Most 401(k) plans today are saddled with fees that are unnecessarily high, but unfortunately there is not much an employee can do since the plan design is decided by the employer. Most 401(k) plan participants are not even aware of plan costs. The fees take two forms: first, administrative expenses, which come directly out of account balances, although in some cases, especially at large companies, the employer may cover these expenses; second, fees paid to the mutual fund companies for the mutual funds that are offered by the plan. The combined fees are known as the “all-in fee.”
High fees can significantly eat into investment returns over time and easily total several tens-of-thousands of dollars of lost savings over several decades. The chart below shows the total 401(k) fees paid by a typical worker (1.0% to 1.3% is common) with a median salary from age 25 to 67. The differences are dramatic over long periods of time and small changes in fees can have a major impact on investment returns.
Typically the largest and most unnecessary expenses are mutual fund fees, which alone can average between 0.70%-1.00% of total assets. The reason for high mutual fund fees is that most 401(k) plan providers offer actively managed mutual funds as the primary investment options. These funds typically have the highest fees, and unfortunately the weakest performance. Instead of high cost, actively managed mutual funds, plans should offer low cost index funds. As discussed in several of our blog articles (here and here) the evidence clearly shows that stock index funds outperform actively managed funds. So why don’t all plans emphasize index funds? Because of “revenue sharing” arrangements whereby the mutual fund companies pay the 401(k) plan providers fees for offering certain funds for a plan. This is obviously a conflict of interest that has a major influence on the investment choices selected by the plan provider. Index funds are not typically selected since the fees are far lower and would significantly reduce the “revenue sharing” that your plan provider would earn.
So how can you improve your 401(k) plan? If you believe that you are paying too much for your plan or would like a menu of index funds consider contacting your plan decision maker to see if the plan can be modified. In the meantime, DIA recommends that participants check their investment choices and compare the performance of any stock mutual funds to their index benchmarks. If the mutual fund is underperforming the benchmark, and your plan does offer an index fund (often there is one index choice, usually an S&P 500 Index fund), consider switching. Another mistake many 401(k) investors make is allocating a portion of their accounts (and ongoing monthly contributions) to cash or cash equivalents, like money market funds. There should be no allocation in a 401(k) plan to cash. As a multi-decade investment, all 401(k) funds should be invested, not sitting in cash. Cash reserves should be held in a regular bank or brokerage account, not a long-term retirement plan account.
Downtown Investment Advisory (DIA) is seeking to “disrupt” the 401(k) market, especially for small businesses, which is dominated by the large brokerage, insurance and mutual fund companies. Downtown Investment Advisory (DIA) recently teamed up with an independent third party 401(k) administrator and Charles Schwab to offer a better and far less expensive 401(k) plan to small businesses. In one case DIA was able to lower the all-in fee for a client from 1.2% to 0.7%, a 40% reduction in expenses. DIA acted as the Registered Investment Advisor and fiduciary for the plan (an important designation that many plan providers avoid) and selected a fund lineup relying on index funds. In order the help the company comply with the new Supreme Court mandated standards, DIA prepared an Investment Policy Statement for the plan which will be updated annually. Since DIA is free of all conflicts of interest (i.e. no “revenue sharing” from the mutual fund companies) we are free to choose the best index funds for a plan, in addition to lowering administrative costs and providing personalized service.