How can a quick math error—plus faulty logic—cost someone $120,000?
A recent Reddit contributor (wisely) asked the “Bogleheads” forum for investing help. His full question is below. The question highlights are:
- My 401(k) offers me a 2% match. 2% is not great compared to the industry average of 4-5%.
- My 401(k) also has funds with 1% expense ratios (a.k.a. fees). Super high! Yuck!
- This combination—poor employer matching and high fees—makes me want to say, “Screw the 401(k). I’d rather invest in a taxable account.”
- But, I haven’t done the math to backup my gut instinct.
Here’s the full text, if you’re interested:
I recently got my hands on my employer’s 401(k) fund options. They are abysmal. The lowest expense ratio is just about 1%. My employer also gives a 2% match (0.25% of 8% contributed though).
So, the general advice is to contribute up to employer match, but even that I feel like it is not worth the expense ratio.
My argument for saying it is not worth it is related to the compounding effect of 1% exp ratio on the total amount invested vs. only 2% being matched each year. Over time, if I stay in this fund, I will lose much more from the expense ratio than I will gain from employer matching.
Even considering the advantages of the tax-deferred space, I have not done the calculations, but long term, I am pretty sure investing in a taxable account would be better than the 401k with 1% exp ratios.Full forum post
Let’s quickly highlight some points about this question.
The Good, Bad, and Ugly About This Question
Open questions about money lead to important lessons. This is a great question to ask!
But we can learn two quick lessons from the “bad/ugly” aspects of this question.
- First, we have to separate what “feels bad” from what “is bad.” It might feel bad to pay a higher expense ratio than standard. And it might feel bad to have a low employer match. But the math of the problem holds true irrespective of feelings.**
- “I have not done the calculations, but long term, I am pretty sure…” Whoa, Nelly! This is a dangerous statement in personal finance. If you don’t know the calculations, that’s ok! Ask for help. The Internet is an amazing resource. But to be “pretty sure” about a mathematical outcome without doing any math—that’s unwise.
**Charlie Munger tells a story of when Berkshire Hathaway bought BNSF Railroad. Some Berkshire Hathways shareholders felt that they were only getting a “good” deal, while the BNSF shareholders were getting a “great” deal on the transaction. They wanted Berkshire’s leadership (Warren Buffett and Munger) to negotiate a better deal. And Charlie Munger wisely pointed out, “If you’re getting a good deal, why the hell do you care what the other guy is getting?” Envy is a potent drug.
To get a real answer, you’ve got to do real math. So that’s what I did.
Remember, the curious Redditor believed that a 401(k) would surely do worse than a taxable account. I’ll give him the benefit of the doubt.
I used conservative assumptions for my hypothetical 401(k) investor and compartively kind assumptions for my hypothetical taxable investor. I wanted to be extra gracious to the Redditor’s theory—could his gut be correct?
The assumptions and the math can all be found in this Google Spreadsheet.
- Both investors contribute the same amount.
- The 401(k) investor receives a 2% company match, but pays a 1% expense ratio.
- The taxable investor pays income tax up front, receives no match, but pays no expense ratio.
- Both investors see the same investment performance (before fees)
- Both investors pay taxes upon withdrawal (30 years), though I assume a 22% income tax rate for the 401(k) investor and only a 10% capital gains rate for the taxable account investor.
Even with my harsh assumptions, the 401(k) investor outperforms the taxable investor by $120,000 (or about 12%) over a 30-year period.
That’s a huge amount. The 2% company match and tax-deferred nature of the 401(k) is significant.
Not to rub salt in the wound, but recall that this person was “fairly certain” that a taxable account was the smarter choice.
Lesson: always question your assumptions, especially if math can help you. I guarantee you know someone who can build this spreadsheet in 15 minutes or less. That’s little time, but much gained.