10 Things 401(k) Providers Won’t Tell You
1. “We’re making money on your 401(k) — even if you’re not.”
With a growing awareness of the importance of preparing for retirement, the number of 401(k) investors has soared in recent years, peaking at 60.6 million in 2007, according to Cerulli Associates, an asset management research firm. But that torrid growth also left millions of investors in the lurch when the market crashed in 2008 and the value of their plans sank, in some cases dramatically. In fact, following the market downturn, the number of 401(k) investors dropped, settling at an estimated 50.5 million this year.
Regardless of a 401(k)’s performance, most providers still get a cut of the expense ratio on the funds. In this practice, known as revenue sharing, there can be money left over after certain costs — for recordkeeping, administration and marketing — are covered. In most cases, this excess revenue stays with the plan providers and at times is used to market their investments to other companies rather than going back into investors’ 401(k) plans, says Matt Gnabasik, managing director at Blue Prairie Group, an institutional retirement and investment consulting firm.
2. “You may not have full disclosure about where all your money is going.”
By the end of 2009, 401(k) plans, IRAs and pension plans had more than $15 trillion in assets under management, says Yannis Koumantaros, principal and director at Spectrum Pension Consultants. With most of these plans charging participants fees, a lot of money is at stake.
It’s often difficult for an investor to know the exact fee breakdown of their 401(k) plan. That could soon change. In May, the House passed the American Jobs and Closing Tax Loopholes Act, which could provide additional fee disclosure to participants in defined-contribution plans, including administration and recordkeeping fees and investment management fees.
“Plan costs will continue to become more transparent,” says Gnabasik. And, “anytime you have more transparency, it tends to lower fees.” Up until five years ago, “record keepers rarely divulged their cost structure to the plan sponsors; they now, for the most part – especially with larger plans – tell the plan sponsor how much they need to make in order to pay for day-to-day administrative costs.”
Still, even if an investor knows the fee breakdown of his or her 401(k) plan, it can be very difficult to know what portion of that is left over as excess revenue. “Nobody is saying that people shouldn’t be paid; all we’re saying is they should be paid fairly and consumers should know what they’re paying for,” says Koumantaros. Also, consumers should keep in mind that you can’t tell how much revenue is shared simply by looking at the expense ratio of a mutual fund .
3. “You’re buying wholesale, but we’re charging you retail.”
When it comes to your 401(k) plan, you shouldn’t be paying the same fees for a fund that you would if, say, you bought it on your own. But you might be. Asset managers sell mutual funds in different share classes, each of which has a different fee structure. From the most expensive to the cheapest class of funds, the range can be as much as a full percentage point, says Koumantaros. That works out to an extra $1,200 a month in retirement for a 30-year-old with $50,000 in his plan and contributions of $3,000 annually. “You’re talking about a difference in your quality of life at retirement,” Koumantaros says. The cheapest investment options with 401(k) plans are often index funds, since they’re not actively managed, he says.
The plans with the highest fees are usually those with the fewest investors. Small plans are expensive to run, so they often have to accept costlier fund classes. But your employer can renegotiate cheaper options as the plan expands.
4. “Our ‘target-date funds’ may miss the target.”
Target-date funds came under immense scrutiny for their performance during the market downturn in 2008. These funds have an asset allocation that becomes more conservative as the investor nears retirement, and they’re supposed to address the worst mistakes 401(k) investors make: investing too conservatively, too aggressively, or not rebalancing. But many had investors close to retirement with too much exposure to risk and few conservative investments to help balance out their 401(k) losses.
The fund companies say some target-date funds are designed to carry an investor to retirement while others carry investors through retirement. They say many glide down following age 65 but typically not past age 80. They’re designed “for employees who don’t have the time, interest or knowledge to make informed decisions about their 401(k) plan,” says Pam Hess, director of retirement research at Hewitt Associates. But that doesn’t mean investors shouldn’t completely ignore their 401(k); instead check up on its performance periodically and ask if there are other target-date fund options that may be better suited to your needs.
5. “We offer tons of investment options. Too many, in fact…”
When it comes to picking funds for your 401(k), plans that offer more choices aren’t necessarily better. On average, 401(k) investors are given 18 fund options, a number that is likely to drop to 17 soon, according to the Profit Sharing/401(k) Council of America. But even 17 can be too many. More choices can lead to participant paralysis or intimidation, says David Wray, president of the council. In some cases, there can be a link between choice overload and poor investment decisions, which can lead to an undiversified allocation that may be cash- or bond-heavy reducing the eventual accumulated balance at retirement.
There aren’t necessarily a specific number of fund options that can derail plan participants, says Emir Kamenica, assistant professor of economics at the University of Chicago Graduate School of Business. Ideally, a plan should offer a handful of core funds including a money market, bond index, domestic equity index, and international equity index, with extra choices for those who want them. This can be especially helpful for sophisticated investors who can differentiate between, say, a large-cap value and growth fund, on their own. “Nobody will be worse off by allowing investors who are more sophisticated to select from a wider range of options,” Kamenica says.
