How to Cut Retirement Fund Expenses

Create thousands in retirement savings simply by trimming 401(k) and IRA fees.

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Cutting the management and investment fees charged by your retirement funds can add a lot of money to your nest egg without sacrificing any of your investment goals. This work will take you an hour or two at most and could add thousands of dollars to your retirement savings. Seem like a good investment?

You may have an active 401(k) retirement plan with an employer. Or perhaps you've rolled over such a plan into an IRA or other self-directed retirement account. The odds are good that most, if not all, of your investments are in mutual funds. A few years ago, a survey of 401(k) account holders found that most people thought they paid no fees at all on their mutual fund holdings. But there are fees—lots of them—and they can be steep. But they are largely invisible to investors. The recipients of your retirement fund fees may be the firm that administers your plan, the mutual fund companies with whom you've invested your retirement assets, or the brokerage company that administers your IRA and other self-directed accounts.

[See The Impact of Mutual Fund Fees.]

The major mutual fund fees are the investment management fees and operating expenses charged by each fund. They are passed on to investors but do not show up on customer account statements. Instead, they are addressed in the funds' investment prospectuses, which are seldom read by mutual fund investors. And in these documents, they appear as hypothetical case studies.

In 401(k) plans, such disclosures are incomplete and voluntary. Legislation to require better disclosures has gone nowhere in past Congresses. It has more traction now because of large 2008 investment losses on many retirement accounts. Backers hope the measure gets tacked on to a developing economic stimulus effort to provide relief to pension plans.

[Also see 4 Funds for the Record Books.]

In a 2007 report, the Government Accountability Office used an example of a 45-year-old with 20 years until retirement and a $20,000 balance in his or her 401(k). If that person's funds were in an account that charged only half a percentage point of investment assets in annual fees, that $20,000 would grow to $70,000 in 20 years if the account earned an average net return—after fees were paid—of 6.5 percent a year. If that $20,000 were placed in an account charging annual fees of 1.5 percent of account assets and invested in the identical securities, the net return would be 5.5 percent a year. And that $70,000? It would be only $58,400, which represents a gap of 17 percent. In other words, $1 of every $6 in the person's nest egg would be lost to higher fees.

That's a big gap. Imagine if that $20,000 were $100,000 or $200,000. The low-expense account would grow to $350,000 or $700,000; the high-expense account would wipe out $58,000 or $116,000 of these amounts. That's a big ouch.

Andrew Gogerty, a senior mutual fund analyst at Morningstar, says the hypothetical example of fees contained in each fund's prospectus is your best bet on getting a handle on comparative fee structures among funds. "It would be nearly impossible for an investor to calculate these fees" on his or her own, he says. What happens is that fund expenses are allocated to all outstanding shares and are subtracted from each day's market performance before the fund's daily closing market value (which is known as its net asset value, or NAV) is calculated.

In their prospectuses, the funds are required to calculate the example the same way, he says, making fund comparisons possible. For each $10,000 placed in the fund, what would fund expenses be for one-year, three-year, five-year, and 10-year periods, assuming that the fund earned an annual return of 5 percent and that all dividends and distributions were reinvested in shares of the fund? Let's look at some real-world situations. Morningstar looks closely at fund expenses, including those for target-date retirement funds, which are designed for people who turn 65 in the fund's target year. The funds automatically shift their investment mix as people near retirement.

The Oppenheimer Transition fund with a target year of 2030 (symbol OTHAX) is a high-expense fund. According to Morningstar, the fund has an expense ratio of 1.48 percent (it also charges an initial sales charge, or load, of 5.75 percent). According to the hypothetical example in the prospectus of this fund, its fees would be $1,088 after three years, $1,357 after five years, and $2,286 after 10 years.

At the opposite end of the target-date spectrum, Vanguard's Target Retirement 2030 Fund (VTHRX) has an expense ratio of only 0.19 percent. Its hypothetical fees are $61 after three years, $107 after five years, and $243 after 10 years.

Across the spectrum of mutual funds, Vanguard's expenses are really, really low. Its holdings are dominated by Vanguard index funds, which are passively managed funds that aim to match common investment indexes (the Standard & Poor's 500, for example). Thus, its management fees are minimal and much lower than most mutual funds (including other target-date funds).

Of course, it might be true that you get what you pay for. So what if Oppenheimer's fees are high? Maybe its fund managers just knock the socks off Vanguard's managers. Maybe those higher fees enable Oppenheimer to hire better managers.

It's possible, in which case its fund's returns would exceed those of the Vanguard fund, even after fees. But, as Gogerty stresses, the only way for Oppenheimer to earn a higher return than Vanguard is to take on more risk in any of several areas of its investment objective. "They are going to have to take on some type of investment risk to generate that higher return," he says.

The Oppenheimer fund returned 9.7 percent in 2007, lost a whopping 44.5 percent in 2008, and rebounded with a gain of 36.3 percent in 2009. The Vanguard fund returned 7.5 percent in 2007, lost 32.9 percent in 2008, and gained 26.7 percent in 2009. While the Vanguard fund posted smaller gains in 2007 and 2009 than the Oppenheimer fund, it ended 2009 in better shape because its 2008 losses were not as steep.

You can see all of these numbers on Morningstar's site, along with expense examples, for every mutual fund. On the main mutual funds page of Morningstar, type in the ticker symbol of a fund. Click on the "expenses" tab to see the fund's fees and hypothetical expenses. Click on the "performance" tab to see total annual returns and other performance measures.

You should do this for every mutual fund you own. If you're in an employer 401(k) program, you may have limited investment choices. But check out the fees and performances of those choices, look at their investment objectives, and decide if you should shift funds. Make sure you have the correct ticker symbol. Many widely held mutual funds have different versions (with different ticker symbols) in employee retirement plans. If all of the choices seem expensive, your only realistic option is to ask your human resources department to consider adopting some less expensive options.

If you manage your own funds, however, it should be easy to shift your fund holdings into lower-fee funds and to do so without sacrificing returns. Over time, the lower-fee funds will mean more money for you.