A question I often get from clients when they start a new job is whether or not they should transfer over their old 401(k) to their new employer’s 401(k). There are essentially three options for your employer retirement plan when changing employers: 1) Leave the account as-is. Now some plans have minimum account balances that when they’re not met they require the funds be moved out of the plan, but otherwise, most plans will allow you to stay there. 2) Move the funds to your new employer’s plan 3) Move the funds to an IRA which can be self-managed or professionally managed by an advisor, or 4) cash out the account, with possible repercussions of taxation and a 10% early withdrawal penalty if you’re under age 59 1/2 . I won’t get into all the variations of options but instead want to specifically address the idea of moving your old employer plan to your new employer’s plan.
There are many factors that go into this decision, but the reason I hear most often from clients is whether or not the account will grow faster if it’s started with a larger amount. This thought is based on the idea that the larger the account the more growth they will get, but that’s not how it works. The account will still grow at the same rate of return whether there is more in there or not. Let’s look at this example with all things being equal (which isn’t at all likely, by the way, due to fees and actual investment performance) and assume we’re earning 5% interest. If we have one account totaling $100,000 it will earn $5,000 at year’s end. But, if we split the account into two accounts both at $50,000 and both earning 5%, then we have two accounts earning $2,500 of interest at year’s end. Together the accounts will have earned $5,000. So it’s not imperative that you have “seed money” in an account as it will grow just as fast with or without a starting balance. On the outside this can be very tricky because 5% growth on a larger amount of money is a larger amount of growth. Another way to show this is with two unequal account values both earning 5% growth. If we have a $99,000 account and $1,000 the larger account will grow by $4,950 and the smaller account will grow by $50. But, altogether, that’s still $5,000 of growth. Again, I need to mention that that account fees/expenses and are often not going to be equal, therefore making the playing field not level.
As mentioned above, when looking at moving accounts around rarely will the fees and expenses be the same in both plans so you must carefully review all fees/expenses for both plans to help make your decision. To keep things easy again let’s assume all things are equal between two plans, Plan A and Plan B. Assuming they both earn 5% returns, we see that because Plan A has a 1% plan expense vs. Plan B’s 0.50% plan expense the net return for Plan A is lower because the higher fee is dragging down the net growth.
This hypothetical example might have you thinking you need to focus solely on fees, but that’s not necessarily the case. I’ve heard several people say they prefer the plan with the lowest fees, which I can understand is very alluring, but fees are only half the story, so let’s look at this from a wider angled lens. I like to illustrate this with an analogy of a car purchase, specifically, the car you drive. When you went looking for a vehicle did you go to the junk yard and ask for their cheapest vehicle in working condition? Or go through the used vehicle listings and search for the absolute cheapest vehicle for sale? Probably not. Why? Because you know that just because something is inexpensive does not mean you will be happy with it. The same could go for investments. Just because something is inexpensive does not mean it will perform the best, nor does it mean you will get the highest level of risk-adjusted return. It simply means you’re not paying a lot to have the investment. This is where it’s important to weigh out both the fees/expenses with all other factors, such as breadth of investments (we’ll talk more about that next), or guidance/assistance from an advisor.
As mentioned above, when considering moving your old plan to your new plan you should also evaluate the variety of investment options available in both plans. If your old employer’s plan offers a small number of fund options and your new plan offers an expansive list, you might benefit from the larger list. Let’s look at the following illustration to make sense of this.
Plan A has 5 funds and Plan B has 13. Between these two options, which plan looks more diversified? I’m guessing you answered Plan B, which is correct. But it’s not always just about the number of funds offered, but more so about variety. Let’s look at this next illustration for a more explanation. Here I’ve added a few funds to Plan A so that both plans have 13 investment options. Is there any difference between the two?
As mentioned, both plans have the same number of funds now, but, if you look closely you’ll see many of the funds in Plan A are similarly focused. There are three funds that are focused on large cap value stocks, three focused on large cap growth stocks, three mid cap blend funds, and two developed international stock funds. In this case it’s not about the number of funds, but the variety. When I say variety I’m referring to diversification. When there are multiples funds focusing on the same part of the market there is little diversification, if any, occurring. An old colleague I worked closely with had a great HVAC analogy for this that I often use showing the value of diversification. When building a house you will likely need to buy a furnace, an air conditioner, install operable windows, and maybe a few overhead fans. Each of these items are useful at different times throughout the year to maintain a comfortable environment. In most cases there is very little reason to buy two furnaces or two air conditioners, right? Why? Because if they are working properly there’s very little additional benefit you would get with a second. So instead of providing any additional benefit it would just be taking up space in the home that could be used for something else. This is similar to investments in that there’s very little benefit you get from having two of the same investments. If you already own Acme Corporation (a hypothetical company) in one of your holdings what benefit do you get when owning it in another holding? Really, nothing. Instead you should consider adding a differently focused option so that it can provide you with an opportunity to potentially grow even when your Acme Corporation stock is on the downturn. Of course I should mention, diversification does not guarantee a profit or protect against a loss, but it’s an important tenet in investing for lowering portfolio risk and increasing your ability to gain risk-adjusted returns.
Hopefully these insights help answer your questions on whether or not you should move your old 401k when you change employers. Consulting with an advisor can help you weigh out these factors as well as work to build an asset allocation that’s appropriate for you, your risk tolerance, and your time horizon.