6. “…but you still might not be diversified enough.”
The two most popular holdings in 401(k)s are premixed portfolios and stable-value funds, says Hess. But neither may be appropriate. “Investing a significant portion of one’s savings in stable value funds is not appropriate for investors with a long time horizon,” she says. Stable-value funds protect your savings but, by design, don’t take enough risk to create as much return as bond or stock funds. Young workers in particular should not have big chunks of their 401(k)s in them.
As for company stock, many planners will tell you not to put any of your retirement money there. Your company pays your salary and provides health benefits, so you already have enough exposure there. Plus, you shouldn’t have the bulk of your portfolio in one stock. If a large portion of your 401(k) match is in company stock, consider selling it; in general, company stock shouldn’t comprise more than 10% of your portfolio. A target-date fund or mix of large- and small-cap equity, international investments, and fixed income is a wiser way to go, Hess says.
7. “If you quit your job, you’ll have to pay to keep your 401(k) here.”
A Hewitt study shows that 29% of people who left their jobs left their 401(k)s with their old companies. That may seem easier than hassling human resources for the paperwork involved in transferring a 401(k) to an IRA, but you’ll end up paying for it. Some employers foot an upfront fee for costs associated with running your plan while you work for them, but an increasing number are pulling the plug once you’re off the payroll, says Sean Waters, co-founder of Cook Street Consulting, an investment consulting firm. This may or may not be obvious to employees. “It’s not like you get an invoice saying, ‘Hey, you owe me $40 a year now,’” Waters says. It makes a case for consolidating your various 401(k)s, because that cost will only increase for those who have multiple plans. “It generally doesn’t make sense to have 401(k) accounts all over the [place],” Waters says.
What if you love your new job, but hate the shoddy funds offered for your 401(k)? Employees should ask their new company to improve their 401(k) lineup. “Many don’t pay attention to it despite the enormous fiduciary (or personal) liability associated with offering a plan, and with a little help they can improve it markedly,” says Waters. (This, of course, is no easy feat and at a minimum will require similar requests for many co-workers.) Another option is to leave your old 401(k) account where it is if possible. Or consider an IRA rollover, which means a separate account with an extra set of fees but also the flexibility to pick the investments you want.
8. “You may be better off in a Roth 401(k) — but your plan probably doesn’t offer it.”
In a traditional 401(k), taxes on your investments are deferred until you begin withdrawing your money in retirement. With the increasingly popular Roth 401(k), however, you pay the taxes upfront and then make withdrawals tax free. The Roth isn’t for everyone, but it can be more favorable to individuals who make less money now than when they retire since they’ll be taxed less now. But, fewer than three in ten company plans, or 29%, offer it, according to Hewitt.
Since Roth 401(k)s first appeared in 2006, the primary obstacle to their rollout has been the fact that they were supposed to disappear after 2010. Now, they’re permanent — but retirement plans have yet to catch up. Companies cite reasons, like lack of evidence of significant employee usage and administrative complexity, for not offering Roth 401(k)s out of the gate, according to a Hewitt study.
9. “You want to see some outrageous fees? Try a variable annuity 401(k).”
Small businesses that have 401(k) plans often offer them packaged as annuities. This is also common with 403(b)s, which are geared to teachers, professors, and employees of nonprofit organizations. These plans can be more expensive than traditional 401(k)s. That’s because the insurance company that sells the annuity adds a mortality and expense fee for the cost of the insurance, which could range from 1% to 3%, depending on the insurance benefits that the participant selects. In return, plan participants can get additional protection such as guaranteed withdrawal benefits – which allow participants to withdraw money even if their balance is zero dollars, says Karen Alvarado, vice president of regulatory affairs and compliance at the Insured Retirement Institute, an annuities trade group. However, this fee is on top of the expense ratio you pay for each subaccount (e.g., a bond fund, mutual fund) in the annuity.
Insurance companies have the clout to haggle successfully with asset managers for lower expense ratios on the underlying funds, but the combined total of the expense ratio and the insurance fee could still be higher than the cost of other plans. Investors should take a close look at the fees, which are explained in the prospectus.
10. “Your nest egg could be a whole lot bigger.”
In many ways, 401(k) plans are getting better. As lawmakers and regulators continue to scrutinize fees, some providers are offering participants access to a more attractive suite of investments and refunding money to plans when expenses exceed costs and a set profit.
“But it’s still hard for 401(k) investors to grasp how a small difference in expenses can make a big one for their retirement. “We are typically able to reduce total plan expenses by 20% to 40% and at the same time dramatically enhance plan services,” says Brent Glading, managing partner at the Glading Group, who used to sell 401(k) plans for Merrill Lynch and Dreyfus but now negotiates better plans for company clients. That doesn’t sound like much, but it can translate into $100,000 per employee over 20 to 30 years.
He says some plan sponsors think that by reducing a service provider’s revenue, they’ll have to protect their profit margins by delivering fewer services. “This is clearly not the case,” he says. “In every situation we have ever been involved in, if properly negotiated, a service provider will always throw in more services to make their offer that much more compelling.”