Does Your 401(k) Cost Too Much?
You can bargain-hunt for virtually any item on your personal balance sheet, from mortgages and car loans to mutual funds and brokerage accounts. But when it comes to what is probably your largest asset aside from your house -- your 401(k) retirement plan -- you're stuck. Stuck, that is, with the investments your company selects, no matter how expensive they may be. Since many 401(k) plans consist of relatively high-cost mutual funds and insurance products, that's generally bad news. Indeed, the average 401(k) participant in a big plan forks over 1.07% of the account balance each year, while small plan participants pay 1.4%, on average. With the most expensive plans running as high as 3%, "people are hollering about abuse," says Ted Benna, a benefits consultant who created the 401(k) in 1980 and is now president of the 401(k) Assn., a consulting firm in Jersey Shore, Pa. It's easy to see why. A worker who puts the $13,000 maximum you can currently invest tax- free into a 401(k) each year will have $1.166 million after 30 years, provided the portfolio returns 8% and costs 1.38% a year. But the investor will have 14% more if costs fall to 0.70% and 25% more if they're just 0.25%, according to Vanguard Group, which is known for managing mutual funds but also administers 401(k)s.
Considering that one study pegs investment fees for the average company pension plan at just 0.28%, why are 401(k) fees so high? For one thing, 401(k) plans are far more expensive to run. Indeed, a 401(k) has to maintain multiple separate accounts -- tracking returns and transactions for each participant. Plus, since the 401(k) took hold in the 1980s, plans have added increasingly sophisticated services, including access to daily account balances, call centers, online transactions, and employee education programs. Over the past decade, employers have quietly shifted much of the cost of those services to employees. This has occurred in large part through a widespread system called revenue sharing, in which fees are taken out of employees' funds and funneled to various service providers.
But there's more to the story. The Securities & Exchange Commission is investigating the disclosure of conflicts of interest in 401(k) fund selection. The U.S. Labor Dept., too, is looking into such issues as whether service providers who have a fiduciary obligation to keep plan costs reasonable are accepting improper payments from funds. They are also examining whether plan providers adequately disclose their fee arrangements. Among the concerns: Such advisers may favor funds that pay them the most, instead of those that are the best investments.
Over the past decade, 401(k) fees have become increasingly complex. Indeed, the fees collected from your account may be parceled out to several service providers (chart). Critics contend that some of these arrangements can create conflicts of interest that -- although often at least partly disclosed in the fine print of mutual-fund prospectuses -- are poorly understood, especially by investors and the small plans that lack the time and resources of their larger counterparts.
Consider Putnam Investments, which besides managing mutual funds administers 401(k) plans. It recently upped the price to be on its selective Gateway list for one fund company that requested anonymity. "They tout these funds as the gold standard," says an executive at the fund company. But while the funds are vetted for performance, it's also "in part a pay-to-play list." A Putnam spokeswoman strongly disputes that characterization. She says the company discussed "the offsetting of costs associated with record-keeping expenses" with just a "handful" of Gateway funds. "This practice is disclosed to plan sponsors" and is "consistent with industry standards," she adds.
What can a 401(k) investor do to contain costs? Start by reexamining your plan's options, weighing fees as carefully as investment objectives. Since 401(k) plans are tax-deferred, you won't take a tax hit for selling a profitable holding. As a rule, the low-cost investment options include index funds and the institutional or co-mingled accounts that some plans -- mostly big ones -- offer. Company stock, though generally free, may leave you dangerously exposed to your employer's fortunes. Meanwhile, although there may be an investment benefit to adding funds that concentrate in specific industries or stock categories -- such as small-cap or international -- keep in mind that they tend to cost more.
If your 401(k) menu is short on bargains, ask your employer to add lower-cost alternatives, advises Sue Stevens, director of financial planning at researcher Morningstar. Be aware that the fees on rock-bottom 401(k)s can be as low as 0.12% a year, according to Benna. So, even if your plan has average costs for its size, there's room for improvement.
Before weighing your alternatives, figure out how much you're paying in fees. This can be tricky, because of a system of disclosure that puts the burden on you to request documents and comb through the fine print. Fees can take various forms: Most small to midsize plans bundle them into an all-inclusive number, while some larger plans break out the parts.
Start by calling your company's benefits department. Employers are generally required to divulge fees when participants ask. Request a prospectus for each of your funds. (You can also call the fund companies directly.) Here, you'll find the expense ratios the funds charge to manage your money. Because expense ratios account for about 90% of the average 401(k) participant's costs, this will give you most of what you need to assess your fees. (If your plan uses annuities or co-mingled funds, ask, respectively, for the group annuity expense contract or investment management contract, says Joseph Valletta, partner at HR Investment Consultants in Baltimore.)
The next step is to pick apart the expense ratio. By examining the fees bundled into it, you can see where the money is going. The prospectus should break the expense ratio into three categories of fees, namely: "investment management," "12(b)-1," and "other expenses."
Most of the expense ratio pays for exactly what you would expect: investment management. But a fund is also free to charge a 12(b)-1 fee -- for marketing and distribution -- of up to 1%. That can be used to cover the costs of servicing your account or marketing the fund to your plan. Some funds also levy "sub-transfer agent" fees to defray administrative costs. These are lumped into the "other" or 12(b)-1 categories in the prospectus and, according to Clark Consulting in North Barrington, Ill., can amount to 0.25% to 0.65%.
Through revenue sharing, the funds in your 401(k) plan collect the fees and funnel some of that money to others. (As with mutual funds, you won't see the fees deducted, since they're taken out of your returns.) Some of the 12(b)-1 fees may go a broker-dealer or other intermediary who helped the fund land a slot in your 401(k) plan. And the sub-transfer agent fees -- and often some 12(b)-1 revenue, too -- goes to the company that administers your plan in order to pay for such services as record-keeping.
Still, these arrangements have drawn criticism. Some contend they provide incentives for brokers and administrators to push funds with higher fees. Moreover, because these extra fees come out of participant's balances, their increased use has transferred much of the 401(k) overhead to employees.
Some revenue sharing payments are hidden. Often, this occurs when funds pay brokers and 401(k) administrators from their parent company's profits, rather than from 401(k) participants' balances. Still, some fund companies are starting to disclose the practice. For example, in a Mar. 18 SEC filing, Boston fund company MFS says that it may pay "dealers" for selling its funds to retirement plans, among other services. The amount: up to 0.25% of the assets placed in the plan.
Ask your employer if you're bearing costs that aren't included in your fund expense ratios. Check your quarterly account statement, too, since in some cases extra fees are deducted from the balance. Of course, your employer may also write a check to cover some plan bills. But that information isn't generally available, says David Wray, president of the Profit Sharing/401(k) Council of America.
Because of the 401(k)'s tax advantages, the only time it might make sense to shun a plan in favor of a taxable account is in the rare instance that its fees are exorbitant and there's no matching contribution from your employer. But there's no doubt that keeping the fees down can make a big difference in how large an amount you're able to save. So don't overlook how much you're paying or remain silent if the tab is too high.
By Anne Tergesen