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Taking Control Of 401(k) Fees

More than 60 million Americans have 401(k) plans. I bet only a few actually know the costs associated with their plans or how those costs can impact their retirements.

401(k) plans have become massively popular since they were introduced in the late 1970s, both because of the bull market that dominated the ’80s and ’90s and because employers have steadily cut more traditional defined-benefit pension plans over that time. Yet 401(k)s remain mysterious to millions of their owners.

In fact, according to an AARP study in 2011, more than 70 percent of respondents didn’t know they were being charged anything for their 401(k)s. In reality, the average investor pays about 0.8 percent of assets annually, a recent Fortune magazine article reported; investors in small plans often face substantially higher fees, sometimes as high as 3 percent.

Even once participants know that they pay fees, the amounts can sound deceptively small. You might ask: What’s a percentage point here or there? Is the difference between 0.5 percent and 1.5 percent anything to get worked up over? In fact, over the course of one’s working life, it means quite a bit.

Consider a worker who invests $10,000 per year in her 401(k) account for 40 years, earning an average of 7 percent annually after fees. A 1 percent increase in fees results in almost $500,000 of lost savings over the course of that worker’s career. Further, this figure doesn’t include the growth on those savings she would have accumulated after retirement. As you can see, even “small” fees can have a devastating impact on retirement savings.

Types Of 401(k) Fees

401(k) plans vary a great deal, and there is no catchall explanation of what a participant is charged and why. This very lack of clarity is part of the problem many investors face. Generally, though, participant fees fall into two categories.

First are plan level expenses, charged by the plan administrator or custodian. These primarily consist of costs for basic administrative services, such as recordkeeping, accounting, legal or trustee services. It is sometimes hard for a layperson to interpret the ways in which plans label these services. For example, a recordkeeping fee might be called a “daily asset charge.” Certain plans may also charge administrative fees for extra services, such as participant access to customer service representatives, retirement planning software or investment advice. Some participants may find these a good value, but they aren’t standard, and they certainly aren’t free.

In some cases, plan level expenses may be paid directly by the employer, but many plans pass these costs to employees, either as a deduction from investment returns or as a separately stated charge to each participant’s account. In either case, plans with more services will tend to charge more in administration costs.

In addition, some participants may also face individual service fees associated with optional features of their 401(k) plans. These are charged separately to the accounts of individuals who use such features, rather than to all participants. Examples are the ability to take a loan from the plan or to personally direct investment decisions within it.

Fees in the second category are those charged by the underlying investments. Each underlying mutual fund charges an “expense ratio,” which is a portfolio management fee that is charged per dollar of assets managed. Expense ratios are paid to the mutual fund company. All mutual funds charge expense ratios, whether they are held in taxable brokerage accounts or in retirement plans, so these fees are not unique to 401(k)s. However, investors in a company 401(k) plan are essentially captive consumers. Some 401(k) plans have limited mutual fund offerings, many of which carry high expense ratios.

Expense ratios can also be layered, depending on the type of fund. For example, a target-date maturity fund may include a management fee itself, but will also include charges for management of all of the underlying mutual funds. It can be difficult to tease such interwoven fees apart. Many funds also include marketing charges in their expense ratios, often referred to as 12b-1 fees.

Some plans may aggregate expense ratios across offerings and provide the participant with a lump expense ratio, in which the fee is presented as a percentage of the participant’s total assets. As noted above, this expense ratio varies depending on the services offered, the size of the plan and a variety of other factors. Generally, however, if an expense ratio is over 1 percent, you should consider whether the mutual fund portfolio manager is worth the fee.

Besides expense ratios, plan participants can also face transaction costs for buying and selling underlying funds. These include trading fees and commissions that managers pay to buy and sell securities. In some cases, this can be a simple trading commission, but many funds also have “sales charges” or “loads.” These may be paid when you invest in a fund — a “front-end load” — or when you sell shares — a “back-end load.”

In addition to mutual fund fees, certain plans may also have unique fees. Variable annuities, for example, can incur insurance-related charges, or surrender and transfer charges, that would not appear in a plan holding only mutual funds.

