Retirement plan fees receive increased scrutiny

Mutual fund expense ratios don't reveal all of the fees associated with 401(k)s. Here's how to spot the others.

If you participate in a 401(k), 403(b), or similar employer-sponsored retirement plan, you are probably paying all or a portion of the fees that come with it.

Even the largest providers of 401(k) plans agree that fees are a big deal because the lower those costs are, the more you'll have to spend when you retire. For example, an information sheet from Vanguard shows a $314,023 difference between a fund that carries an expense ratio of 0.30 percent and one that charges 1.40 percent, based on 40 years of compound growth, annual contributions of $3,000, and an 8 percent return. (The expense ratio represents the percentage of the fund's assets that go toward running the fund.)

But read Vanguard's example more closely and it indicates that its calculations were made "before costs." (Hmmm ... wasn't this scenario designed to illustrate costs?)

Clearly, expense ratios do not include all of the costs associated with a 401(k), notes David Loeper, CEO of Financeware Inc., and author of the new book, "Stop the 401(k) Rip-off!" In fact, he says, there are other costs that aren't easy to find, but employees are probably paying them.

Mr. Loeper is not alone. Sen. Herb Kohl (D) of Wisconsin and Rep. George Miller (D) of California have introduced bills calling for full disclosure of 401(k) fees.

In addition, at least a dozen class-action lawsuits have been filed against such companies as International Paper Corp. and Lockheed Martin Corp., alleging violations of pension laws by allowing plan participants to be overcharged by plan managers. "One was dismissed in early February," says Pamela Hess, director of retirement research at Hewitt Associates, one of the largest retirement-plan service providers in the country. The suit linked investment losses and fees, which the judge didn't think was reasonable.

Yet all this attention means fees are receiving more scrutiny. "A GAO [Government Accountability Office] report from last November noted that 80 percent of the public doesn't know what they're paying for their 401(k) plans," says Loeper.

The GAO reported that changes were needed to give better information on fees for plan participants, noting that even a seemingly small difference in the fees can make an enormous difference in the overall size of an employee's 401(k) account balance. A 1-percentage-point difference in fees can reduce retirement benefits by 17 percent over 20 years, the report states.

Currently, some 62 million people, – active participants, former employees, and retirees – are holding $2.7 trillion in assets inside 401(k) accounts, according to the Investment Company Institute (ICI). More than half of those assets are invested in mutual funds. (See chart.)

With those funds come fees. A fund's expense ratio accounts for many of those expenses, including the investment advisory fee, administrative costs, as well as its marketing and distribution costs.

But Loeper con­­tends that some fees aren't disclosed at all, making it next to impossible to determine if the costs associated with a 401(k) are too high. Among the frequently non­­disclosed fees he lists are wrap fees, which include costs for trading and monitoring investments for which the investor could be charged as much as 2.5 to 3 percent a year.

"Charges are often clumped under administration expenses, a most-effective means of hiding extra costs," he says.

Loeper discovered all this when he got fed up with his company's 401(k) plan and switched service providers. "We were paying more than $500 a year per participant; now the administrative costs are down to only $60 a year per participant, and I was personally paying $1,500 a year for my own 401(k) and now pay just $198."

The new plan for his 25-person company costs less than 0.6 percent of assets, he says. Not only did the shift decrease costs, it increased the flexibility and number of investment choices. As a result, his employees can choose from 1,500 no-load funds instead of what had been 10 to 20 choices for no additional cost other than what each fund itself charges. "So, despite the variety available through these self-directed accounts, we can still keep the costs down."

During the exploratory phase, Loeper was pitched by vendors who said that they could bury the fees for expensive funds so that the participants – the employees – pay all the costs. "They were telling me that I could rip off my employees," he says.

Conflicts of interest on the part of the service providers were brought up in Rep. Miller's bill and in Loeper's book. For example, service providers would offer higher commissions on expensive plans, and so understandably sales people would want to sell them to plan sponsors – the employer offering the 401(k).

Employees who want to know all of the costs inside their 401(k) must ask their benefits department for a copy of the Summary Annual Report for their plan, says Loeper. "If you divide the total plan expense you see on this [report] by the total plan value, you'll get the annual percentage being charged against your 401(k) balances...." To figure out your costs down to the last penny, take that percentage and multiply it by your total account balance.

One fund Loeper's company now offers employees in its 401(k) is Fidelity's Spartan 500 Index Fund, which has an expense ratio of 0.07 percent. "You have to look within the fund behemoths to find lower-cost funds. Fidelity recommends its target funds that look to have very low expense ratios, but because they buy their own funds, [these target funds] actually have fees incurred within the funds."

Loeper says an ex­­pense ratio of 0.75 percent a year or less is fair. ICI research backs that up: The average total expense ratio incurred by 401(k) investors in stock funds was 0.74 percent in 2006, about half of the 1.5 percent simple average for all stock funds and lower than the industry­-wide asset-weighted average of 0.88 percent.

A flat fee for administrative costs for employers of $1,500 to $2,500 per year, with an additional fee of $5 to $15 per participant, is reasonable, according to Bill DeShurko, author of "The Naked Truth About Your Money" and president of 401 Advisor in Centerville, Ohio. When weighing plans and fees, he says, consider whether you're receiving advice that helps you make the most of your investments. "For your 1-to-2 percent in fees, you should receive advice, that's the issue."

He says that he's seen plans in which each employee account was debited $35 a month for administrative costs. "There's no reason to have to pay such a high fee," Mr. DeShurko says.

But he suggests that stock funds with high expenses can be worthwhile. "If you have a cheap fund that doesn't perform, what good is it? If you have an expensive plan but it's beating the socks off the Vanguard S&P 500 Index fund, which I use as a benchmark for my clients, then it's worth it."

There's a price for complacency. Your employer's role is of "prudent fiduciary" so employers should be shopping for a better deal for you, Loeper contends.

An employee stuck in a 401(k) with high fees may find it's not easy to switch plans. Some 401(k) service providers impose surrender charges on companies that don't hold onto a plan for at least five years. "If you cash out, there's a 2-to-3 percent penalty for each participant – the employees," says DeShurko.

To keep fees down, watch transaction costs. Most mutual fund companies won't charge a transaction fee if you buy or sell a mutual fund inside a retirement account, but they will charge a 1-or-2 percent fee if you change your holdings within a 30- or as much as 90-day period, he adds. Some plans restrict how many trades you can make in a certain period.

"I have a problem with that. Suppose you're in an emerging-markets fund and a bomb or some headline made you feel it was too risky. You should be able to get out without incurring a 1-to-2 percent penalty," DeShurko says.

The bottom line is that employers need full disclosure, says Hewitt's Ms. Hess. Employees should talk with their plan's administrator about all fees inside their retirement plan. "If the plan sponsor or employer is not assessing fees, they aren't doing due diligence," she says. "Without this info, how would you know if you're getting a good deal?"

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