July: the 401k Post

Here’s the next in a series of monthly posts focusing on meeting small, manageable financial objectives in order to create a path to overall financial success. You can find June’s post here.

For July, I thought we’d shift gears from talking about cash flow. Let’s discuss your 401k instead.

By now you’ve probably seen John Oliver’s hilarious recent segment on retirement savings in general, and 401K plans in particular. He, rightly, pointed out the importance of understanding the fees you pay to invest, and how the power of compounding works both in your favor - investing early pays off! - and against you: even seemingly small annual fees make an enormous dent in your eventual wealth. And for long-term investments like retirement savings, that matters a lot. How much? For a one-time $30,000 investment, losing 1% annually to fees over 30 years results in a loss in eventual value of about $50,000. And if you invest a regular annual amount, starting at $6,000 and increasing by inflation for 30 years, paying an extra 1% in fees leads to a loss of $130,000. That is real money. 

It’s important to note that both of these isolate the effect of just a 1% difference in fees (expressed as a difference in return). Nothing else changes: we hold the rest of the assumptions (performance, contribution rate, inflation rate) constant in order to highlight just how big an impact a relatively small number can make over time. Remember, you need to control what you can control! Market returns, tax rates and interest rates are squarely in the “cannot control” column. Expenses are something you can control somewhat, so it’s important that you do that where you can. But the truth of the matter is that it can be really difficult to tell what fees you’re paying in your employer plan. There are two kinds of fees: those associated with your account and those associated with the investments in that account. Here’s how you can get them.

First, locate copies of:

• Your plan’s Summary Plan Description (available from HR)

• Your plan’s Summary Annual Report (available from HR)

• Your most recent statement (mailed to you or available on your plan's website)

On the Summary Annual Report, find the following:

• The administrative expenses (an example from one I found online: $332,193). Make sure this number does not include benefits paid to participants.

• The total plan assets at the end of the year (from that same one: $451,665,355).

Then:

• Divide the first number by the second: $332,193/$451,665,355 = 0.000735, or 0.0735%

• Multiply the result by the total value of your account on your statement (let's imagine a $50,000 account balance): .000735*$50,000 = $36.75

This is your portion of the expense of running the plan itself. However, it’s also possible that your employer is covering this fee, and you’re not paying it at all. In general, the larger the firm, the more likely that these costs won’t be passed on to participants (but then again, the larger the firm, the lower the expenses are likely to be in general). The Summary Plan Description will tell you, as will asking your HR department directly. It’s also possible that your statement will list all of these specifically, but it’s still good to check with the overall plan information.

The next fee (or group of fees) relates to the specific investment choices you’ve made. Here as well, the information is available, but you might have to do some digging. Ideally, all of the investment choices - those you’ve opted to invest in as well as the ones you haven’t - are listed clearly on the statement, with their expense ratios, or the amount you pay each year to own the fund. That’s unlikely to be the case though, so look up the menu of choices in the Summary Plan Description document, or on the website you use to access your plan account. But don't just add up all the expense ratios of the funds you've invested in! Here's what to do:

• Make a list of all the funds you own, the amount invested in each, and its corresponding expense ratio. Here's a sample:

FUND ABC    $25,000  0.75%

FUND DEF    $10,000  0.55%

FUND XYZ     $15,000 1.25%

• Multiply the amount invested in the fund by the expense ratio:

FUND ABC    $25,000*0.75% = $187.50

FUND DEF    $10,000*0.55% = $55.00

FUND XYZ     $15,000*1.25% = $187.50

• Add up all the results: $187.50+$55.00+$187.50 = $430

• Divide that by your total account balance: $430/$50,000 = .0086, or .86%.

Ideally, you want a broad range of low-cost index funds (the ones in the sample above are pretty high, but unfortunately not unusual for a typical plan). You will likely have some target-date funds available as well, which can be good choices depending on your situation. While fees aren’t the most important thing in making investment choices, there’s certainly no need to pay more than you have to for the same products. If you don’t know what choices are best for you and how to weigh it all with outside investments you may have, a qualified fee-only planner can help sort it all out and guide you to setting the right allocation from the available funds.

Add the two numbers you calculated above to find your total annual fees: .0086+0.000735=.009335, or .9335%

So now you have all the information for the expenses associated with your employer plan. What do you do next? How high is too high? Well, it’s difficult to say, but in general you don’t want to pay much more than 1% overall (smaller firms will be on the higher end, larger firms on the lower end, just due to economies of scale). If you find that you are, you might want to have a conversation with HR about your concerns. It’s a big deal for a lot of people, just not one that is particularly clear. Look up your firm on brightscope.com to see how it rates - sometimes having an outside opinion will help cement your case.

Also, while being aware of the fees and taking action to address them if excessive is absolutely something you should do, understand that this service does cost money to provide; there’s a lot of regulation and legal expense and paperwork and technology involved. So be realistic in your expectations, but the more pressure is put on plan administrators to make expenses transparent and reasonable, the better for everyone.