The first step in controlling 401(k) fees is to understand as best you can what you currently pay. A Labor Department rule, accepted in February and rolled out at the beginning of July, requires 401(k) providers to disclose to employers the fees they charge for administration and money management. A separate proposal, not yet accepted but slated for the near future, would require providers to publish a concise and easy-to-follow “road map” of their fees.

While this new rule is a step in the right direction, it doesn’t afford perfect clarity. Providers only have to disclose expense ratios annually, not quarterly. And since the providers aren’t required to confine the lists to just funds investors own, it might become a scavenger hunt for investors to find the relevant information. These disclosures will list costs in dollar amount per $1,000 invested; investors will still have to do the math themselves.

Employers aren’t required to do these calculations for their employees, and even getting your hands on the disclosure may not be automatic, so it’s important to pursue the information should you need to. The more information you can get about the fees you pay, the more accurately you can evaluate whether the services are worth the costs.

Reducing Or Avoiding 401(k) Fees

Once you have a good idea of what you’re paying, you can make some choices. There isn’t much you can do about the plan level expenses of your employer’s 401(k) that are passed through to employees. Unless there is enough momentum, either from employees or from human resources, to get your employer to switch plan providers, you’re generally stuck with the 401(k) plan that your employer offers. However, knowing the fees you pay can impact decisions on how you invest within your account.

For example, many custodians charge a flat fee for each mutual fund held in a plan participant’s account. If you’re in a plan that charges a $20 annual fee per mutual fund owned and you are considering a $400 investment in one of the mutual funds, you might want to reconsider whether it’s worth owning such a small amount of a single fund.

Costs can often be reduced significantly simply by carefully choosing among the funds offered within your plan. Index and exchange traded funds, for instance, typically offer broad diversification within an asset class at a low cost. Most actively managed funds have expense ratios north of 1 percent, whereas index funds might charge a fraction of that. Numerous studies have shown that active fund managers generally lag their index fund counterparts in efficient market segments because of such funds’ higher expense ratios. Even 401(k) plans with limited fund choices will often provide investors with both actively managed and index fund options, and switching to the lower-cost index funds where appropriate can greatly reduce annual costs.

Non-mutual fund investments within 401(k)s can have other costs. Beware of insurance products such as variable annuities, which can have high, hard-to-understand fees. Also avoid borrowing against your plan. It’s usually not a good idea to withdraw from your retirement fund unless you have no other options, but in addition, you can face some hefty service fees.

What do you do if your employer’s plan doesn’t offer effective lower-cost choices? If you know that you plan to leave your employer in the near future, or if you still have an old employer’s 401(k), you can roll over your 401(k) funds to a lower-cost IRA with more investment options when you switch employers. Alternatively, if your employer 401(k) plan option is not very good, you may choose to forego investing in your 401(k) and instead invest your retirement savings in an outside account, such as a traditional or Roth IRA, if you are eligible. However, if your employer offers matching 401(k) contributions, it makes sense to contribute as much as your employer will match; such matching will generally overcome any disadvantages resulting from high investment fees.

The Employee Retirement Income Security Act (ERISA) requires employers to follow certain rules of due diligence and care in managing 401(k) plans. Smart employers will want to be sure they have a plan that has reasonable fees and offers diversified investments, for their sake as well as yours. If you’re not satisfied with your current plan, talk to human resources or the plan administrator at your firm. Asking for more fee disclosure and a greater variety of lower-cost investment options can alert your employer to wider dissatisfaction, and it’s not in an employer’s best interests to offer its employees a subpar 401(k) plan. It is, however, important to bear in mind that 401(k) plans are group plans, so your employer may not be able to accommodate each individual’s preferences. Even if your employer doesn’t change providers, do not use your plan’s expense levels as an excuse not to save for retirement; saving with fees is still exponentially better than not saving at all.

A comprehensive 401(k) plan should offer funds that provide broad diversification across each asset class, as well as on a total-portfolio level. Even for smaller plans, there is no reason for fees to be out of control. While participant fees are part of the 401(k) package, understanding them can help you preserve a greater portion of your retirement savings.

Vice President David Walters, who is based in our Oregon office, contributed several chapters to our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 5, “Estate Planning,” and Chapter 6, “Transfer Taxes.” He was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.
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