Fees in 401(k)s

401K“Yes, hello? Is this the Human Resources Department? Yes, I’d like to file a complaint about the retirement plan offered here. No, I don’t work actually here. But still, hear me out…”

Today is my day to complain about the (somewhat) hidden costs of employer-sponsored retirement plans. These plans come in a variety of flavors like 401(k), 403(b), SIMPLE IRA, and SEP-IRA, and hopefully you have one of these available at your job.

And by the way, if you take away from today’s column that I don’t like these plans, then you missed the point. Mostly I love them. Economists and astrophysicists all agree: the only free lunch ever discovered in the known universe is employer-sponsored retirement plans with matching funds.

Unfortunately, in plans I’ve reviewed, employees often pay far too much in management fees. That overpayment is especially egregious when compared to fees that employees could pay for investments outside of their retirement plans.

There’s been a revolution over the past 10 years in lowering the costs of fund management fees. But you would not know that revolution had ever occurred, based on the plans I reviewed recently.

Here’s the crux of the problem, I think. Many plan sponsors, the companies that actually offer investments to employees, offer their service to employers for free or nearly free. Now you’re probably thinking, free sounds good. Free is the opposite of a problem. But hold on.

Free to the employer often translates into expensive to the employee. What I mean by that is that plan sponsors have to be paid some way or another for their services. If the employer gets the retirement service plan for free, then the employee probably ends up paying that much more.

A few examples best illustrate this problem.

I recently completed a consulting gig for a public entity in Texas that employs less than 100 people. The plan sponsor for their 401(a) plan, a professional and reputable non-profit, charges no money directly to the public entity. Which, again, sounds nice at first.

Employees, however, always pay 0.55% in extra fees dedicated to the plan sponsor, in management fund costs, on top of their regular fund management fees, which are somewhat high to begin with. Enrollment in this retirement plan is mandatory, as employees are ineligible for Social Security and no longer eligible to enroll in a pension. Employees in other words are captive to paying significantly higher fees with their retirement money than they otherwise would pay outside of their retirement accounts.

What is the effect of this 0.55% that employees pay rather than employers? Employees of this public entity have approximately $14 million under management, meaning the plan sponsor earns $77,000 per year for their 0.55% fees on funds charged to employees. That’s the one-year cost.

Indulge me in a little more math, however, so we can calculate costs in a more sophisticated way.

As funds grow over time, so too do the fees. Over ten years, at an assumed growth rate of 6% in the fund value, the fees will total $124 thousand per year and $989 thousand cumulatively.

Over 30 years, the total fees would be $5.5 million.

But that still understates the costs of paying fees with retirement money. Since fees are charged from within the accounts, the retirement accounts end up growing more slowly.

And that’s the real problem! The funds grow to a value $11.6 million less over 30 years than they would have if these fees were paid from outside the accounts. The real “cost” of the fees – as measured by this slower growth – is therefore nearly twice the amount paid to the sponsor, by my reckoning.

This problem is not limited to the public sector. A few years back I helped a friend set up an employer-sponsored SIMPLE IRA plan available to all employees of her 12-person company. I was excited for her all the way through the process until realized the bad news: The plan sponsor charges way too much to employees for the funds in the plan. A US large cap fund, a very plain vanilla offering, charges 1.64 percent per year. A US small cap fund, similarly basic, charges 1.84 percent. Depending on what you compare it to, that’s between 2 and 10 times too much in fees. There are no low-cost funds at all, because a management fee between 0.45 percent and 0.55 percent, as well as a distribution/service fee of 0.25 percent, gets tacked on to every single fund.

For my friend’s SIMPLE IRA plan, the impairment on wealth would be even higher than that public sector plan, since her employees pay around 0.75 percent extra, rather than 0.55 percent.

I’m not entirely opposed to fees in finance. The big problem in this case is two-fold. First, it’s inefficient to pay fees from within retirement accounts, compared to paying fees from outside retirement accounts, as an employer could offer to do. Second, it seems contrary to the spirit of a retirement benefit program that all costs are borne by employees. I understand why it happens, but that won’t stop me from complaining.

Were I an employee of either that government entity or my friend’s small business, I’d be annoyed about these charges. Plan sponsors don’t work for free but I’d wish that my employer had volunteered to pay those fees, rather than making them payable with my own retirement money. Some employers do, and some don’t. Do you know if yours does?

Finally, what is a financially-savvy person to do?

First, as an employee, definitely still participate in your employer-sponsored plan to the maximum level available, given your resources.

Be the Erin Brockovich of your employer-sponsored retirement plan

Second, be a squeaky-wheel when it comes to costs in your employer-sponsored plan. Maybe even contact your human resources department and ask about the fees. This likely will affect absolutely zero things in the real world, but will at least give you that nice moral superiority feeling. If you managed to actually affect change at your job, well then, you would be the Erin Brockovich of retirement plans to your fellow colleagues.

Finally, if you are a business owner, executive, or board member overseeing the employer-sponsored plan of an organization, know that you actually might be able to affect change. And not spare change either, but rather substantial, life-altering amounts of money for people’s retirements. It’s far more efficient to your company and your employees if you pay those plan sponsor fees at the employer level. Also, it’s the right thing to do, as a benefit to employees.


