The Hidden Fees in 401(k)s

Even if you’ve managed to avoid sitting through a company benefits meeting, you’re no doubt familiar with the concept of a 401(k) plan. A 401(k) is a defined-contributions plan. You sock away a set amount each paycheck, your employer may match some percentage of the contribution, and years later you declare your own financial independence.

But even if you know how a 401(k) works and enthusiastically contribute to one, do you know about hidden fees that can come with it?

Finding the Fees in 401(k)s

Many workers don’t. A TD Ameritrade survey found that just 27% of investors knew how much they paid in 401(k) fees, and 37% didn’t realize they paid fees at all. Unfortunately, many never think to ask how much a 401(k) provider makes off the money you hand over to invest. Your provider takes a fee every month, and over time these fees can impact your returns. Some 95% of 401(k) plan participants pay fees.

These fees aren’t truly “hidden.” The U.S. Department of Labor requires 401(k) providers to disclose all fees in a prospectus that is given to you when you enroll in a plan, and which must be updated every year.

We know you devour these statements the minute they arrive. As the fees are no longer difficult to locate, it pays to pay attention to them. When you receive a 401(k) statement or prospectus, check for line items or categories such as Total Asset-Based Fees, Total Operating Expenses As a %, and Expense Ratios.

Two Key 401(k) Plan Fees

Finding the fees is one thing. Understanding them is another. The most firmly entrenched of the fees is the 12b-1 fee, named after the relevant section of the Investment Company Act of 1940. Generally filed under marketing and distribution expenses, 12b-1 fees are ostensibly earmarked for the intermediaries who sell 401(k) plans to your employer. These fees are capped at 0.75% of assets, while some funds impose a 0.25% shareholder services fee.

Note that 12b-1 fees charged by individual funds are separate from investment management fees, which are the cut the 401(k) provider takes for itself.

For example, Fidelity bills itself as the No. 1 recordkeeper of 401(k) plans in the United States. Businesses that use Fidelity report paying as little as 0.53% in fees, though some say expenses are well over 1%.

Breaking Down 401(k) Plan Fees

Notably, 401(k) plan fees typically fall into four categories:

• Investment
• Administrative
• Individual service
• Custodial

To illustrate the point, here’s a sample account quarterly summary, not from a 401(k) provider but rather from a third-party firm that administers plans and keeps records. (Yes, you can bet they get a cut too, but your employer probably picks that up.) The figures, which represent dollar amounts, are on a total contribution of $3,207.70 for the quarter.

This means the contributor is paying $44.91 in fees on a principal of $3,207.70. Curiously, that’s 1.4% to the penny, which makes it seem as though the expenses are retrofitted to the ratio.

Is it reasonable that only 98.6% of your contributions find their way into the designated investments? That’s not a rhetorical question.

The Impact of 401(k) Fees

401(k) plan fees can vary greatly, depending on the size of your employer’s 401(k) plan, the number of participants and the plan provider. One study found that large plans (more than $100 million in assets) almost uniformly have fees below 1%. The largest plans are usually below 0.50%.

The small plan marketplace is a different story. Average fees for small plans (under $100 million in assets) were between 1.5% and 2%, with plenty of plans with less than $50 million in assets paying more than 2% a year in fees.

The difference in these percentage points doesn’t sound like much, but it can really add up over the years. Take these three hypothetical friends: Joe, Tyler and David each invest $100,000 in a mutual fund at age 35. Each account earns an annualized return of 8%, but the accounts charge annual fees of 1%, 2% and 3%. David paid 3% and has $432,194 in assets at age 65. Tyler paid 2% and has $574,349 for retirement. Joe paid 1% and is the big winner, with $761,225 saved for retirement.

What to Do About 401(K) Fees

Short of boycotting the 401(k), there’s not much you can do about fees charged by the plan provider or administrator—although, if you discover they’re egregious (say 2%) you could raise the issue with your human resources department. The marketplace is incredibly competitive. If one provider’s fees are too much, there are plenty of alternatives.

However, you can take some action on charges for individual funds within a 401(k) plan. Look in each fund’s prospectus for the listed expense ratio, which is the sum of fees expressed as an annualized percentage. If you have a choice between two similar funds—two growth-stock funds, for example—consider the one with the lower expense ratio.

In general, equity funds tend to be more expensive than bond funds, while ETFs are cheaper than mutual funds. But of course, don’t compromise your investment goals, risk tolerance or common sense just in to score a lower fee.

The Bottom Line

Fees, regardless of how conspicuously they’re disclosed, should be but one criterion in choosing a 401(k) investment. The most important factor should be overall return. Look at asset class, the fund manager’s competence and track record first. These areas should have a greater impact on long-term returns than fees. And don’t forget to consider whether you are more comfortable with an index fund or an actively managed fund.