Does Your 401(k) Have a Nasty Surprise For You?
The Department of Labor (DoL) has enacted new rules that for the first time ever give 401(k) plan participants some transparency into what they are paying for the service. This is an important milestone because, according to a recent AARP study, 71% of Americans that participate in a 401(k) plan think that it doesn't cost them anything (presumably that either their employer covers all costs or it's a free service to begin with). This is obviously a very misguided view of reality, but one that has been perpetuated by the financial services industry for years, with their opaque and convoluted fee structures.
If you are a 401(k) plan participant you will soon be receiving, if you haven't already, the newly mandated fee disclosure that will detail just how much your 401(k) is costing you.
Shocking as it may be to learn that something many participants thought was free actually isn't, it will likely be even more shocking when the true costs of the plan is revealed. First, I want to make it clear that the 401(k) is a great savings tool. It provides many benefits to the retirement saver, such as:
- tax deferred accumulation of assets,
- automatic contributions,
- immediate tax advantages, and
- employer contributions.
But there has been one consistent drawback to 401(k) plans, and that's been cost – many tend to be quite expensive. Most participants, and even many plan sponsors, never really knew just how expensive – until now.
It's important to understand that 401(k) plans are largely customized and costs have many components. For example plans that have greater assets are typically less expensive than smaller asset plans. Plans with many participants are typically more expensive than those with fewer participants, all else being equal. Other factors also have an impact on overall costs. For example, hiring an advisor to provide education will cost the plan more than not having an advisor, but could be seen as a valuable option by the plan sponsor. There is also the issue of fund costs to consider, some types of funds are cheaper than others, and many funds have multiple share classes, each with a different fee structure.
Taking into consideration the weighted average sum of investment expenses, advisory costs and administrative and recordkeeping fees will provide a fairly complete picture of what your plan costs you every year, represented as a percentage of your balance over the year. For example if the total came to 2% then someone with a balance of $100,000 would pay $2,000 in fees annually. If the balance increases or decreases the fee would change as well. Cheaper investment options, if available, could help lower the fee somewhat, but other fees are likely fixed.
To the layperson 1%, 2% or even 3% may not seem like much, but the effect over time is substantial. Let's take for example a plan with 2% fees, this is the difference between earning 5% versus 7% annually, and over the course of a working lifetime can add up to tens or even hundreds of thousands of dollars in savings lost to high fees.
Many factors go into determining what the cost of a 401(k) plan is and some providers are naturally less expensive than others. A general rule of thumb is that anything that costs over 1% annually in total costs likely has a less expensive, and therefore more attractive, alternative.
Do yourself a favor and read the fee disclosures carefully when you receive them or if you've already filed it away, dust it off and take a few moments to study it. As an informed consumer you will be able to make better choices about your investments and possibly even convince your plan sponsor to go with a better 401(k) provider that saves you money and makes it more likely you'll be able to hit your savings targets.
About the author: Michael Prus is the President and Founder of Scale Investment Group, LLC, a registered investment advisory firm based in White Lake, Michigan. Scale Investment Group is a leader in providing low-cost institutional investment services, like 401(k) and 403(b) plans, to small and mid-sized organizations and also manages money for private clients. The firm is a champion for small investors promoting low-costs and transparency of the investment advisory industry. For more information visit scaleinv.com or contact Michael directly at firstname.lastname@example.org.