Dog Plan

I’ve always had dogs and love them to pieces. I’m not sure how I got into the habit of calling horrible 401(k)-type plans “dog plans.” It’s a bad rap. My apologies to your pooch as well as to my dog Rosie.

Keith and Rosie

Most employers who offer plans, I’ve found, do a decent job with their retirement offerings. Still, make no mistake, some employers’ plans are better than others. When looking for employment, don’t forget to check out the retirement plans offered, along with everything else.

Does your 401(k)-type plan have one or both of the following? If it does, you’ve got a dog plan, and you have my sympathies:

High Expense Ratios

Expense ratios can be confusing because they’re “build in” to the fund’s share price. Because investing expenses are taken directly out of the fund, you’re never actually billed for the expense even though you “pay” for it through a lower share price. It’s one of the sneaky ways Wall Street robs you blind without you even realizing it.

Besides high expense ratios, look for additional fees, which is another bad sign. For example, there may be brokerage fees, account fees, and other ridiculous charges like 12b-1 fees in addition to the expense ratio.

Why would an employer choose such a horrible plan? I’ve found many times its ignorance, but it mostly comes down to money. These money-grubbing investment companies offer to cover many of the start-up costs associated with 401(k)-type plans, which oftentimes can be steep. This is gleefully done in exchange for decades of bloated prices and fees.

Choosing a dog plan is an incredibly short-sighted move. Since most employers save for their retirement using the same plan, they’re limiting their own wealth-building too, to say nothing of the employees. It doesn’t take long for high investment fees to dwarf any initial upfront savings.

Expense Ratio Example

To compute the dollar amount you’re indirectly being charged through the expense ratio, you need your fund’s average yearly balance, since the expense ratio is expressed as a yearly percentage. Multiply that average balance times the expense ratio to compute your expense.

Assume a $250,000 average yearly balance. How much more expensive is an actively managed fund with an expense ratio of .75% versus an index fund with an expense ratio of .05%?

Actively Managed Fund: 250,000 x .0075 = $1,875

Index Fund: 250,000 x .0005 = $125

Difference: $1,750

No Index Funds

If your 401(k)-type plan doesn’t offer index funds, march on down to HR and give them a piece of your mind! Tell them index funds have better returns than actively managed funds and do it at a much lower cost. Better yet, keep your mouth shut and look for another employer. I know I can be a bit fanatical about it, but that’s how strongly I feel about you keeping your expenses to a minimum in your investment plans.

What if you love everything about your job except the lack of quality low-cost funds in your 401(k)-type plan? Contribute enough to get any company-sponsored match, then direct the rest of your retirement money to other tax-advantaged accounts.

If you’re age 59 1/2 or older, there is a workaround. Reaching that magic age gives you the ability to do what is known as an in-service withdrawal. Once a year, you can rollover the balance of your 401(k)-type plan to a traditional and/or Roth IRA without any tax or penalty.

Make the maximum contribution you can afford during the plan year. Suck it up and suffer through the year with those high fees. Then roll over every penny to an IRA(s) at Vanguard®. Repeat the next year and every year thereafter.

This means you’re still paying high fees, but only until the next year comes around when you can roll your money out of there. This strategy lets you take advantage of the high 401(k)-type plan contribution limits in those crucial last years before retiring while minimizing your expenses. Keep doing it for as long as you work there, or until your employer comes to their senses and replaces that dog plan with a good one.

Luckily, there are alternatives if you’re stuck with a dog plan.