April is National Financial Literacy Month – but do you know what’s hiding in your retirement nest egg?

Most Americans do not.  InvestingNerd finds that the overwhelming majority of people don’t know the full extent of the 401(k) fees they’re being charged, with many underestimating their total lifetime fees to the tune of $150,000 or more.

Key Findings:

  1. There are at least 28 types of fees to watch out for in your 401(k): A fund’s expense ratio only tells part of the story – there are several other costs stemming from the plan provider and from the mutual fund itself investors should be aware of. (See fees table below.)
  2. 9 in 10 Americans severely underestimate their 401(k) fees: InvestingNerd surveyed over 800 Americans to find that 92.6% of American adults have no idea just how big their cumulative 401(k) related fees are – to the tune of over $150,000.
  3. Actively managed mutual funds underperform index funds due to high fees: If you have several actively managed funds in your 401(k), you may want to reconsider.  InvestingNerd’s mutual fund study finds that over the last 10 years, index funds outperformed actively managed mutual funds by 0.80% annually.  Although actively managed mutual funds outperformed the index by 0.12% before fees, fund managers charged more in fees than the value they created.

See also: InvestingNerd’s 401(k) Fund Screener planning tool.

Knowledge of these fees is critical because they can eat away at large amounts of families’ savings over time. Just how much can these fees add up over time?  A retirement savings model by the think tank Demos calculated that, over a lifetime, all 401(k)-related fees can cost a median-income two-earner household almost $155,000 – almost a third of their total investment returns.

Meanwhile, a case study from the U.S. Department of Labor finds the potential for staggering losses in savings due to these fees:

“Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7% and fees and expenses reduce your average returns by 0.5%, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5%, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28%.”

When it comes to retirement planning, most people remain in the dark about how many fees their 401(k) providers are charging them – and just how much money they are losing as a result.

The Expense Ratio and Beyond: Fees to Look For

Where are all these fees coming from, and how can those saving for retirement minimize the expenses eating away at their returns?  New Department of Labor regulations set in 2012 mean that all of your 401(k) fees are disclosed in your annual prospectus statement.  The problem?  Few people understand these fees and it’s very hard to gauge whether or not you’re being given a good deal without also being given industry averages for context and comparison.  In addition, many don’t even know that 401(k) providers charge fees at all; a 2011 AARP survey found that 7 out of 10 of 401(k) holders didn’t know they were paying any fees to their 401(k) plan providers.

The expense ratio, which measures a fund’s total annual operating expenses, is the most well known fee you will encounter in your fund selection process, but it would be a mistake to believe this is the only fee you’re being charged within your 401(k) plan.  Expense ratio is the fee displayed most prominently by each mutual fund because these types of fees do not vary much year to year; this is a static fee listed in each fund’s annual report.

While fee structures vary widely from plan to plan, the following three-layer 401(k) fee structure is most standard.  The first two fee types are associated with the funds within your plan, while the plan level fees consist of the fees and costs of the 401(k) plan provider.

  1. Expense Ratio: The expense ratio associated with each mutual fund is probably the most cited fee you’ll see, but it only tells part of the story.  It measures a fund’s total annual operating expenses.
  2. Other Mutual Fund-Level Fees: While the expense ratio encapsulates many of the costs of investing in a fund, there are also other mutual fund-level costs of purchasing a fund, as well as the trading costs that come with it.
  3. Plan-Level Fees: These are the fees of the 401(k) plan providers and administrators. These are the costs of keeping your company’s 401(k) plan up and running, as well as any investment and service fees.

This is the full list of fees you can expect to see, and the rough averages you can expect each fee to take of your returns:

Breakdown: 3 Layers of Fees in a 401(k)  
   
1. EXPENSE RATIO FEES: OPERATING EXPENSES   
Averages around 1.105% of assets  
Management Fees include:
  • Fees to fund’s investment advisor for managing the fund’s portfolio
 
  • Administrative fees due to the investment advisor not
Distribution/Service Fees include:
  • Marketing fees – e.g. 12b-1 fees
 
  • Sales charges
 
  • Shareholder service fees
Other Administrative Expenses include:
  • Custodial expenses
 
  • Legal expenses
 
  • Accounting expenses
 
  • Transfer agent expenses
 
  • Any additional shareholder service expenses
   
2. MUTUAL FUND-LEVEL FEES NOT INCLUDED IN EXPENSE RATIO  
Averages around 1% of assets  
Transaction/Trading Costs include:
  • Brokerage Commissions
 
  • Bid/Ask Spreads
Shareholder Fees can include:
  • Sales loads
 
  • Redemption fee
 
  • Exchange fee
 
  • Account fee
 
  • Purchase fee
 
  • Maintenance fee
   
3. 401K PLAN-LEVEL FEES (OF THE SERVICE PROVIDER)  
Highly variable range: median ‘all-in fee’ averages 0.72% of assets  
Plan-level Investment Fees include:
  • Plan set-up
 
  • Portfolio management fees
 
  • Advising plan sponsor fees – either by recordkeeper or portfolio manager
 
  • Educational materials and services expenses
   
Plan-level Administrative Fees include:
  • Recordkeeping services
 
  • Employee enrollment services – meetings, paperwork, etc.
 
