Patrice S. is a 30-something office worker with a new job and an old problem: Her new employer's retirement plan is filled with lousy mutual funds, stinkers that she'd never buy if left to her own devices.
Now the North Modesto, Calif., woman must decide whether to participate in the plan. While many companies have terrific savings plans with abundant options and outstanding funds, some cheap out and give workers the "benefit" of a plan without providing a program that the workers truly benefit from.
That's the case with Patrice's employer, which offers six fund choices, and never more than one per asset class. The best fund in the plan is AIM Constellation (CSTGX), which epitomizes mediocrity with middle-of-the-pack results for the last one-, three- and five-year periods, below-grade results over the last decade, middling-or-worse ratings from the independent research firms, and no significant upgrade in performance after a management change in 2005.
"That's the best fund [in the plan], and I don't want to buy it," Patrice said in an e-mail. "The other funds are in other parts of the market, but they're as bad or worse even. ... So what do I do?"
The obvious answer is "complain to the employee benefits department," but that's not necessarily a solution. The fact that workers want a better plan doesn't mean they'll get it; besides, Patrice may not want to rock the boat when she's new to the job.
Patrice can't keep investing in her old employer's plan, which was her hope. She can leave the money accumulated there on account - or can move it to a self-directed individual retirement account (IRA) if she believes she could find improved options on her own - but can't add money from her new job. (If the situation was reversed, and the new plan was an improvement, she might want to roll the old account into the new one.)
So she must deal with the new employer's bad plan options and decide whether to invest or do the unthinkable and give up on a significant retirement-savings tool.
First, however, she must consider "the match," the monies that the employer contributes to the plan for workers who invest their own cash. The match, effectively, is free money, generally a guaranteed return of 25 percent up to 100 percent on what the worker sets aside, depending on the employer's rules.
Take even a mediocre mutual fund and give it a 25 percent head start and its performance will top the charts, so missing the match is out of the question.
"You have to take it, but you don't have to put it into a lot of bad funds," says Christine Benz, director of mutual fund research at Morningstar Inc. "You might put a disproportionate amount into the plan's best fund, but don't get hung up on trying to build a well-diversified portfolio within that plan. Just take the best and dump the rest, and then build your well-diversified portfolio on the outside."
Without a match - or once the maximum has been secured - the decision moves from grammar-school math to calculus.
Most investors believe the biggest benefit of retirement-savings plans is tax deferral, but most experts think the real plus is the easy, regular savings. So any investor looking outside of the plan must first know himself enough to be sure he will contribute as much as if he enrolled. A mediocre fund is better than nothing.
If investors will make those contributions, they can invest instead in a traditional IRA or a Roth IRA if they qualify. Traditional IRAs have similar advantages to a 401(k) plan, in that the money is invested before it is taxed; Roth IRAs use after-tax money, but the gains are free of taxes.
While experts loathe the idea that a worker might ignore her retirement plan and simply use a taxable account for savings, the numbers for a lousy plan may make the extreme strategy plausible. For starters, factor the retirement plan's administrative costs into those of the lousy funds (the plan sponsor must provide cost disclosure statements when asked), because the worker carries the burden of those additional fees.
Then, recognize that while the retirement plan allows before-tax savings, it treats all gains as ordinary income, meaning they are likely to be taxed at a higher rate than the capital-gains rate applied to earnings in an ordinary taxable account.
"A really good fund with low costs, low risks, that is managed to be tax-efficient and that inspires investor confidence can be a lot better than a high-cost, lousy fund in the retirement plan," says Frank Armstrong of Investor Solutions, a Miami-area advisory firm.
"When your choices are bad, run the numbers. ... And if you can save the same amount and come away thinking that you're better off without that bad retirement plan, then stay out of the plan, and tell your employer why you are doing it. ... Maybe it will help convince them to get better funds."
Charles Jaffe is senior columnist for MarketWatch. He can be reached by mail at Box 70, Cohasset, MA 02025-0070.