Investors should prepare to get paid.
Well, at least to learn how much they’re paying. New rules require companies to do a better job communicating exactly how much employees are paying to participate in the company retirement plan. Come end of August, people with 401(k)s should receive communication from their employers with specifics on their investment expenses.
What does it mean for you and your 401(k)? Ultimately, as the investor, you come out ahead, as this increased transparency in costs should drive fees down and nudge returns up.
What’s Going On
Over the past few decades, the burden of saving for retirement has shifted from employers to employees, putting more of the burden on us. Long gone are the days of a guaranteed pension. Instead, most people must invest for retirement with a 401(k). Sponsored by employers and sometimes sweetened by matching programs (you add $1, your employer adds, too), these investment accounts have the tax advantage of letting you defer paying taxes on your gains until you begin withdrawing money.
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It’s extremely important to save for retirement, and 401(k)s are a helpful way to do so, especially if your employer matches your contribution–free money! Unfortunately, many 401(k) plans offer way fewer options than investors get with their own brokers. Fees—lots of them—are also par for the course. You can read more about 401(k)s and retirement in general here.
In general, mutual fund fees have been gradually decreasing over the past two decades. Investors are paying 20% less in fees to mutual fund companies than in 1990, but investors with 401(k)s haven’t enjoyed the ride. Fees have remained somewhat opaque for 401(k)s, which represented $3 trillion and 72 million people at the end of 2010.
At present, 401(k) fees are:
- More expensive for smaller investors: Employees with just a few thousand dollars in their 401(k) plans can pay as much as 3% a year in fees—in other words, a mailroom employee may get hit with proportionally more fees than a CEO who’s investing a lot more money each year.
- A lot over a lifetime: An ordinary family with two working adults will spend over $155,000 in 401(k) fees over their lifetime, according to a recent report.
- Void of low-cost options: Obviously, investors prefer low-cost funds–the median fee investors pay for a mutual fund in regular investment accounts is just 0.79% … but many 401(k)s offer expensive funds that run over 1.5%.
- Hidden from most investors: 71% of people polled in one study weren’t even aware that they’re paying fees for their 401(k)s.
This Is All Changing
At the beginning of July, providers of retirement accounts—in other words, the firms that administer 401(k)s—were required to let employers know what fees their employees are paying.
As August rolls around, employers will need to disclose these fees to you in a yearly letter, and within each quarterly performance statement you receive for your holdings in your 401(k). This doesn’t fix all the problems with the system, but it is a much-needed step to getting a better handle on retirement planning.
The disclosure you get will look like a laundry list of fees–you can see what the approximately 15-page document will look like here–and not everything will be explained clearly–some experts expect that administrative fees will be lumped together with investment fees. But all in all, this is a really good start.
The Changes You Need to Make (to Earn Better Returns)
Mutual fund fees can eat away at the returns on your investments (here’s more on mutual fund fees). One of the best, and easiest, ways to pick mutual funds is by picking the cheapest in its category.
Once you get a clearer picture of how much everything costs, there are a few things to put on your to-do list:
- Swap out expensive funds: Wherever possible, start pruning expensive funds and replacing them with similar, good quality ones with lower expense ratios (those are the operating fees a fund charges). Compare apples to apples: When price shopping, compare a U.S. government bond fund to a U.S. government bond fund—don’t compare a stock index fund to a foreign bond fund.
- Move from actively managed to passively managed funds: With an actively managed mutual fund, money managers try to outsmart the market by buying and selling winning investments. The problem is that very few succeed (the market beats 72% of professional investors). That’s why Schwab rolled out a whole suite of low-cost, passively managed funds for 401(k)s, which aim to mimic the movements of the general market instead of trying to beat it. Passively managed funds are also known as index funds. For more info, check this out.
- Talk to HR: Most companies are as confused about all this as we are. They’re not out to “get” employees by offering expensive investment options. Bring your concerns to Human Resources if you’d like more affordable options in your 401(k) plan. Explain the connection between fees and investing results.
Investing is hard enough–people shouldn’t need to hire a forensic accountant to figure out how much they’re paying in fees on their 401(k)s.
These new regulations demonstrate that there’s a shift in power underway, away from brokerages and large financial institutions and into the hands of individual investors. Knowing what we pay for an investment is a hugely important step to making sure we invest smartly over the long term.