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Fees can ravage retirement plan

By Barbara Whelehan · Bankrate.com
Friday, March 4, 2011
Posted: 3 pm ET

Some 401(k) plan participants don't get mad about fees. They get even. Such was the case with workers at Bechtel Corp., a privately owned firm in the engineering, construction and project management business.

Recently a U.S. District Court judge approved an $18.5-million settlement by Bechtel in an excessive 401(k) fee lawsuit filed by employees. The lawyers representing the plaintiffs will get nearly $4.9 million of that, plus $1.57 million to cover their costs. The balance will get spread among the plan participants, "generally pro-rata based on balance," says Nevin Adams, an attorney and editor-in-chief of Plansponsor.com. "They don't usually wind up with all that much," he adds, referring to the rank and file.

The problem: Bechtel's plan offered retail mutual funds rather than institutional funds. The latter are generally only accessible to investors with large minimum amounts to invest. That mostly means pension plans as well as 401(k) plans, which pool millions -- and sometimes billions -- of dollars in a plan.

Bechtel has more than 17,000 participants in its 401(k) plan, and while no one will get enough funds to afford an immediate exit from the 9-to-5 grind, the employees had their day in court and were rewarded for their efforts.

Other company suits

The fiduciaries in charge of a company plan ought to know that they can ask for fee waivers or for admittance to a particular share class. Bechtel isn't the only company to have made this faux pas. Last year, Caterpillar agreed to a $16.5-million settlement and General Dynamics to a $15.1-million settlement in their respective excessive 401(k) fee suits.

Last week in a blog titled "Does the 401(k) deserve an F?," I mentioned that 401(k) plan fees have been difficult to figure out, but next year this information will be accessible to plan participants, thanks to new regulations that go in effect January 2012.

Most people don't realize they're paying fees. They're not only paying fund expenses, but they may also be forking out money for 12b-1 fees, record keeping and accounting fees, trustee-custodian fees, sales charges, legal and auditing fees -- the list goes on. On top of that, revenue-sharing agreements and soft-dollar arrangements are common, and these are difficult to calculate, much less disclose.

A fee primer

So, expense ratios of mutual funds are only part of the costs. These include the fund operating expenses, such as legal, accounting and auditing fees, and 12b-1 fees if applicable, that are levied by the investment firm managing the fund. They are expressed in percentage terms (total expenses divided by the fund's average net assets). They are siphoned out directly from fund assets, so you never even notice the loss.

Here's the breakdown of average expense ratios for retail funds versus institutional funds:

Retail funds vs. institutional funds
Fund type Average expense ratio
Retail stock funds 1.55 percent
Institutional stock funds 0.99 percent
Retail bond funds 1.16 percent
Institutional bond funds 0.64 percent
Source: Morningstar

What's the big deal?

The expenses may seem small to the uninitiated. There's a 56-basis point differential between retail and institutional share classes. So what? Ditto for bond funds -- a 52-basis point difference.

But over time, 50-odd basis points can makes a big dent in your retirement savings.

Retirement planning calculations are more complicated than this, but let's keep it simple and imagine you invest $500 per month throughout your career. Your average annual return is 8 percent in this hypothetical example, minus fund expenses.

After 30 years, you will have amassed $547,745 had you invested in retail stock funds charging 1.55 percent annually. But if you had invested in institutional stock funds charging 0.99 percent, your nest egg would be worth $611,190, or $63,445 more. That's enough to pay for cable and the occasional dinner out on the town.

Which nest egg would you rather own?

***

Check out Bankrate's Retirement Realities series. We'll be adding stories to it throughout the year.

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6 Comments
Jack
March 09, 2011 at 5:47 pm

Ok, but people don't understand bundled vs. unbundled plans. A LOT of employers choose bundled plans to keep the expenses lower to even provide the 401k. A pure 401k is an IRS qualified salary deferral, no match, no profit sharing. Employers have to bear the brunt of the costs of the administration unless they pass it through the bundled expenses of the fund. Things are a lot more complicated than at first blush. Employers are already have a hard time affording health benefits for employees so shiftng administration costs to the employee via expense ratios allow the employer to even offer a plan. Small/Mid size businesses employ a large part of our country and a lot of them can't even afford to administer a plan so this is the yang to your ying. There is a value to having the ability to defer income regardless of expense ratios. I would hate for employers to pull offering 401ks because they can't afford the expense and no longer have the option to pass the expense on...

Barbara Whelehan
March 08, 2011 at 11:15 am

It's not always so cut and dried. Occasionally it happens that large plans worth $2 billion or more invest in the more expensive retail funds, even though they can have access to less expensive institutional share class funds if they ask or investigate properly. Yes, it's a breach of fiduciary duty. That's what these excessive 401(k) fee lawsuits bring to light. I'm hoping to raise awareness among plan participants so they can ask questions if they discover that their plan doesn't offer cheaper institutional funds. Because over many years, a few basis points can make a dramatic difference in someone's nest egg.

End the Ponzi Scheme
March 08, 2011 at 11:00 am

Incomplete information. If you have funds sufficient to buy an institutional class fund, then you have access to that fund. In many cases the class can be changed once you amass enough in the retail fund. So, the time that you spend in retail funds is quite limited. If you take the cited example, in less than 8 years you reasonably should be into institutional class products.

If a 401k plan isn't in institutional funds already, either the plan has so little money invested that they don't qualify, or the sponsor is asleep at the wheel. Not much you can do on the first count, the second, well there is that fiduciary duty you can ask them about.

Jack
March 04, 2011 at 5:38 pm

Barbara, I know.

It just infuriates me that the Internet is full of people saying that 401k's are conspiracies and that you can make more money elsewhere because of fees so you shouldn't participate. It is cult like mentality. Yes, there are fees. Certain custodians have done a great job with what I call a “fee propaganda campaign” over the last 20 years that now the investments are secondary to fees! Mutual fund returns are NET of fees. Period. I am not of the camp of buying a bad manager because they are on the NTF platform or a “no load”. I rather pay a $45 ticket charge for a good fund manager with a good track record.

Jack
March 04, 2011 at 4:33 pm

Ok, ok. This is for sure an issue in the Qualified Plan world but let's not get stuck on it. I hear too many participants blaming fees for why they don't save. Also, 401k's are really the ONLY place a small investor can gain access to institutional funds since the employer bears some costs too.

Bottomline, SAVE people. No excuses.

Let's not harbor on basis point arguments as to why Americans fail at saving for the future.

Barbara Whelehan
March 04, 2011 at 4:32 pm

Hey Jack -- you're preaching to the choir here. I totally agree and am a big fan of 401(k) plans. Thanks for writing.