  • Customer service – e.g. phone and web support
 
  • Legal advice to employer
 
  • Compliance testing expenses – e.g. audits
   
Plan-level Service Fees include:
  • Fees for additional features or services – e.g. investment advice, loan fees

The SEC provides full definitions of each type of fee and FINRA has a useful tool for looking them up.  Technically, these are not so much hidden fees – most should be listed out in any fund’s prospectus under “Shareholder Fees” – as they are difficult to understand fees. However, it is incredibly important to know how the money is being spent, since all of these fees, whether directly or indirectly, are passed on to 401(k) plan participants.

What is a 401(k) and Why Do You Need One?

Americans should start saving for retirement as soon as they can, and contributing to a 401(k) is one of the most common ways to begin doing so.  A 401(k) is a tax-advantaged retirement account set up through an employer that the government allows you to contribute to while you work, so your savings can grow tax-free.  Your investment returns then compound significantly over time, making your initial investment worth far more in several years than if it had been left in a savings account not even beating inflation.  Once an employee leaves a job, the money stays with them, and they can roll it into a rollover IRA to maintain its tax-advantaged status.

Once an employee has a 401(k) set up and there is money in the account, he or she must decide how to invest the money.  Each 401(k) plan’s offerings vary by provider and by company, but typically there will be a choice of index funds, actively managed mutual funds, target-date funds, bond funds, etc.  An employee can select one or a mixture of these investment vehicles within the plan.

The State of Retirement Savings Today

The great retirement crunch is coming, and in light of this fact, 401(k) savings – or the lack thereof – can really make a difference to many American families. Many indicators show that Americans simply aren’t saving enough for retirement:

  • The Federal Reserve found that the typical household with workers aged 55 to 64 had a combined $120,000 in 401(k) and IRA savings.
  • Unfortunately, more than half of workers have less than $25,000 in savings.
  • Even worse, 31% of retirees have less than $1,000 in savings and investments.

However, as the state of our future social security system is uncertain, Americans may be increasingly realizing that they need to save more – and sooner.  A sign of hope, according to Fidelity, is that the average amount invested by the company’s 12 million 401(k) plan participants is $77,300 as of the end of 2012 – setting a record high for the company.

Investor’s Guide – How To Minimize Your Overall 401(k) Fees

Families saving for retirement should follow a three-part plan to optimize their 401(k) savings.  By first figuring out the full extent of account fees, they can then be minimized to the extent possible.

1. Pick Funds With Low Expense Ratios

While a fund’s expense ratio doesn’t tell the whole story, studies have shown that the expense ratio is one of the best fund performance indicators. Conveniently, this is also the easiest fee group for the casual investor to control.

The proof is in the pudding: a fund’s expense ratio has been shown to be the most reliable indicator of performance over time – a far better indicator than anything else, including Morningstar ratings.  An August 2012 Morningstar study concluded lower expense ratio funds did better at predicting mutual fund success than Morningstar’s own star rating system. The study went so far as to say, “In every single time period and data point tested, low-cost funds beat high-cost funds.”

So what’s a good, low expense ratio to look for?  The InvestingNerd mutual fund database compares over 13,000 funds to find that the average expense ratio paid to a fund is approximately 1.105%. However, don’t feel pressured to pay 1% in fees, there’s a large selection of mutual funds with expense ratios below 0.5%.

2.  Compare and Rank Your 401(k)’s Fund Offerings

While casual investors are often tempted to look solely at a fund’s past returns, keep in mind the number one rule in investing: past performance does not guarantee future results.  There are several other metrics that should come into play to determine the best mutual funds for each investor’s needs, such as risk adjusted return, relative outperformance, and volatility.

For casual investors less well versed in these figures, InvestingNerd’s 401(k) screener tool allows investors to compare all the funds offered in your employer’s 401(k) plan, so investors can pick the best ones for their portfolio.

3. Identify Hidden Fees – Then Take Action

Whether you’re signing up for a new 401(k) plan or you have to dig through old paperwork to find the information on your old plan, it’s worth taking the time to read your prospectus and identify all the fees listed – it could pay off big time.

Here are some tips for what to do if you identify excessive fees embedded in your plan:

  • Select index funds with low expense ratios – they are much lower cost on average.
  • Consider saving via other types of retirement accounts such as a Roth IRA, a self directed IRA, or your spouse’s retirement account if the fees are more favorable.
  • Not all no-load funds are created equal, so check out the details of yours.  Legally, FINRA allows a fund to charge up to 0.25% of its average annual net assets in 12b-1 fees and still call itself a no-load fund.
  • If your menu of 401(k) fund options is full of poorly performing mutual funds from the same family, you may want to find a new plan trustee.  Ideally, your 401(k) plan provider isn’t affiliated with the mutual funds offered.  This is in large part because, as an Indiana University study found, “poorly-performing funds are less likely to be removed from and more likely to be added to a 401(k) menu if they are affiliated with the plan trustee.”
  • If the terms and fees of your 401(k) plan provider are bad, consider getting fellow employees together to ask HR for a lower cost provider.

 Hundreds of thousands of dollars worth of 401(k) fees are eating away at most Americans’ retirement savings without their knowledge.  By following these basic steps, many investors can capture much more value from their 401(k) plans and retire more comfortably.

Though not all fees can be avoided, following this process will help investors cut the wasteful fees in order to save more money for retirement.

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