Is Expensive 401k or 403b Worth It?

1. Reader Question

Thanks for your wonderful blog. Love it!! My employer allows me to contribute the max into a Roth 403b - no matching, into Vanguard funds. An additional 0.40% on top of the regular Vanguard expense fees are tacked on. What I don't like is the only Vanguard funds they offer are: VIGRX - .24% VBINX - .24% VEXPX - .50% VISGX - .24% Given the extra .40% expenses and lack of diversification in stock funds (and no bond funds), I'm wondering what to do. Would I be better off just putting my $$'s in a taxable account? WWLTR do? Thanks for you insight.

My Reply

Thanks for writing and for this question -- I learned something while preparing my reply! I put together a spreadsheet to answer your question and it yielded to a somewhat surprising to me conclusion. Even with extra expenses to the tune of 0.50-0.60% annually (which is what you are facing relative to the absolute cheapest you could do in a taxable account) it is still easily in your interest to make fullest use of your 403b instead of investing in taxable. In fact, additional expenses of as much as extra 0.8% (80 basis points) are likely to still be worth it for an average investor.

Although your specific case is a Roth 403b, the exact same conclusion would hold for a "Traditional" (pre-tax tax-deferred instead of post-tax tax-free) 403b. And, of course, it would also hold for a Roth 401k or Traditional 401k just as much as for a 403b. The decision to go with post-tax tax-free Roth versus pre-tax tax-deferred Traditional account type, by the way, comes down to whether your tax bracket is higher during the accumulation years or withdrawal years. If your tax bracket is higher during accumulation years, then Traditional account type is preferable. If your tax bracket is likely to be higher during withdrawal years, then Roth is preferable. There are a few other considerations that play into it but the core of it comes down to tax bracket now versus during withdrawals. If you are interested in that discussion, you may want to use the search feature on the right, since I've had quite a few posts on this subject.

But back to your specific scenario... My baseline assumptions were:

• All-stock portfolio (I'll explain why in a bit)
• 25% tax bracket, both currently and in retirement
• 15% dividend and long-term capital gains tax rates
• 8% (nominal) annual compounded future returns
• 2% dividend yield
• Staying with your currently employer and current 403b choices for life

Under these assumptions you should go with 403b (or 401k as might have been the case) instead of taxable as long as additional 403b/401k expenses are under about 0.8% annually. Since your additional expenses are only on the order of 0.5-0.6% annually, the 403b/401k option is easily preferable for you.

Inclusion of bonds in the examined portfolio would further cement the case for 401k/403b since bonds are very tax-inefficient. That is the reason I looked at stock-only portfolio. OK, to tell the full truth I also did not have the time to build the more elaborate spreadsheet that allows for a balanced portfolio, but I am quite certain the conclusion would not be any different.

I assumed just 2% dividend yield which is correct for today's US stocks, but underestimates total portfolio dividend yield if we take higher-yielding foreign stocks into account. It is also far below historical average dividend yield even for US, but that may well be a permanent change as companies now choose to return value via share buybacks. This is another subject that you may want to search for in my blog. Higher dividend yield would tilt the conclusion further in favor of 403b/401k.

And the above analysis of course assumes that you are stuck with those higher expenses for life. In reality it's very unlikely that you'll stay with the same employer for life and you can roll your 403b into an IRA when you change jobs. And even if you do stay at the same job for life one would hope that after 5-10 years you will get some better choices in your 403b. Either of those scenarios would again make it an even more of a slam-dunk to max out 403b/401k before investing in taxable. You would only pay higher expenses for a few years, but continue to benefit from tax-sheltered compounding for life.

Only very, very low future returns would make it worth your while to invest in cheaper taxable over more expensive 403b/401k. In your case (with my assumptions above) future returns from stocks would have to be below 4% nominal to make taxable investing be preferable to 403b/401k at ~0.5% higher expense. I am not overly optimistic about future returns from stocks, but I certainly expect them to be higher than 4% over the long term!

The last thing left to do is decide which of your 403b options to go with. Since, as you point out, your 403b choices are not well-diversified you would probably want to complement them with other investments in different accounts (yours -- such as an IRA -- or perhaps your spouse's). My preference would be to go with VBINX and complement it with international stocks in a separate account. Another option -- especially if you prefer to avoid the admittedly overpriced treasuries that are large part of VBINX -- would be to go with VIGRX (large-cap growth) and complement it with VIVAX (large-cap value) in a separate account (again, either yours or your spouse's). Combined in equal measures the two are equivalent of S&P 500 and are in my view a perfectly acceptable substitute for the entire US stock market.



2. Reader Question

Great blog! Have you written about lifetime annuities? Can you offer your perspective?

My Reply

Annuities is one topic I tend to undeservedly overlook in this blog. They are absolutely a viable -- and in many case optimal -- investment choice. Plain immediate fixed income annuity is usually the best choice among different types of annuities. The more you wish to stretch your portfolio (e.g. withdrawal rates higher than 4% while you are still in your early 60s) and the less you care about leaving legacy, the more annuities should figure into your plans. One very reasonable in my view approach is to purchase an annuity (or annuities) with the fixed-income part of your portfolio while keeping stocks for potential growth and/or legacy. Owning bonds is not the same thing as having an annuity, of course, but they do have similar risk levels. With an annuity you give up liquidity, but gain perfect longevity protection and (somewhat illusory) peace of mind of not having your fixed-income investments be marked to market.

Of course today's annuities are paying relatively low rates since their rates are directly related to general fixed income market rates. But we have to make do with what's available, not what we wish was available. There is absolutely no guarantee that rates will rise significantly any time soon. If you are looking at retiring soon and need to squeeze a bit extra out of your fixed income investments and don't care about legacy, you absolutely should look at an annuity as a part of even all of your fixed-income portfolio.

I am not doing justice to this important topic in this short reply, so I will try to make a more substantial post about annuities soon.



3. Reader Question

I have invested in the Vanguard STAR Fund for many years. I never see any positive feedback on owning the STAR Fund but a lot of good things about Wellington and Wellesley. What is your opinion on the STAR Fund? Thanks. Great blog, very well written.

My Reply

Thank you for your kind words. I am one of those who don't have much good to say about the STAR fund. Its best feature is probably its low $1,000 minimum that makes it very accessible to new investors. But that's about it. Although it looks diversified because it holds so many different funds within it, that impression is misleading. It is not particularly well diversified and certainly not as cheap as index-based alternatives. You can find my comparison of STAR to LifeStrategy in my reply to reader comment http://www.longtermreturns.com/2012/09/betterment-as-savings-account.html?showComment=1355683716905#c6382800598266660949

Wellington/Wellesley have certainly been great funds to own through the years, but I don't think you should count on their great returns to continue. They have been beneficiaries of huge bull market in bonds which is now definitely in its final stages -- simply because the rates don't have much room to go lower. That doesn't mean Wellington/Wellesley are bad holdings, but some people tend to confuse their terrific past returns with what they are likely to deliver going forward. I would recommend LifeStrategy over Wellington/Wellesley for a single-fund solution. And most investors can do even better by using VTSMX (US stocks) and VGTSX (international stocks) for stocks and a combination of I/EE-Bonds, CDs, and munis and corporate bonds for fixed income.