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How Your 401k Works and How to Save $100,000 in Fees

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This video shows investors how reducing their investment expenses can improve the performance of their portfolio.

How Your 401k Works and How to Save $100,000 in Fees

In this video we will be “pulling back the curtain” so to speak, to show you how a 401k plan works and what it really cost you. Then we will discuss an option that can cut your 401k plan fees by thousands of dollars.

During my years in the 401k industry, I found that most people who have 401k plans really don’t know what they’re paying in fees. If you’re one of these people this can eat into the value of your account.

However, it’s not your fault.

The 401k industry, meaning the service providers who “package” 401k plans, do a great job of keeping certain expenses “hidden from view” – which makes it easier to sell a retirement plan when it’s perceived that certain plan services are “free”.

An AARP study found that 7 in 10 workers said they didn’t realize they were paying any 401k fees at all. When in fact it’s estimated that service providers of 401k plans collect nearly $60 billion a year in fees. The problem comes down to a practice known as “revenue sharing” whereby, 401k service providers layer their fees inside the mutual funds that are inside your 401k plan. The mutual fund company then deducts these fees from the value of your mutual funds then pays the fees to the 401k service providers behind the scene.

To best understand how all this works, let’s take a look at an illustration. (See video)

There are four types of service providers associated with administering a 401k plan.

Let’s begin with the most visible component associated with a 401k plan, the investment options within your plan, usually these will be mutual funds. This is where you invest your money.

This brings us to the first service provider, the mutual fund manager, whose job it is to manage the investments within the mutual fund. The fund manager gets paid by charging an “asset-based” fee based on the invested assets in your mutual fund, as a percentage of your account value. So as the value of your account grows so does the fee fund manager receives.

The second component of a 401k plan is called the record-keeper – every plan has one. It’s their job is to keep track of, and report on, your account balance.

The third component of a 401k plan is Administration – again every plan has this. It’s their job to make sure your plan is in compliance with government rules and regulations.

And finally, the fourth component, which your plan may or may not have, is a financial advisor who offers employee education and enrollment support to plan participants.

So how do these other three service providers get paid?

First thing, everyone gets paid,nothing is “free” when it comes to 401k plans. This is where revenue sharing comes into play. The mutual fund company creates a “share class” specifically designed for retirement plans. These share classes carry higher costs due to two types of added revenue sharing fees. One is called a Sub-TA fee. This fee is paid to the record-keeper and whoever is providing administration services. The second is a called a 12b-1 fee, which is a commission that pays the financial advisor for their services. If there is no financial advisor associated with your 401k plan the 12b-1 fee may, in some cases, be used to offset a portion of recordkeeping and/or administration expenses. These fees increase the fund’s total expense ratio, allowing the mutual fund company to pay these service providers from your invested assets.

The problem with revenue sharing fees is that not only are they hidden from view, but they’re also an “asset-based fee” that is charged as a percentage of your account value.  So, as your account grows in value so do the revenue sharing fees you pay to 401k service providers.  As a result, people with larger account balances end up paying more towards the plan’s cost than people with smaller account balances.

So, how could plan participants with larger account balances save thousands of dollars?

To see this let’s look at the average mutual fund expense ratio for mutual funds in 401k plans. According to Morningstar, a research firm that tracks mutual funds, there are over 3,300 mutual funds with “share classes” designed for retirement plans.  Their average fund expense ratio is 1.15%.  One option for lowering your investment expenses is to simply avoid funds with revenue sharing and instead invest in low cost index funds, such exchange-traded funds, also called ETFs.

So how do you invest in ETFs within your 401k plan? By choosing to use an investment option associated with most plans called a self-directed brokerage account, also known as a brokerage “window”. This option works just like a regular brokerage account, allowing you to purchase investments that are “outside” the limited number of funds available in your 401k plan.

That said, what would be the average fund expense for a globally diversified portfolio that invests in about 10 different ETFs. The answer, about 0.15%, which represents a 1.00% cost savings. ETFs not only have lower fund manager fees, but they also don’t offer revenue-sharing payments, such as 12b-1 or Sub-TA fees, to plan service providers. This is also the reason you rarely see ETFs offered as investment options within 401k plans.

So how much money can you save by cutting your 401k plan cost by 1.00% annually?

The results may shock you.

The following chart (see video) assumes your 401k account balance grows at 7% annually. Based on this, a $100,000 account can save nearly $40,000 over 20 years. That translates to having an extra $40,000 during retirement. A $250,000 account can expect to have an extra $100,000 over the same time period, and if your account is valued at $500,000 you can accumulate nearly $200,000 extra dollars by reducing your investment costs by 1.00% annually.

So, what does it cost to access the brokerage account option associated with your 401k plan?

Depending on your plan provider, it may cost you nothing to access – you’ll just pay a transaction fee, usually around $8-10 per trade when you buy or sell an ETF.  But, since you’re not trading often the cost is minimal when compared to paying a higher fund expense as a percentage of your account value.

In total, a 10 fund portfolio should cost you roughly $80–$100 in trading cost to set-up, then after that, you’ll make portfolio adjustments 1 or 2 times a year. So you may average $300 a year in trading cost. In the end, asset-based fees are better for service providers and fixed fees are better for you.

So remember, when it comes to investing in your 401k, it’s what you don’t see that can hurt you!

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Retirement Essentials