Second in a series of articles about retirement plan costs for investors, business owners and plan administrators
- You don’t have to know all the answers, just ask the right questions.
- 401(k) costs can have a major impact on long-term results for participants.
- Be aware of the costs you are incurring and be diligent about reducing them where possible.
How many of these acronyms have your heard of–401(k), 403(b), 401(a), 457, S&P, SEC,DOL, NASDAQ, D.B., D.C., SIMPLE, SEP, ERISA and more? OK. That’s pretty good. But, how many do you really understand? Hmm. That’s what I thought.
It’s a great ball of jargon-loving confusion in today’s retirement plan world. How could any of us be expected to understand the ins-and-outs of this environment, with all of its mysteries and complexity? The good news is that you don’t have to know what all those confusing terms mean. Instead, by simply knowing what questions to ask the professionals it becomes much easier to ensure we are on the right path to retirement.
I’m still amazed at how many individual investors go it alone and believe they need to have all the answers even when investing may be a world away from their personal professions and area of expertise. Why is it that when planning for retirement and investing, individuals often fail to ask for help. I compare it to treating an illness or injury myself rather than going to my physician, even though I have never been to medical school.
Whether you are a business owner and retirement plan sponsor or an individual participant diligently saving for a secure financial future, chances are you don’t have a clear picture of the fees you are paying for your retirement plan. Although new disclosure rules were adopted in 2012, 401(k) fees are still very much a mystery and they’re often overlooked by retirement plan participants. To make matters worse, fees that sound nonmaterial on the surface have the potential to add up to hundreds of thousands of lost dollars over time.
Take a look at this example from the U.S. Department of Labor:
Assume that you are a young employee who’s at least 35 years from retirement age and that you have a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, then your account balance will grow to $227,000 by the time you retire–even if there are no further contributions to your account. If your fees and expenses are much higher however, say 1.5 percent, then your account balance will grow to only $163,000. The 1 percent difference in annual fees and expenses will reduce your account balance at retirement by a whopping 28 percent.
The above difference equates to having $64,000 less in your account at retirement, and that’s if your 401(k) has only $25,000 in it. Imagine how much you could be out of pocket if you had a larger balance and had saved aggressively. The number could quite literally be hundreds of thousands of dollars.
The Employee Retirement Income Security Act of 1974 (ERISA) requires employers to follow certain rules pertaining to managing 401(k) plans. Employers are held to a high standard of care and diligence. They must discharge their duties solely in the interest of the plan participants and their beneficiaries. This is known as being a fiduciary. Among other things, this means that employers must:
- Establish a prudent process for selecting investment options and service providers
- Ensure that fees paid to service providers and other expenses of the plan are reasonable in light of the level and quality of services provided
- Select investment options that are prudent and adequately diversified
- Disclose plan, investment and fee information to participants to make informed decisions about their investment options under the plan and
- Monitor investment options and service providers once selected to see that they continue to be appropriate choices
As an individual participant however, it’s certainly possible that you didn’t know you were paying fees at all. Therein lies the problem. A 2013 study by the Life Insurance Marketing Research Association, showed that almost one in four (22%) workers believe they are paying nothing for their plans. As the old saying goes, if it sounds too good to be true then it probably is.
Three primary categories of 401k expenses
In fact, there can be dozens of fees attached to a 401(k), although the fees typically fall into one of three categories:
- Investment fees. In the mutual fund world these are referred to as “operating expenses” or “expense ratios.” These are the fees you pay for ongoing operations of the investment. It is typically stated as a percentage.
- Plan administration fees. These are the fees associated with the cost of providing and maintaining your 401(k) platform. They may be included in the investment fees or may be charged separately.
- Individual service fees. These fees are usually a la carte and are associated with “services” for such things as loan processing or rebalancing your allocation.
Although these fees can amount to thousands of dollars each year, many investors are not aware of them because they never have to write a check for the fees. Instead, the fees are taken directly out of the investor’s account and most never even see it happen.
This is not only a serious matter as a plan participant, but it’s even more important to understand the implications as a business owner. The disclosure rules require the plan’s administrator (employer) to provide plan investment and fee information to participants. As an employer and fiduciary, you have a specific legal obligation to consider the fees and expenses paid by the plan. The degree of fiduciary liability carried by the plan administrator depends greatly on the structure of the 401(k) plan arrangement.
After reading this article series
After reading this book, you should have a much better understanding of your fiduciary responsibility if you’re a business owner or plan sponsor. You should also gain a better understanding about how to minimize costs, maximize investment choices and returns, increase transparency for plan participants and guide them better toward a happy and financially secure retirement.
Today, there are tremendous opportunities for business owners and participants to lower their costs and improve their platform thanks to:
- Lower-cost platform options available
- Bundled services rather than paying Third Party Administrators (TPA) separately
- Non-commissionable products now available
- Non-insurance-based platforms now available
- Fund operating expenses coming down across the board due to better educated consumers
- More low-cost, evidence-based investment vehicles rather than just high-cost actively managed funds
Plan sponsors and participants can save hundreds of thousands of dollars over time
Oftentimes, plan sponsors are not aware that there are much lower-cost options for 401(k) platforms than the typical brokerage or insurance-based plans. For these individuals, it is possible to see an immediate and often significant reduction in actual “out-of-pocket” costs. When our firm began managing a 401(k) plans for a group of anesthesiologists a few years ago, we were able to save them “hard-dollars” of more than $100,000 per year. By hard dollars we mean direct payments made to financial institutions (e.g. writing a check or account withdrawal) versus “soft dollars,” such as a mutual fund reimbursing a broker via a “load” (commission).
From the participants’ perspective, cost-savings over time can have an even greater impact on the future of their retirement. I have personally seen case after case, in which participants are invested in high-cost, actively managed mutual funds and they have no idea how much they are paying. Many of these funds can cost well over 1 percent per year, and in some cases, twice that amount or more. By contrast, the typical evidence-based fund can range from 0.10 percent to 0.50 percent annually. Therefore, it is not a stretch to cut costs 1 percent every year simply by choosing the right investment options. Using simple numbers, let’s look at an example in which you have a balance of $100,000 in your account. Let’s also assume you make no additional contributions, but earn an average annual return of 6 percent. If you cut your costs by 1 percent and compound the savings over 25 years until your retirement, then you would have $542,743 versus $429,187 in your account. In other words, saving 1 percent annually provides you with an additional $113,556 over time.
Whether you are a plan sponsor or individual participant, my hope for you upon completion of this article series is that you will be armed with enough information to make informed decisions about your financial future. At minimum I want you to walk away knowing what questions to ask in order to ensure that your costs are reasonable, you are properly diversified, and you understand where to focus your efforts for maximum effect.