What it is, why it matters.
So your company’s 401(k) plan is doing well… You and your employees are setting aside money for a better retirement. Your advisor set up a solid investment lineup, and it seems like you have some good options for growing your nest egg.
While the investing may appear to be going great, there is a potential sieve that could slowly rob you and your employees of a large percentage of your hard-earned (and saved) retirement… Watch the expense ratio!
Keeping an eye on plan expenses may not sound like cutting-edge investment advice, but a low-cost structure increases the odds that you and your employees will reach retirement nirvana.
401(k) fee roundup
As you now know, there are lots of moving parts in a retirement plan, and several third parties may be involved. The financial services industry is notorious for less than transparent pricing – so don’t be surprised if it is difficult to know what your plans costs are and what each provider is getting paid. Plan administration, employee education, IRS compliance and even a solid lineup of mutual funds do not have to come at a high cost. But determining exactly what those costs are is not always easy. Some fees may be paid directly by the company, while others are deducted from plan assets. Asset-based fees include those charged by the mutual funds offered in the plan. Other expenses, such as investment advisory, plan administration and custody fees may also be charged against plan assets.
What is a 401(k) expense ratio?
The expense ratio of a 401(k) fund is the percentage of fund assets used for administrative, management, advertising (12b-1), and all other expenses, paid for by the investor. As an example, if a fund’s expense ratio is 0.75% a year, and the stock market has no change, then the investor’s assets will decrease by 0.75% each year to pay for these fund expenses. Typically, published annual fund returns are net of the expense ratio, so that if the fund’s assets increase in value 7% and the expense ratio is 1%, the fund’s annual returns will be 6% to the investor.
Mutual fund fees alone can vary widely, with actively managed funds charging far more than passively managed or indexed alternatives. According to the Investment Company Institute, the average actively managed equity fund charged 0.84% in 2015 compared to just 0.11% charged by passive equity funds. The discrepancy among bond funds was similar. Actively managed bond funds charged 0.60% on average compared to 0.10% charged by their passive competitors. ForUsAll typically recommends a low-cost, passively managed fund lineup that comes in at an average of 0.13%.
To complicate matters, when fixed expenses are charged against assets, participants in small plans are likely to face higher costs than participants in plans with more assets. Throw in the various level of services offered by plan providers, and the total costs can vary widely from plan to plan. In fact, the publishers of 401(k) Averages (14th ed.) discovered that a company with 10 employees could pay anywhere from $1,692 annually on the low end to $6,200 on the high end.
In our mind, the really nefarious asset-based expenses are in the form of commissions – money paid to your broker or advisor out of the employee assets. Mutual funds, in particular a lot of actively managed mutual funds, have several “share classes” – with the only real difference between the classes being the commission that is paid by the investor. These fees are called “12b-1” fees, and they are likely to go to your broker/advisor in the form of a revenue-sharing commission on the investments that they recommend to you. (CFOs: 12b-1 fees may represent an easy way for you to reduce the cost of your company’s 401(k) plan, learn more in one of our recent blog posts “Five things every new CFO should know about the 401(k) plan.”)
Big implications from small differences in 401(k) expense ratios
These differences in plan costs can seem small when viewed as a percentage of plan assets. Does it really matter if your plan’s expense ratio is 1% of assets instead of, say, 0.58%? The answer is yes. It matters a lot! Just a few extra basis points over an employee’s career can mean the difference between retiring “on time” and postponing retirement to keep accumulating assets.
The table below illustrates how asset-based fees can impact a retirement nest egg. We assume three separate retirement plans. In each, an employee invests $10,000 at the first of each year for 40 years. (These employees are young! But the example is designed to reflect the impact of higher fees over an entire career.)
We also assume each plan delivers a 7% return before fees each and every year. In fact, the only difference among the plans is that each sports a different fee structure reflected in the expense ratios. As a result, each year the net investment returns are different under each scenario.
But these small differences have big implications. By the end of year 40, the investor in Plan C would have $390,233 fewer assets than an investor in Plan A. Such a large difference might equate to several years of salary:
Comparison of Investment Results with Varying 401(k) Expense Ratios
|**Plan A**||**Plan B**||**Plan C**|
|Gross Annual Return||7%||7%||7%|
|Net Annual Return||6.42%||6.20%||5.70%|
|Assets in Year 40||$1,831,422||$1,728,534||$1,441,189|
|Difference from Plan A||–||-$102,888||-$390,233|
|Shortfall in Assets in Year 40 vs. Plan A||–||(6%)||(21%)|
This difference becomes even larger if the saver is an executive who contributes more than $10,000 to retirement each year – in this example, for every $109,000 saved in the plan, an executive unlucky enough to be in Plan C would pay $1000 more per year in fees vs. a saver in Plan A! That’s a lot of extra money spent, each and every year.
Of course, luck has nothing to do with it if you are the astute plan sponsor with a high quality, low cost 401(k) plan. At ForUsAll, we can likely reduce the cost of your plan by over one third vs. traditional providers — meaning both you and your employees increase savings each and every year.
Alternatively, a high 401(k) expense ratio can actually deter employees from contributing to the 401(k). For example, if employees have only a limited selection of investment options, and these funds are burdened with high expenses, astute investors may contribute only up to the company match, and divert the rest of their retirement savings outside the plan. For example, they may prefer to contribute to their personal IRA over their high-cost company plan. A study by Yale University showed that some young investors may effectively lose the tax advantage of their company’s 401(k) if the plan’s fees are too high!
So, when it comes to maximizing your retirement assets and those of your employees, make sure to offer a plan with low fund expense ratios. Now that’s some pretty exciting investment advice!
Ready to talk with a retirement consultant who is excited to offer advice, and investment options, that are only in your best interest? Schedule a time to talk with us today!