Rightfully so, savvy investors pay close attention to their 401(k) fees. Average, every day 401(k) plans typically charge 1% or more of assets managed. Over the course of a working lifetime, this can add up to hundreds of thousands of dollars.
One of my favorite television documentaries, The Retirement Gamble, presented by PBS on their excellent show, Frontline, notes that retirement is big business in America as there is a lot of money at stake. I highly recommend you take the time to check it out. The impact of fees is also addressed in a recent book I reviewed, Empire of the Fund. In the opening paragraph of chapter four, Fees, author William A. Birdthistle notes, “Fees cause money to leak out of funds, and their aggressive application can dramatically deflate investment returns and ruin the party.” Indeed!
One of Birdthistle’s proposed cures for the diseases and disorders impacting our retirement system is to allow individuals to invest in the Thrift Savings Plan (TSP), the federal government equivalent to the 401(k) and a program I have championed on the pages of this blog (here [see comments section] and here) in the past. Birdthistle astutely notes its success can be tied to its modesty, prudence, and most importantly, its low (.029%) fees.
Choose Your Mutual Funds Wisely
When choosing a mutual fund as an investment vehicle, I alway suggest people start with index funds. As a short refresher, an index fund is a specific type of mutual fund. These types of mutual funds are designed to track the performance of a stock market index (e.g. Russell 2000, S&P 500, Wilshire 5000, NASDAQ Composite, etc.). Advantages of these types of funds is that they offer investors broad exposure to the markets and most importantly, expenses that are typically lower than traditional mutual funds due to their passive, vice active, management.
Regarding those expenses, I recommend that investors seek funds that have an expense ratio (the operating costs, including management fees, expressed as a percentage of the fund’s average net assets for a given time period) that is less than 1%. The more money you have working for you, and not going to fees and other expenses, the more you can leverage the power of compound interest.
Minimize the Fees
Can we quantify the impact? Absolutely. Assume we have a 25 year-old who plans to retire at age 60, currently has $20,000 invested, they plan to invest an additional $30/month during that 35-year period, and they average 5% annual returns, before fees. The only difference? The fees charged. In scenario 1 we have our 5% – .029% (the TSP fee) which leaves 4.97% return compared to scenario 2 where we have 5% – 1% (the typical 401(k) fee) which leaves a 4% return.
According to my calculator, that is a $93,856.28 difference. And remember, with compounding the growth is exponential. The more we have working for us (the current principal and/or annual contributions) over a given time period, vice being paid out in fees, the more dramatic the growth will be. Moreover, it is not unusual to find mutual funds that charge more than 1%. Again, the bigger the difference is between the fees charged for two respective funds, the more dramatic the difference in gains over time.
Another good option, which is relatively new, is target-date funds. These types of funds are an easy way to manage investments during your working years. They consist of a series of target retirement date funds in five or ten-year increments and you select the fund nearest your anticipated retirement date. The underlying idea of target-date funds is that they are low-cost, as the management is fairly passive (like index funds), and their weighting with regards to equities and bonds; and volatility and risk are adjusted to become more conservative as you get closer to the target date, near your date of retirement.