024 11:12 am

Many experts believe that 401(k) plans remain among the best savings tools for those looking to supplement their social security in retirement. That’s mostly because as society has shifted away from things like company-sponsored (or government-sponsored) pension plans and other programs to help take care of employees after they retire, putting the onus on individuals to save via providing tax benefits for doing so has been one way to shift costs off of burdened balance sheets and onto those of individuals and households. 

The 1974 Employee Retirement Income Security Act (ERISA) established minimum standards for private retirement and health plans, including 401(k)s. These standards provide what should be an equal playing field for all looking to save for retirement, and do so on most levels. However, there are plenty of potential pitfalls investors looking to save for retirement should be aware of. The reality is that not all 401(k) plans are equal, with employer matches, investment options and fees varying quite significantly across companies, industries, and plan providers. 

Here are a few of the biggest red flags those putting money into their 401(k)s right now may want to think about.

Key Points About This Article:

• The rise of the 401(k) plan has brought about a new era of investing for millions of Americans, and remains the top source of private funding for retirement among most households.
• That said, not all plans are created equal, and there are some key red flags investors may want to look for within their current 401(k) retirement plans.
• Also: Is your 401(k) optimized for your retirement plans? (Sponsored)

Limited Investment Options in 401(k) Plans

When many investors put part of their paycheck into their 401(k) plan on a consistent basis, that’s the end of the thought process. The idea is that money magically disappears into a long-term savings and investing vehicle, and when one retires, the growth one should see over their lifetime should be at least close to that of the overall market.

The thing is, investors may be placed in company-specific funds set up by various 401(k) providers such as Vanguard or Schwab, with target-date funds and other offerings making up a significant portion of where employee savings go. These funds may have different portfolio structures than investors would otherwise like to see (some may want to simply own index ETFs or have a certain allocation to specific stocks), but depending on the provider, picking individual stocks or specific ETFs may not be possible.

Indeed, many 401(k) plans offer a limited range of investment choices, often confined to the aforementioned list of specific target-date funds or provider-owned index funds. Some plans only offer a handful of options, while others are more liberal, so taking a look at what one’s options are and re-allocating where one’s paycheck is invested is a key step when starting out in the process (and doing so periodically can be a good move as well, since the breadth of offerings can change over time). 

Additionally, consulting with a financial advisor can help you identify supplemental investment vehicles, such as IRAs, to fill the gaps left by limited 401(k) choices.

Employer Match Vesting Schedules

Employer matching contributions are a valuable perk of many plans, but they’re not universal. Many employers will match an employee’s contributions to their retirement savings plans up to a certain percentage, offering investors a 100% return on their money (all financial advisors will tell you to take advantage of this perk, if possible). Indeed, this is one of the best ways long-term investors and those saving for retirement can grow their wealth, and is an option all of us should take advantage of, if it’s available.

That said, some employers will put stipulations on this match, with vesting schedules that determine when the matched funds become available. In other words, the money won’t be yours until you work a certain amount of time at a company, with the funds placed in a holding account with your name on it until that time comes.

Thus, for employees who have taken advantage of their match but may be thinking about switching jobs, being aware of potential vesting schedules is important. If a particular company offers an employee match of, say 5% with a 2-year vesting window, choosing to leave this job at month 23 (one month before the funds would otherwise be vested) could cost that employee thousands of dollars in forfeit funds. For those who switch jobs frequently or are thinking of doing so, timing can indeed be important.

Some employees may mitigate this issue by exploring additional savings vehicles like IRAs to reduce their reliance on employer contributions. But, as mentioned, these contributions can add up, so it’s generally wise advice to contribute at least up to the match to take full advantage of these perks.

High Fees Can Erode 401(k) Returns

Having access to diversified funds within a 401(k) plan is a great thing, and most of the top plan providers do have options with rock-bottom fees. Again, the most common financial advice long-term investors can get when choosing to invest in passive funds is to choose those with the lowest fees. That’s because while a 1% fee may seem small, over the course of decades, that lost compounding potential can add up to tens or hundreds of thousands of dollars. Investing in an index fund with an expense ratio of around 0.05% (yes, many are available with fees this low) can provide amplified compounding over time and create meaningful excess wealth to be used in retirement. 

Many of the top funds employers are automatically enrolled in can come with higher expense ratios on average or hidden costs such as administrative and fund management fees. Those saving for retirement should read the prospectus for the funds they’re currently enrolled in, to see if these funds match their long-term savings goals. 

In my view, paying excess fees for an actively-managed fund versus an index fund for decades can be the biggest pitfall investors can fall prey to. I typically review holdings at least once a year, but when starting a new job, doing one’s homework on this particular issue can provide big long-term gains.

Safeguard Your 401(k) For a Secure Future

Navigating the complexities of 401(k) plans requires vigilance, awareness, and proactive management. These retirement accounts can be a “set it and forget it” program, but there’s the “set it” part that can’t be ignored. Knowing what funds you’re being put into, their fee structure, and how to optimize everything from an employee match to which funds you ultimately choose to be invested in can be six or seven-figure decisions over the very long-term.