Report: 401(k) Fees Can Cut Nest Eggs 30%

May 31, 2012

Just how badly are U.S. investors being ripped off in their 401(k) plans?

The median-income two-wage-earning American family participating in a 401(k) retirement plan loses nearly one-third of its nest egg to fees, according to a new report by the New York City-based public policy organization Demos, which slams high-priced mutual funds for their poorly understood costs.

The report, “The Retirement Savings Drain,” comes at a time of increased scrutiny of the U.S. retirement system, which accounts for $9.2 trillion that savers had invested in IRAs and 401(k)s as of 2010, and argues that fees and lost returns in 401(k)s cost the median-income two-wage family almost $155,000.

The problem is that many families don’t realize how much they are really paying due to lack of information about 401(k) plans and standard operating procedures in the mutual fund industry, the report argues.

Worse yet, higher-income two-wage families—those who earn above the 75th percentile of American households—have paid as much as $277,969 in fees by the time of retirement, according to Demos’ calculations.

The author of the report, Robert Hiltonsmith, a policy analyst in Demos’ Economic Opportunity program, said retirement plans based on ETFs—which he noted are advocated by the Center for Retirement Research—would eliminate many of the problems.

“The costs of mutual fund shares is set by the mutual fund company,” Hiltonsmith said in a phone interview. “ETFs are much more transparent—the share price is always available and the costs of the trading are borne by traders.”

On its website, Demos calls itself a multi-issue national organization that works with policymakers to foster economic equality, a robust democracy and a strong public sector.

Changes Coming

Under a U.S. Department of Labor rule change to the Employment Retirement Income Security Act of 1974 (ERISA) scheduled to go into effect July 1, retirement plan fiduciaries will have to be more explicit about the fees they charge by providing information on the total indirect and direct compensation they receive annually.

ERISA is the federal statute that pretty much put the nail in the coffin of so-called defined benefit pension plans that employers ran on behalf of their employees.

In place of such DB plans, ERISA ushered in 401(k) plans, which have come to increasingly dominate the retirement plan landscape.

The problem, as the Demos report argues, is that many employees haven’t a clue what they’re paying.

Hiltonsmith lamented the fact that the new Labor Department rule will make only some 401(k) fees explicit.

 

 

Accounting For Trading Costs

That means consumers will still be in the dark about the true costs of their retirement plans, largely because of a lack of transparency in the mutual fund industry.

“What the Department of Labor rule doesn’t do is disclose trading costs,” Hiltonsmith said.

According to Hiltonsmith’s report, median total expense ratios of mutual funds in 401(k)s came out to be 1.27 percent of total assets under management in 2010; annual trading costs average out to be another 1.2 percent. That’s almost 2.5 percent in costs.

In context, that means that average net returns of mutual funds of around 7 percent are in reality 4.5 percent when both the expense ratios and the trading costs associated with mutual funds are taken into consideration, according to the Demos report.

Vanguard Sets An Example

The situation is worse in smaller 401(k) plans, according to Hiltonsmith.

Because of their relatively small size, they’re unable to keep operating expenses as low as larger plans that benefit from larger economies of scale.

Although the Demos report hammers the mutual fund industry for its hidden fees, Hiltonsmith made an exception for Vanguard, which he said offered a much better deal for investors than typical mutual fund companies.

“Vanguard is a great provider because they value investors and because they keep their trading costs low,” he said.

According to Hiltonsmith, America’s retirement system is in need of a complete overhaul. What the country ought to have, he argued, is a new low-cost retirement alternative that pools assets and lowers exposure to market shocks.

“ETFs would help with the fees,” he said. “But you still would have market risk.”

 

 

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