Why Small Fees Could Be a Big Threat to Your 401(k)

Julia Chang
Posted

401k nest eggIn most circumstances, a 1% fee wouldn’t cause anyone to blink an eye. If your credit card APR was just that, you’d probably lose a lot less sleep over paying down your balance.

When it comes to your 401(k), however, 1% could mean the difference between retiring on time and having to work extra years to make up for what’s lost to that seemingly small percentage, according to a study by Washington, D.C., think tank the Center for American Progress.

The study gives the example of three 25-year-old savers who earn the median for their age range, $30,502. They each contribute 5% of their annual salary to their 401(k)s, which is matched by their employers, and their investments and salaries grow at the same rate every year. One chooses a low-fee fund (0.25% of assets); another chooses a medium-fee fund (1%); and the third chooses a fund with a high fee (1.3%).

By the time they reach age 67, the small-fee saver has earned $476,745. The medium-fee saver has accumulated $405,454, and the person who paid the high fees has just $380,649—a difference from the medium- and small-fee accounts of $24,805 and $96,096, respectively.

And while the obvious takeaway would be to choose lower-cost funds in your 401(k), it’s not quite that simple. The Center for American Progress report points out that fund disclosures are often buried and hard to understand; many people are not even aware of what their fee is or can’t find it on their statements.

Then there are those investors who are willing to pay a higher fee, also called an expense ratio, because they are paying fund managers to try to beat the market.

But research shows that passively managed index funds, which follow an index like the S&P 500, actually outperform those actively managed funds. The report points to a 2009 study that shows a negative correlation between fees and fund performance.

One other issue exacerbating the problem is that some employers don’t offer enough low-fee options. “The good options are out there,” Alicia Munnell, director of Boston College’s Center for Retirement Research told USA Today. “But when you introduce bad options into a plan, you attract people to them. There are a lot of people who think they should buy a little of everything, and that’s diversification … I want the world to know that fees can really eat into your retirement savings.”