How We Increased One Family's 401(k) by Over $500,000

  2013-12-31 13:18:38


NerdWallet was recently featured on ABC's "Real Money," where we helped one family save over half a million dollars in retirement fees. How did we do it? We'll walk through how we evaluated the family's 401(k) and the recommendations we made.

The question:

Graeme is a chiropractor with Queen Anne Chiropractic Center, a small family business owned by Graeme's father. A few years ago, the family's financial advisor offered to set up a 401(k) for the company. Greame faithfully contributed and found other ways to improve his finances including paying off debt and doing work with a second company, Dental Departures. As he worked to minimize expenses across his entire budget, he began to wonder if his no-fee 401(k) was actually charging any hidden fees and if there were simple changes he could make to maximize his long-term savings.

The recommendation:

  1. Switch 401k Providers: Graeme's 401k provider is charging outrageous fees in the form of high expense ratios that will cost him over $500k more than a low cost provider by the time he retires. Every 401(k) should offer a stock fund and a bond fund with expense ratios lower than 0.50%. If yours does not, ask your employer to switch 401(k) providers.
  2. Contribute to an IRA: For as long as he has this 401k, he should contribute only enough to get the employer match before contributing to a low-cost IRA. This small change will save him $100k in unnecessary expenses over the course of his career.
  3. Choose Better Funds: His mutual funds invest disproportionately in foreign funds. This is unnecessarily risky and since foreign markets have underperformed the U.S. market recently, this mistake has been costing him approximately $400 per year.

Action Plan for Viewers at Home:

1. Ask Your Employer to Switch 401(k) Providers

This is the most important thing you can do. If you start with nothing and contribute the maximum to your 401(k) each year ($17,500/year) for 35 years, earn 7% return and pay zero fees, you will reach retirement with $2.6 million. A high cost retirement plan, like Graeme's 1.62% expense ratio plan, will reduce this nest egg by $786k while a low cost retirement plan at 0.50% will reduce it by only $277k, a savings of over $500k. Frankly, you may even be able to do better than 0.50% if you really shop around.

2. Contribute to an IRA

If you are stuck with a bad plan and you can't convince your employer to switch to a good one, there is still something you can do. An employer-sponsored retirement account is just one form of tax-advantaged retirement savings plan. The other type is an Individual Retirement Account, or IRA. By choosing a low-cost IRA plan, you can avoid your 401(k)'s high fees on a portion of your retirement savings.

Your Plan for optimizing retirement contributions:

1. Contribute enough to your 401(k) to receive matching funds

If your employer will match some of your contributions then you have immediately made a 100% return. This enormous gain trumps the negative of high expenses.

2. Contribute your next $5500 to an IRA

Open a low-cost, no-fee IRA and contribute to the limit.

3. Contribute remaining funds to your 401(k)

This is controversial advice, and there are some scenarios where the fees are high enough and the restrictions onerous enough that you might be better off just investing the remaining money in a taxable account. But these days people change employers frequently and when you leave your employer, you can roll your 401(k) assets into a low-cost IRA and eliminate the negatives while getting all of the benefits of a tax-advantaged account. The government knows tax-advantaged accounts are valuable, which is why they strictly limit how much can be contributed each year. Don't miss an opportunity to get money into one, especially if you are young and have many years for the benefits to compound.

Further information on Individual Retirement Accounts:

3. Improve Your Asset Allocation

Completely separate from the issue of fees is whether or not your 401(k) is optimized for peak performance. Many people spend great effort choosing the right fund or manager when the truth is that almost all investment performance in the long run is driven by asset allocation. Your asset allocation should take into account the length of your investment horizon and your ability to tolerate risk.

Optimizing your 401(k) portfolio allocation:

1. Determine your Optimal Allocation

A good general rule of thumb is to take 120 minus your age and invest that proportion in stocks and the rest in bonds, meaning a 40-year-old should be 80% in stocks and 20% in bonds. Our asset allocation infographic has more detailed suggestions by age. There are also some great tools around the internet.

2. Determine your Current Allocation

Think you are 20% in small cap stocks because 20% of your portfolio is in a small cap fund? That's what Graeme thought and it turns out only 3% of his money was invested in small companies. A fund's name often doesn't represent what it really holds. Use the Morningstar Portfolio X-ray to see exactly what you are investing in. Don't want to enter this information manually? Use Personal Capital to link your accounts and to monitor your asset allocation for free.

3. Determine how you will get to your optimal allocation

You should optimize your asset allocation across all of your holdings, so put all of your assets from your 401(k), IRAs, and any other investments (even your spouse's!) into the Morningstar X-ray. How far off are you? Try different allocations across funds in the X-ray until you find one that is roughly in-line with your optimal allocation. This may involve adding funds that you don't currently invest in, or it may involve removing a few that are unnecessary. For most people, there is no need to have more than three different low-cost funds (stocks, bonds, international).

The outcome:

After the show, Graeme let us know that he talked to his boss (his dad!), and they have decided to start the process of switching to a low cost 401(k). In just about a month, Graeme and the other employees of Queen Anne Chiropractic Center will be well on their way to one-third more in retirement savings in the future thanks to smart financial decisions today.

Editor's note: This story by Joanna Pratt originally appeared on NerdWallet.

To read more from NerdWallet, see:

73 Will Be The Retirement Norm For Millennials

466 Hours of Worker Overtime Equals One Hour of CEO Pay

The Golden Rules of Personal Finance