What Your 401(k) Really Costs You

By Kirk Shinkle

How much does your 401(k) cost? It's a surprisingly difficult question to answer, but the amount you're charged for your tax-exempt retirement plan can make a huge difference in how much you'll have when it comes time to retire.

The problem is, navigating the web of fees exacted by an army of Wall Street intermediaries who administer your plan and its investments is currently an exercise in guesswork. Bits of your hard-earned cash are siphoned off to pay a long list of middle-men: plan administrators, bookkeepers, lawyers, compliance experts, and the investment advisors who manage the mutual funds you hold are just some of the folks who get paid in the process. But don't expect their cut to show up on your quarterly statement.

Instead, the fees most investors see barely scratch the surface. Right now, the 50 million or so Americans who depend on 401(k)'s for their retirement must rely on glaringly incomplete measures like individual mutual fund expense ratios that cover only part of the expenses charged by their plans. A host of other costs are either unknowable, painted in broad strokes, or obscured by confusing language, experts say. As a result, most workers simply don't know how their 401(k) fees work. In an oft-cited survey from AARP, more than eight in 10 401(k) participants didn't know what kind of fees and expenses were associated with their plan.

"The problem is, people simply don't understand what they're paying, and for what," says Olena Berg, a boardmember at the Pension Rights Center and former head of the Department of Labor's Employee Benefits Security Administration during the Clinton administration.

Unfortunately, that lack of knowledge can be very costly over time. For a sense of just how great a difference fees make, consider this example: You're an employee with 35 years to retirement who's managed to save $25,000 in your 401(k). If your returns average 7 percent a year and fees and expenses shave 0.5 percent off of you returns, you'll retire with $227,000 even if you don't contribute another dime to your account. But if fees rise to 1.5 percent, your account will grow to just $163,000, according to the Department of Labor. That's a 28 percent difference.

Luckily, understanding 401(k) costs could be getting easier, and the most sweeping change could come as soon as this week from Washington.

As part of the American Jobs and Closing Tax Loopholes Act of 2010, regulators are taking aim at the way fees are disclosed and how they're presented to both employers and workers. Included in the bill H.R. 4213 are some new provisions that get to the heart of the transparency issue. Specifically, the bill requires fees for investment options in retirement plans be expressed in dollars or as a percentage. It also requires 401(k) providers to break out fees in more comprehensive ways for plan sponsors. They'll need to disclose all fees assessed against the participant's account, and group those fees into three categories: plan administration and record keeping fees, investment management fees, and all other fees.

"Guaranteeing the disclosure of hidden 401(k) fees will give Americans a fighting chance to strengthen their retirement and increase our nation's future economic security," said Congressman George Miller, a democrat from California, who authored that legislation, in a press release.

At the same time, old hands in the industry are getting ahead of the legislation with better fee tools of their own. Putnam Investments, which runs some $22.6 billion in defined-contribution plan assets, has taken the lead in building better ways to break out fees in plain English. The firm is launching new online tools for retirement plan sponsors that will break out fees paid to plan providers in ways that generally match the model proposed by the government. For 401(k) participants, Putnam will unveil new tools to outline fund expense ratios, transaction fees, and other information designed to show individual costs of their plans sometime in July.

"There shouldn't be anything left [out]. It should be clear. Ideally it'll be simple," says Edmund F. Murphy, a managing director and head of defined contribution at Putnam Investments. He cautions, however, that while transparency is the goal, the way costs are displayed should be watched carefully. Simply showing workers a dollar amount of what their 401(k) costs each year, given the variety of investment expenses that can exist in an individual 401(k) plan, could leave some participants with misleading impressions of what they're getting for their money. "It's important that the fees are expressed in such a way that they understand the services being provided so they understand the value they're getting for the fees that they're paying," he says.

In addition to those new rules, start-ups are taking a look at obscure fee data and building better ways to dig into individual plans. BrightScope, a San Diego-based company, is tracking and rating thousands of individual 401(k) plans. On the fee side, for plan sponsors, BrightScope uses audit reports to recreate portfolios in addition to those disclosed in government filings. It also offers free fee reports for some individual plans. One downside: BrightScope's data remains a bit outdated. Much of its current data is from 2007, although new disclosure requirements mean more current information is coming on line now and will be updated more frequently.

Still, there will be a few corners of the 401(k) world that will remain cloudy. Trading costs, for example, will still be nearly impossible to discern even though they can add substantially to the cost of owning a mutual fund if managers buy and sell frequently. This is less of a 401(k) issue than an issue with mutual funds in general, but it's an another argument for trading-fee free index funds. Mike Alfred, one of BrightScope's co-founders, says trading costs can add an average 40 basis points on average -- above and beyond the expense ratio -- across 401(k) plans he's surveyed. In small funds that trade frequently, he says trading costs can double overall costs. Company stock ownership in a 401(k) can come with additional broker fees as well.

More broadly, 401(k) plan size and the size of your company also matters when it comes to fees, and generally bigger is better. Smaller plans can be more costly since they lack the economies of scale when it comes to fixed costs like bookkeeping that larger plans can spread around to a wider pool of assets. Also, larger companies often pick up a bigger chunk operating expenses for their employees 401(k)'s. Alfred says he's uncovered small plans where 401(k) fees ran as high as 7-8 percent.

Broadly, the rule of thumb for plan expenses is this: If you're paying more than 1 percent on your investment, you're probably paying too much. If the government's transparency measures pass, investors will have a vastly improved range of tools to accurately calculate that number.

Personal Finance - What Your 401(k) Really Costs You