The Most Important 401(k) Chart Youll Ever See

By Brian Stoffel Markets Fool.com

"That's impossible," my aunt said when I showed her the chart. "There's just no way that they could take that much money from me and I barely knew it." That was how the discussion ended 6 months ago when I drew up the most important 401(k) chart that she'd ever seen.

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Unless you have a background in finance -- or you have an exceptionally devoted employer -- most people's experience with making 401(k) investment decisions goes like this:

  • Schedule an annual meeting with a representative from the company providing your retirement plan.
  • Arrive at meeting, answer a few questions about your life -- when you plan to retire, what level of risk you are comfortable with, what your broad financial goals are, etc.
  • "Advisor" punches in your answers, and within seconds has a recommended plan for you.
  • Wanting to get back to work, you say, "OK", sign the requisite papers, and thank your lucky stars you don't have to do that again for a year.

Of course, everyone's experience is different. But for far too many working Americans, this is the approach taken to picking where to put your 401(k) -- or for those in the non-profit sector, 403(b) -- money.

The glaring problem with this approach

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Even if you're someone who does read the fine print, it can be easy to be lulled into a false sense of security when it comes to your investments.

Let's say that you choose to invest in a plan that has an expense ratio of 1.25% per year.That doesn't sound like much, does it?In fact, it seems like a pretty fair price given that these people are managing all of your retirement money for you, right?

Not so fast. The fact of the matter is that sometimes, you have options available to you that are almost identical in content, but have far lower costs. Vanguard -- a low-cost leader that is now insanely popular since more soon-to-be retirees wised up -- has an average expense ratio of just 0.18%, versus an industry average of 1.01%.Over time, that seemingly insignificant difference becomes enormous.

Let's get back to my aunt. After evaluating where her 403(b) money was, I saw that she was paying -- on average -- 1.2% per year for her investments. However, her employer's plan had options that (1) were similar in structure, (2) had expense ratios of just 0.20%, and (3) had outperformed the selected funds over the past ten years.

I'm not going to use her actual numbers here, but let's talk about a hypothetical soon-to-be-retiree. We'll say this individual has earned an average of $75,000 per year over 40 years after adjusting for 3% inflation. And because this person followed the recommendations to a tee, she put away 10% of her salary every year.

Below, you'll see two lines.

  • The red line represents what happens if your investments return 7% per year over this time frame, but you lose 1.2% of that gain every year to expense ratios.
  • The green line represents what happens if you get slightly higher returns of 7.2%, and pay an annual expense ratio of just 0.2%

Small Percentages Add Up Over Time
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At first blush, this might not seem so bad. In fact, that was essentially the reaction I got when I showed my aunt a similar graphic. Both lines are clearly trending upwards, and they don't even look all that different.

"What's the big deal?" was the response.

In order to really drive home this point, I showed her something else.

Here's Why It's Such a Bad Deal
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Usually, it is the last frame -- which shows how much you're currently paying for inferior investments -- which really drives the point home. For our hypothetical hard-worker, paying over $7,000 per year for sub-par performance is pure lunacy. In fact, that would be most households' highest or second-highest expense, depending on if they own their homes outright.

How to right your 401(k) ship now

If, after researching your own nest egg's performance and fees, you find yourself in a similar boat, there are a couple of simple steps that need to be taken:

  1. Consider hiring a fee-only financial planner that has a fiduciary standard to act in your best interests.
  2. Schedule a meeting with a representative of the company that carries out your 401(k) plan.
  3. Tell them that you want low-cost options to dominate your portfolio.

Of course, everyone's individual case will be different. I was shocked to see the position that my aunt had ended up in without even being aware of it. I'm pretty sure she's not alone. Luckily, the tides are turning against the hidden effects of such fees -- make sure that your own 401(k) account doesn't fall victim to them.

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