I don't want to dump on your boss. She/he/it gives you a job (assuming you still have one). Besides a paycheck, you also get some benefits. One perk might be a retirement plan such as a 401(k). Your boss doesn't have to do that; in fact, it would be easier on her/him/it if there were no plan, since such things cost money, take up time, and expose the company to lawsuits.
So I want to start by commending your company for sponsoring a plan.
That said, there's been a disturbing trend over the past several years: Companies are shifting more of the cost of the plan onto their employees, and not necessarily being up front about it. One of the brave souls exposing this practice is David Loeper, a certified investment management analyst and the author of Stop the 401(k) Rip-Off.
How did Loeper come to take up the rallying cry for 401(k) reform? Here's what he told me in an interview:
It was time to put our 401(k) plan up for bid and look for competing vendors, and I got the typical sales proposals. They would say things like, “Hey, we can save you all of your administration costs if you use our expensive funds. And you don't have to pay that, your employees do. We are going to hide the expenses from the employees so they don't see them, save the company a bunch of money, and people won't know they are getting ripped off. Isn't that a nice deal?”
Well, I got ticked off when I got those presentations because we don't want to rip off our employees. We are honest with them.
So I went through my last five years' worth of statements from our prior 401(k) vendor. There is a column that says “Expenses,” and for five years it has shown zero in that column. Four times a year I get a statement that says I am not paying any expenses. [But then I looked through] some stuff like the summary annual report, and I figured out that I was paying $1,500 a year. I thought, “This is nuts!” I was paying 130 basis points [1.3% a year] to be in index funds.
Loeper's experience isn't unique. A study by the Government Accounting Office [PDF] found that an increasing number of employers are making employees pay more. These additional fees can take a huge bite out of your retirement savings. According to the GAO, paying an additional 1% a year can reduce your nest egg by 17% after two decades.
How can you determine if your employer-sponsored plan is beleaguered by hidden fees and kickbacks? Take these four steps.
1. Look at the Expense Ratios of Your Mutual Funds.
The expense ratio is the percentage of your assets that are withdrawn by the mutual fund company to pay for management and administrative costs. It should be found on your plan's website or other information made available by your employer. Ideally, you shouldn't be paying more than 1.0%, unless it is an exceptional fund.
Keep in mind that the expense ratio listed on a fund-information website, such as Morningstar.com, may not necessarily be the expense ratio you're paying. Extra administrative costs may be added to the funds in your plan (which we'll discuss in the next step).
Finally, we should note that the expense ratio for any mutual fund — whether in your 401(k) or elsewhere — doesn't capture all the costs you're paying. The biggest missing expense is commissions the fund pays to buy and sell investments, which are disclosed in the “statement of additional information.”
As un-thrilling as it might be to read such a document, you can get a rough idea of how much your fund is paying in commissions by looking at its “turnover,” which tells how much of a fund is bought and sold over the course of a year. For example, a turnover of 80% means that 80% of the fund's investments have been sold (or “turned over”) in the past year. The higher the turnover, the more the fund pays in commissions. Ideally, look for funds with turnovers less than 50%. Not only will this reduce commissions, but many studies have found that low-turnover funds, as a group, outperform high-turnover funds.
2. Ask Your Human Resources Department
Next, you'll want to know how the administrative expenses of your plan are paid. Your employer might be picking up the total tab — or it might be withdrawn from each employee's account. This could be a fixed amount (e.g., $300 for each participant) or a percentage of assets.
If you trust that the folks in your HR department will give you reliable information, ask them how much the plan costs and who pays the bill. They should be able to find out that information, and provide some documented proof.
3. Look at Your Summary Annual Report
If you want to investigate the plan expenses yourself, request a copy of your plan's Summary Annual Report, Summary Plan Description, and/or Fee Arrangement — essentially, any plan documents your employer will give you. As you scan the documents, you'll learn all kinds of good stuff about your plan, and it might spell out explicitly whether you or your boss covers administrative costs.
If not, then you might have to do a little math. Let's look at the example Loeper provides in Stop the 401(k) Rip-Off, based on his own (former) 401(k) plan.
In his Summary Annual Report, under the “Basic Financial Statement” section, Loeper learned that there were $11,304 in additional expenses. By dividing that amount by the total value of plan assets ($1,341,870), he calculated that his plan has an additional 0.84% in fees. After adding that to the expense ratios of his funds, he discovered that he was paying 1.3% a year to be mostly in index-based investments. That's way too high.
4. Evaluate Your Investment Choices
Retirement plan providers don't just get money from you. They also receive money from mutual fund companies to include their funds in your 401(k). These so-called “revenue-sharing agreements” (a.k.a. bribes) might entice a plan provider to stock your 401(k) with funds that will make the most for them, not for you. The solution is to match your investment choices up against a relevant index. If your funds consistently underperform, then you know you have sub-par choices.
What You Can Do
If your employer-sponsored retirement plan is the pits, you have several options:
- If you no longer work at the company, transfer the money to a low-cost IRA.
- Many retirement plans offer a brokerage window, which allows employees to buy individual stocks, exchange-traded funds, and other mutual funds.
- Some plans allow for in-service distributions, which allow employees to transfer money to an IRA while still working for the company.
- Your company may have a benefits committee, or at least a group of folks who occasionally think about the retirement plan (typically, the human resources folks and perhaps the CFO). You can agitate for better investment options, a brokerage option, or even a completely different plan.
Stop the 401(k) Rip-Off has some great advice for how to rally your colleagues around the cause of a better plan. Over at The Motley Fool, we've created a sample letter to send your benefits director. After all, their retirement is on the line, too. They may need just a small nudge to improve the plan.
J.D.'s note: In 1995, we set up our employee retirement plan at the family box factory. For the first few years we used SmithBarney to manage our investments. Then we noticed they were killing us with fees, both obvious and hidden. We said good-bye to them and now managed the retirement accounts in-house using Vanguard funds. This isn't practical for every business, but we only have about ten employees, so it works. I guess what I'm saying is: Brokamp has some great points in this article.