Even if you’ve so far managed to avoid sitting through a company benefits meeting, you’re probably familiar with the concept of a 401(k), if not the hidden fees that can come with it. A 401(k), of course, is a defined-contribution plan, which means that payments into it are fixed and not arbitrary. You put in a set amount per paycheck, your employer may match some percentage of that amount, and years later you’re enjoying some degree of financial independence instead of begging for meals.
It warrants repeating that you should accept that employer match-up to the maximum allowed. Otherwise, you’re rejecting free money. That's the good stuff. Now, what about those fees?
- Your 401(k) provider charges a fee every month for its services.
- The 12b-1 fee goes to intermediaries who sell 401(k) plans to employers.
- You can cut down on fees by maintaining a large balance in your account.
Hidden Fees in 401(k)s
Unfortunately, investor naiveté is such that millions of people never stop to ask how much the 401(k) provider—the mutual fund company that devises the baskets of holdings into which your money goes—is making off the cash you give it to invest. These are the “hidden” fees. Your provider’s services aren’t free. It collects a fee every month, and the cumulative size of those fees can shape your eventual returns.
Thanks to a 2012 mandate of the U.S. Department of Labor, your 401(k) provider is now required to disclose all its fees in the prospectus statement that it sends you every year. As the fees are no longer hard to locate, it pays to pay attention to them.
The U.S. Department of Labor requires your provider to list all fees in your fund’s yearly prospectus, so look for an account of them there.
Naming the Fees
The most firmly entrenched of the fees even has a name, or at any rate a sequence of letters and numerals: The 12b-1 fee is named after the relevant section of the Investment Company Act of 1940, which was enacted decades before such investments had been popularized and democratized to the extent that they are today. Generally filed under “marketing fees,” 12b-1 fees are ostensibly earmarked for the intermediaries who sell the specific 401(k) plans to your employer. These fees, capped by the act at 1% of assets, constitute a commission, which is to say an expense, as distinguished from an investment in the fund’s possible returns.
Note that 12b-1 fees are separate from investment management fees, which are the cut the 401(k) company takes for itself. For instance, Fidelity Investments is America’s biggest provider of 401(k)s. A typical advisory fee for a Fidelity portfolio account starts at 1.7% and decreases from there by as much as half, depending on how much you put in. So there’s a surefire way to avoid at least some fees: have a large balance.
Types of Fees
There are essentially four major categories of fees. To illustrate the point, here’s a sample account summary, not from a 401(k) provider but rather from a third-party firm that administers plans and keeps records. If your company happens to do business with this third-party firm, you’d see this table (or a prorated equivalent) in your quarterly statement:
That is $44.91 in fees on a contribution 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.
Do the Math
Despite the complaints about hidden fees, fees aren’t hidden so much as they’re judiciously disclosed, thanks to that Labor Department rule. And the unavoidable mathematical fact is that expense ratios exist in a narrow band. In one survey, expense ratios for equity funds ranged from 1.55% to 0.5%. Doing a rough calculation on a mutual fund calculator using these two numbers, the fund with the lower fee would earn 11% more over 10 years and 37% more if held for 30 years. Finding a 401(k) fund with a lower fee could save you money.
The Bottom Line
Fees, regardless of how conspicuously they’re disclosed, should be but one criterion in choosing your 401(k) investments. Each fund is different, and the most important factor in how much you make is its overall return. Look at asset class, management’s relative competence, and track record first. Each of them will have a far greater impact on your long-term returns than fees. And don’t forget to factor in whether you are more comfortable with an index fund or an actively managed fund.