Sunday, November 9, 2014

401(k) Fees Charged Are Often a Ripoff ... They're Much More Costly Than Participants Believe

We know that frequently it's not what we know that we don't know that causes us big problems. Instead it's what we think we do know but in reality we do not know. Want an example? How about 401(k) plans, how they operate and how one sided and costly they are?

In my opinion, the vast majority of people (95%?) who participate in 401(k) plans don't have a clue concerning how costly they are, and as a result how much account appreciation they are missing over a working career, or for that matter, even from year to year. And they simply aren't aware that this inferior account appreciation is likely to be caused by unnecessarily high and non-value adding annual charges by the plan's fund managers and administrators.

To begin our analysis, please consider the simple difference between assets and earnings. If $100 (assets) is invested and grows by $7 (earnings) during the year, that results in earnings of $7, or 7% before expenses. {NOTE: We're assuming the $100 is invested in a balanced mixture of stocks and bonds, with the stock portion earning 9% and the bond piece earning 5%.}

Depending on how the earnings picture is presented and viewed, expenses related to managing the account and amounting to $2.10 either are 2.1% (expenses in relation to total assets), or 30% (expenses in relation to total earnings).

But regardless of how the picture is presented or how we may choose to view it, the plan participant will only receive $5 in account growth and not the publicized $7.

And what makes up those annual fees and expenses equating to 2.1% in relation to assets under management? Well, they are an aggregate of (1) administrative and recordkeeping fees (.2% to .4%), (2) marketing fees (up to 1%), (3) investment advisory fees (.5% to 1%), and (4) trading costs related to buying and selling securities (~1%). In other words, they frequently are much higher than the 2.1% estimate we're using in our example.

The trading fees and costs in #4 above are essentially unpublicized, aka hidden, but real and directly related to trading activities. They represent variable trading costs and often equal the total of the three other enumerated charges (administrative, marketing and advisory fees).

But let's go ahead and lowball the total expenses number. We'll assume it's "only" 2.1% of the assets under management or 30% of the account's earnings. {In our hypothetical case, the reason for arbitrarily picking 2.1% is simple math. 2.1 is 30% of 7.}

To repeat, in the case of an account earning a gross annual rate of return of 7%, that 2.1% expense charged in reality is 30% of earnings --- not 2.1%. Get the picture? It's not a pretty one.

You're paying more than you think in 401(k) fees is worth reflecting upon carefully:

"How much do you pay for your 401(k) plan? If you said nothing, you’re in good company — but, unfortunately, you’re also wrong.

According to a new survey, nearly half of baby boomers with full-time jobs believe their 401(k) plans are free. Another 19% believe less than 0.5% is deducted from their account’s balance annually. But ... the average employee pays 1.5% a year in 401(k) fees. . . . In smaller plans, fees average a much higher 2.5% a year.

“Employees don’t seem to understand what they are paying” for their 401(k) accounts, says Mitch Tuchman, managing director of Rebalance IRA, a registered investment advisor . . . .

People incorrectly “believe that because a 401(k) plan is an employee benefit, then the employer is picking up the cost,” Mr. Tuchman says.

Over a 30-year career, an extra 0.5% annual fee can slash a worker’s savings at the time of retirement by 10%, according to Vanguard. A worker who saved $10,000 a year in a fund with expenses of 1% would wind up with $829,000, or $91,000 less than a worker paying 0.5%.

The good news: Thanks to a Department of Labor rule that went into effect in 2012, it’s easier to figure out how much you are paying in 401(k) fees. The DOL rule requires plan administrators to disclose fee information in quarterly and annual statements they send to participants. Among other things, administrators must disclose investment-management fees, plus the one-year, five-year and 10-year performance of investments versus their benchmarks.

The disclosures can also give you clues as to the indirect compensation plan administrators receive — which often slides under the radar. For example, the so-called 12b-1 (marketing) fees that are embedded in the expense ratios of many mutual funds frequently defray plan administrative expenses. . . .

Other findings from the survey:
  • 28% of baby boomers who are employed full-time are not saving for retirement.
  • 66% of respondents say they are either very anxious or somewhat anxious about their retirement readiness.
  • 20% do not know what percentage of their portfolios are invested in stocks or stock funds.
  • 44% said that if they could go back in time, they would learn more about investing and 67% said they would save more."
Summing Up

Here's the real deal. The 'no skin in  the game' administrators, investment advisers and other managers will be paid regardless of whether the employee's account grows or gets smaller. Thus, if the account breaks even before expenses, the employee loses money. However, he still pays the fund managers, and they still take their designated cut. 

And when the employee makes additional contributions, or more employees decide to enroll in the plan, or when the account increases because of a rising stock market, then the manager gets an even bigger take. And the employee benefits somewhat as well.

Managers and administrators are being paid as a percentage of the total assets being managed. and not based on how those assets perform.  Inflation, increased employee contributions, increased contributions due to enrollment increases, and account performance all operate to the benefit of the fund managers.

It's definitely a heads we win, tails you lose proposition for the investment advisers as 100% of the investment risk belongs to the employee while the advisers are guaranteed a profitable return.

So now you know what perhaps you didn't know previously. It's not fair, but that's the deal.

More to come later. So stay tuned.

Thanks. Bob.

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