We’ve all heard the mantra: “Work hard, save money, invest in your 401(k), and retire”.

But does this really work?

I have to admit I’m a little afraid to write this article. The 401(k) has been lauded in the mass media and mass financial publications (Kiplinger’s, Money Magazine, etc…..) as the savior of Americans’ retirements.

If you are not contributing to your 401(k) you are considered daft and financially inept, and people assume you simply cannot afford to contribute.

And people who do contribute proudly shout the fact from the rooftops, “I’m contributing the MAX to my 401(k)!” and well-known best-selling financial pundits like Suze Orman and David Bach tell you to of course contribute to your 401(k), proclaiming it the “bedrock” of your future retirement.

Well…I disagree.

Yes, if your employer matches that’s a great thing (free money!). Yes, if you have absolutely zero financial discipline and would just spend the money on crap otherwise, then by all means, sock it away in your 401(k).

There is a place for a 401(k) and IRA’s in most people’s financial strategies, but they are not the be-all end-all panacea that the mass media and mainstream financial pundits would have you believe.

If you will empty your cup to some new ideas for just a minute, I’d like to present you with 4 ways in which your 401(k) just might not be the “dream investment vehicle” you think it is:

1. Fees

PBS did a fascinating interview with John Bogle, founder of Vanguard, in February of 2006, where Bogle admitted that most mutual funds were terrible investments and that expenses and fees ate up to as much as 80% (yes, you read that correctly….80%!) of investors’ returns.

How does that work, you ask? Your expense ratio on your carefully selected equity fund is “only” 1.01%?

Let’s take a look:

Frontline: So, what percentage of my net growth is going to fees in a 401(k) plan?

Bogle: Well, it’s awesome. Let me give you a little longer-term example. The example I use in my book is an individual who is 20 years old today starting to accumulate for retirement. That person has about 45 years to go before retirement — 20 to 65 — and then, if you believe the actuarial tables, another 20 years to go before death mercifully brings his or her life to a close. So that’s 65 years of investing. If you invest $1,000 at the beginning of that time and earn 8 percent, that $1,000 will grow in that 65-year period to around $140,000.

So far, so good… $1000 –> $140,000 sounds terrific!  But let’s look more closely…

Bogle: Now, the financial system — the mutual fund system in this case — will take about two and a half percentage points out of that return, so you will have a gross return of 8 percent, a net return of 5.5 percent, and your $1,000 will grow to approximately $30,000. One hundred ten thousand dollars goes to the financial system and $30,000 to you, the investor.

Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return, and you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return.

WOW. And you wonder why you can’t retire when you’re 65! Don’t understand this math? (Don’t worry, I didn’t either at first…how can 2.5% in expenses and fees turn into 80% of my entire return??? I thought this was crazy!)

But apparently I wasn’t the only mathematically challenged one…a viewer to Frontline also questioned the math and wrote in to the show, prompting the publishing of the following explanatory tables. Here it is, all laid out for you in exquisite detail…the table on the left shows the growth of $1,000 invested by an individual at age 20 until his/her death at age 85, assuming 8 percent annual growth.

On the right, it shows what happens to that same $1,000 over the same period assuming a 2.5 percent annual cost, such as a mutual fund management fee. Over the 65 years, these annual fees eat up a staggering 79 percent of what the investor would have earned with no management costs:

John Bogle Fees Image

Left: $1000 Before Fees, Right: $1000 After Annual Fees

Wow. (Can you say “sucker”??? Yours truly was a big one, pre-Kung Fu Finance!)

And it gets even trickier, if you can believe it…I dug into Bogle’s book, The Battle for the Soul of Capitalism, to see if I could find out a bit more. Sure enough, fund investors and the public have been “educated” to measure fund management fees and operating expenses as an annualized percentage of fund assets, which makes the resulting expense ratios (the tiny numbers you see like 0.92 percent) seem almost trivial.

But when you look at the expenses as a percentage of a fund’s dividend income, in Bogle’s words, “the numbers take on a more ominous cast”. For example, if the dividend yield on stocks is say 1.8%, a typical 1.5% fund expense ratio will consume 80% of a fund’s income!

And furthermore, expense ratios represent only about half of the cost of owning mutual funds—you also need to factor in hidden portfolio transaction costs and sales loads…this is what raises your “tiny” expense ratio up to a full 2.5 – 3%.

Bogle goes on and on and provides lots of specific examples in his book if you are interested (this stuff is found in Chapter 7). He also skewers the market-timing scandals that my former pre-Kung-Fu-Finance self found out about the hard way in my crappy Janus Mercury Fund….it’s a good read if you’ve got the time and the interest.

The moral of this story, however, (and almost the title of this email…) is of course, that “Mutual Funds Are the Devil”!

And what is the primary investment vehicle to be found inside of 401(k) plans? …Yep, you guessed it… MUTUAL FUNDS.

Please, if you are bent on investing in your 401(k) (and we’ll get into some other pitfalls to be aware of tomorrow…), do not put your money into mutual funds. Find yourself the lowest cost index fund instead (here’s hoping your plan provider has one…).

More tomorrow….

To your financial success,

—Kung Fu Girl “Mutual Fund Free for over 10 years”