Nibbling at Your 401(k)
By: Source: AARP Bulletin Today Date Posted: 2003-11-04 09:06:00-05:00
Millions of workers and retirees are shrinking their nest eggs to pay the costs of their 401(k) plans—and don't even know it.
The fees, experts say, can take a huge bite out of the value of a 401(k) over time. And the burden is even worse for midlife workers and retirees who usually have larger account balances and thus pay a disproportionate share of expenses.
Yet the practice of having employees foot much of the management tab for their 401(k) accounts is a little secret virtually unknown outside the financial industry. The fees, described in the fine print of investment prospectuses, are deducted from the accounts of workers, but they are not reported on 401(k) statements.
"Most people think they are paying nothing for their 401(k)s," says Ted Benna, president of 401(k) Association, a consulting firm in Jersey Shore, Pa., and creator of the original 401(k) investment plan as a way for employees to save for retirement through automatic payroll deductions at work.
The plans, first introduced in the early 1980s, are increasingly crucial to retirement saving as the number of employers providing traditional pensions dwindles. Without a pension safety net, employees need to squeeze as much return as possible from their 401(k)s.
The phenomenon that has forced many older employees to shoulder more of the 401(k) cost burden than younger workers is called "revenue sharing." Under this practice, an employer often selects mutual funds—the most popular investment choice of workers with 401(k) plans—with high investment fees that employees pay from their assets. The charges are high enough to cover all operating costs of the plan, leaving the employer with little or no financial responsibility.
The fees are assessed as a percentage of the employee's account balance, not according to the cost of managing the account. Over the span of a worker's career, says Gerry Mullane of the Vanguard Group of mutual funds, the deductions can make a big dent, reducing holdings by tens of thousands of dollars.
Average mutual funds in 401(k) plans deduct 1.40 percent from each fund share in an employee's account, according to the U.S. Securities and Exchange Commission.
An individual with a $60,000 retirement account invested in average-priced funds, for example, would pay $840 for the year. Someone with $5,000 in a 401(k) would owe only $70. Yet both participants receive the same services.
As a result, workers with larger accounts, who are usually older, end up paying hundreds of dollars or more in fees each year that subsidize poor or younger savers. "Plan sponsors," says Walt Bettinger, president of Charles Schwab Corporate Services, "want to keep older participants, presumably with higher 401(k) balances, in the plans because they are paying the freight."
David Wray, the president of the Profit Sharing/401(k) Council of America, defends the practice. "There is a philosophical belief that when you have more money in your account, you should pay more to have it managed," he told the AARP Bulletin.
Furthermore, he says, individuals investing in a mutual fund outside a 401(k) pay the same percentage-based investment fee regardless of how much they have in their accounts.
But Mullane of the Vanguard Group says the drain on 401(k) balances can be immense. He cites as an example an individual who has invested $5,000 a year in an account with a mix of bonds and stock funds that earns 8 percent annually. If annual expenses were far below average—for example, at .26 percent, a possibility with inexpensive mutual funds—the portfolio after 30 years would mushroom to $538,123.
But an account with average-priced funds charging 1.40 percent would ultimately reach $432,557, or $105,566 less. The expense drag is even more dramatic at 2 percent—the accrued balance would be only $387,200.
As a rule of thumb, says Michael Weddell, a retirement consultant at Watson Wyatt Worldwide, an international employee benefits firm, the average cost for a 401(k) plan should work out to about 1 percent a year of a worker's retirement assets.
One way to encourage employers to choose lower-priced mutual funds, says Brooks Hamilton, a lawyer and employee benefits consultant in Dallas, is to separate recordkeeping from investment costs. The employer or plan participants would pay an annual recordkeeping fee of $100 to $150 for each account. Such a move would reduce overall investment costs—and with them, the need for high-end mutual funds to generate the fees to pay for them.
If Hamilton had his way, he'd end revenue sharing altogether. But Wray of the Profit Sharing/401(k) Council says even when workers pay much of the tab, executives still have a big incentive to keep costs as low as possible.
"The largest account balances belong to CEOs," he says. "This has always been a discipline on the system."
Lynn O'Shaughnessy is a freelance writer in California.
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