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Ask An Ex-Banker: Is the Finance Game Rigged Against Outsiders?

Q: A question for debate:

We all seem to get mad that the financial-industrial complex is repeatedly rigged for the Big Boys.  I’d suggest to you that the public should just give up on the wall street-banker/big bank/mutual fund industry as having any possibility of being fair to you or me.  Thus, it makes no sense to be mad at it.  Instead, people should invest the way their grandparents did: bonds, cash savings in a local bank or a hole in your backyard, real property, and (if they’re savvy enough) businesses or stocks that they understand.  –Michael G., San Antonio, TX


This is a really good question for debate, Michael, and I agree with some of the spirit of it.  I suspect millions of people have had a version of this thought, wondering if they’re the suckers at a rigged game and whether it’s time to take their marbles and go home – to bury their savings in the back yard or the local bank.  But while I’m sympathetic with the question, I disagree on the actionable consequences of your view.

I particularly like your suggestion, paralleling Michael Pollan’s food movement of the last few years,[1] to do only what your grandparents would recognize as investing.  There’s virtue in simplicity, and you could not go too far wrong that way.  Many of us have an imaginary Amish pastoral scene in mind as a balm on a particularly confusing day.  The horse-drawn buggy approach to financial life could be a good financial life.

I’m not willing to actually go along with the Amish pastoral investing life, however, either in my own life or for people who ask me my opinion on what they should do.

Mutual funds, to pick the most beautiful of the babies you’ve tossed out with the bathwater, are just like some of the other totally awesome things we love to complain about.  If you’ve got money to invest, with a few clicks or a simple phone call, you can own a piece of a wide swath of the world’s most successful companies.  At any point in your lifetime, should you choose, you can get your investment back with a similar amount of effort, with a day’s notice.  Real property investing doesn’t work that way.  CDs don’t work that way.  Private business investing doesn’t work that way.  Our grandparents had to wait for the end of their 6 months (or whatever time) period to get their cash out of CDs, or possibly years to liquidate their real estate or private businesses.

ETFs, the ADHD sufferer’s version of mutual funds, are similarly awesome, if used correctly.  You can even invest in a wider variety of instruments than mutual funds, including currencies, commodities, real estate, in addition to the opportunity to short markets and take on leverage.

As a recovering hedge fund manager, I also obviously maintain a soft spot in my heart for hedge funds as a way to access a still wider variety of investing strategies.  As a former mortgage bond salesman as well, I could similarly wax poetic about a whole universe of investment vehicles with an alphabet soup of acronyms that, like an Elizabethan sonneteer declaring his undying devotion, would make you long to  possess a super-senior CDO linked to a basket of credit default swap positions.  Ah, financial innovation…But I digress.  Where was I?

In sum, I’m actually a fan of financial technology, albeit with one important caveat that I think will link back to your original question, about whether the financial game is incorrigibly rigged for the Big Boys.

Not to be too John Kerry about it, but my answer is No, and Yes.

I infer that what you mean by “rigged” is the idea that insiders cheat in sufficient numbers to leave outsiders at a severe disadvantage when it comes to earning a fair and worthwhile return on capital.

I disagree.  In my fifteen years in the financial industry I saw no evidence of widespread cheating.  On the contrary, I can honestly say I trust “the system” in our country to treat outsiders far more fairly than any other industry I’m aware of.  I would also trust our system in the US better than any other country’s financial system, based on quite a bit of anecdotal and experiential evidence across borders.

Where I would blanket-statement agree on the rigged part for your average outside investor, however, is in costs.  The insiders depend on your ignorance of the cost of their product.

Most investment products designed in the past 50 years are compensation schemes for insiders.

Hedge funds are the most egregious example, of course, as knowledgeable insiders correctly and dismissively refer to hedge funds as ‘compensation schemes masking as investment vehicles.”

Products like retail ETFs, primary designed to encourage high-frequency day-trading, wrap up a casino-like product in an investing package, for the benefit of the house casino.

Even the mutual fund industry typically charges far more than is necessary to accomplish what are really simple tasks with minimal value-added.

Fees to insiders in all of these areas remain stubbornly high and extremely difficult to track down for the average outsider.  In no other area of life do we willingly purchase a product costing many thousands of dollars without asking about the price of the product or attempting to price-shop the product.

I can’t emphasize enough how much of the inside game is devoted to convincing outsiders of the ‘special sauce’ of a particular investment vehicle.  Contrary to what the insiders want you to believe, simple would generally be better and low cost would be best of all.

I linked to this page before, but it bears repeating.  I have no link to this investment advisor, I’ve never met him, and I just found his stuff a month ago.  Do yourself a favor, print out pages 9-12, post them on your bulletin board, and refer to them frequently when considering where and how to invest.

[1] He famously advised people to avoid eating anything your great-great-grandmother wouldn’t recognize as food.  Incidentally, my great-great-grandmother ate a lot of Nutella.  In my own mind.

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