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Why you should not use your 401k

Max out your 401k… It is one of the most commonly given pieces of advice by many financial experts. With the 2011 401k contribution limit of $16,500, it IS one of the best ways to save a good chunk of money for your golden days. But not everyone should use their 401k to save for their retirement. For some people the company sponsored 401k might be a very bad deal. Why should you not use your 401k? Because of the 401k fees. Oh I am using a cheap index fund, so I am good… you might think. Well the fund’s expense ratio is only part of your 401k fees, in some cases the expense ratio might be dwarfed by other hidden 401k fees. Do you know all your 401k fees? According to a recent survey by AARP, 71% of the 401k participants surveyed said they do not pay any fees, which is not possible. And 62% said they have no idea how much they are paying in 401k fees.

401k fees survey

First of all if your employer is matching your contribution, def. contribute at least up to that matching amount to take full advantage of the free money. But beyond that, evaluate whether your own traditional/ROTH IRA is a better deal than a company sponsored 401k. It might be.

Quick rundown on how 401k works

  • 401k is sponsored by your employer (who is called the “plan sponsor”)
  • You can choose to contribute as much or as little you want (within the 401k contribution limit set by the government)
  • Employer might choose to match your contribution up to a certain amount (Example : 100% match up to 6% of your salary)
  • If it is a traditional 401k, the entire contribution is tax deductible, if it is a ROTH 401k you can’t deduct the amount, but you can withdraw the amount tax free during retirement.
  • The employer will select a brokerage/company to manage your 401k, they are the service providers.
  • Based on the negotiation between your company and the brokerage, you will get a certain set of investments to choose from.
  • The company will also negotiate the fees for other services with the brokerage.

Overall, 401k is a great retirement vehicle, but it is only as good as what your company negotiated for you. The last 2 points (investment choices and fees) could be a real deal breaker and cost you a boat load of money. So what are these 401k fees I am talking about? The fees can be roughly categorized into 3 buckets – Asset based, Plan administration & Transaction and service based fee.

401k fees – Asset based

Asset based fees are taken out of your assets, so you will never see this in your account statement. For example, if the asset based fees totals to 1% and you have $10,000 in your 401k, every year you are paying $100 to keep that $10,000 invested. This category includes – Management, expense ratio and investment advice .

  • Management fees : If all your funds are managed, meaning it has an investment manager who actively makes decisions on what the fund will hold, then you will be paying a management fee.
  • Expense ratio : This is the most widely known fee. This is based on the fund you choose. This is the total of the mutual fund’s operating expenses paid by the fund.
  • Investment advice : Some companies have an external firm advising the employer on their investment selection. For example, some companies may choose a firm like Financial Engines to help with their employee’s retirement plans. And Financial Engines will take a % of your assets. This is in addition to the expense ratio of the fund they will invest your money in.

Example :
$10000 invested in Fund A with 0.2% expense ratio = 10000*0.002 = $20
$10000 invested in Fund A with 0.8% expense ratio = 10000*0.008 = $80
$100 fee deducted from the assets every year.

Who pays them? You. As I said, this is deducted from your assets so you won’t see it in the statement.

How to reduce them : Choose a good low cost index fund. If your company’s 401k plan has limited choice of funds, all of them with high costs, contribute just enough to get the company match and invest the rest (up to $5000) in an IRA. Based on the company you choose, you will have an excellent selection of low cost mutual funds without any additional choices. And make sure to roll over your costly 401k to your IRA when you change companies.

401k fees : Plan administration

This is the second category of fees that is charged for the administration of the workplace retirement plan. This is not a flat fee for all the companies, it is negotiated by your company. Generally smaller sized companies have higher plan administration fees due to their lower bargaining  power in negotiations.

  • Record keeping & accounting : This might include monitoring employee deferrals, employer matching, profit sharing contributions, vesting schedule, conducting legally required audits and reports to the DOL.
  • Custody and trustee service : A custodian, a trust company physically holds the plan assets.
  • Other admin fees : Any other admin services like educational seminars, dedicated customer service lines, access to retirement planning software, electronic access to plan information, etc.

Example : $10 plan administrator fee per quarter X 4 (number of quarters per year) = $40 annual maintenance fee.

Who pays them? In some cases the employers pay them, some companies happily pass all the expenses to you. The amount you pay is negotiated by employers. These will be deducted mostly quarterly and you will see them in the statements.

How to reduce them : The only way to reduce this part of the fees is to talk to your employer. Some times in small companies it might be the lack of people to research the expenses better, if you talk to your HR and form a 401k committee within your company by taking volunteers, you can research the fees, talk to different brokerages and submit recommendations. As long as it won’t cost your company a lot of money most companies will listen to your concerns, esp. if you are willing to do most of the work.

401k fees : Transaction and service based fee

This fees is for any special transaction or service you might use. For example 401k loan fees, or for doing all the legal paperwork in your divorce to split the assets or termination fees if your company wants to change service providers.

Example : If you take a 401k loan, other than the interest rate,
$125 loan initiation fee (one time fee)
$5 ongoing maintenance fee per quarter X 4 (number of quarters per year) = $20 annual maintenance fee.
$145 for the first year and $20 every year.

Who pays them? Mostly you, in some cases, the employer. The amount is also negotiated by the employers.

Why should I care about these 401k fees?

The percentage esp. without doing the actual calculation might seem small, but with the power of compound interest, it will eat into a big chunk of your retirement fund. To illustrate, lets take an hypothetical example. Lets say you have $100000 in assets right now (for the sake of simplicity I have ignored the extra yearly contribution).

You work in a company A which has the following fees
Total assets  : $100000
Fund A : expense ratio = 0.69%
Total Asset based fee = $690
Other admin fee =$100 (0.1%)
Total fees : $690+$100/$100000 = 0.79%

Your friend works for company B which has a better fund selection
Total assets  : $100000
Fund A : expense ratio = 0.19%
Total Asset based fee = $190
Other admin fee = $0
Total fees : $190+$0/$100000 = 0.19%

 

401 k fees over the years

Growth of the 2 funds over the years

401k fees comparison

You end up with $226k, your friend will end up with $255k, just due to the difference in expenses

Both of you had the same amount to start with and invested for lets say 20 yrs. He will have ~$29000 more than you do. Add in regular yearly contributions and if you have a large enough asset, the difference could be close to $500,000. That’s a pretty big chunk of change, don’t you think?

When to use 401k?
If the overall fees is low for your company (call you HR and the plan administrator to clearly get an itemized fee list), contribute the max by all means.

When not to use 401k?
You should use your 401k to take full advantage of the company match. Beyond that if you are planning to invest <=$5000 (if you are <50 yrs old, $6000 if you are 50+), open an IRA with Vanguard or Fidelity or any low cost brokerage firm like Scottrade, Optionshouse etc. Some companies will have a fee if you have low balance, it might be waived for an IRA with regular contribution, check that out. That way the only fee you will pay is the expense ratio.

401k fee disclosure in 2012

The Department of Labor Employee Benefits Security Administration came up with a rule that requires all the 401k plan providers to clearly spell out the fees and expenses each quarter, starting in Jan 2012. It is a great step in the right direction, but it will only be as useful as the effort we put in too. How many people actually open and read the fund prospectus that these companies actually send out? How many people take serious effort to regularly check if their funds are still the best in class? Investing in an index fund is better than chasing hot stocks any day. But “too” much of passive investing is not a great idea either. After all, we are the only ones responsible for our future right? The bottom line : if you don’t know exactly how much your 401k in costing you, give your HR and your plan company a call.

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