Average 401(k) plan participants currently pay more than 1.5 percent of their accounts' asset values in fees each year to the companies that provide the plans with investment management, record keeping, and advisory services.
That number comes from industry data cited by Jim McCool, executive vice president of institutional services for Charles Schwab. Compared with firms like Fidelity and Vanguard, Schwab is not a big player in 401(k) plans. But it would like to be, and McCool believes the path to success will come from cutting that 1.5 percent (it's actually 155 basis points, or 1.55 percent) to about 0.6 percent, or 60 basis points.
To an investor, the cumulative difference between fees of 1.55 percent and 0.6 percent can be enormous. In Schwab's example, over the span of 30 years, participants can pick up an extra $115,000 through lower fees alone. This assumes that they earn $50,000 a year when they begin saving with a 401(k), and get typical employer matches for contributions, annual raises, and investment gains over the 30-year period.
According to a 2009 U.S. Government Accountability Office report on 401(k) fees, paying an extra percentage point in annual fees would shave a sixth off of total retirement savings after 20 years.
The secret to sharply cutting 401(k) fees is no secret at all, McCool says. It would come from building 401(k) plans that rely extensively, if not exclusively, on passively managed funds that track major investment indexes. These match-the-market funds could be index mutual funds or their cousins, exchange-traded funds (ETFs).
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Index funds and ETFs have very low fees, with ETFs generally offering the lower of the two. Many investors prefer ETFs because they trade like stocks, whereas mutual funds can only be traded at a single price that is not determined until the close of each trading day. ETFs that hold stocks also provide tax savings compared with stock mutual funds. But whereas mutual funds are often free of trading commissions, ETFs usually charge commissions, just like stocks. (Schwab says any ETFs offered on its 401(k) platform would charge no trading commissions.)
The popularity of index investing has grown even more because extensive research shows that investors invariably lose in their efforts to beat market averages. They either pick poorly performing individual stocks and funds, or fail to time the market's ups and downs, or both. And while some actively managed mutual funds can point to superior results, they seldom match the market when measured over multiple decades of performance.
In its 2011 study of investor performance, financial measurement firm Dalbar documented the shortfall of annual returns compared with market averages. "For the twenty-year period, equity investors earned 3.83 percent and asset allocation fund investors earned 2.56 percent compared to the S&P 500 return of 9.14 percent," Dalbar reported. "For the same period, fixed income investors earned 1.01 percent compared to the Barclays Aggregate Bond Index return of 6.89 percent."
While index funds are popular, McCool notes, they are largely absent from the investment choices provided to 401(k) participants. Schwab is developing offerings for plan sponsors who want to move to a lower-cost set of offerings for their employees.
As this is happening, the 401(k) industry is also responding to widespread criticism that employees don't have access to clear information about retirement plan expenses. Employee surveys, for example, have found that many employees believe their 401(k) plans are free because they do not pay a fee to join a plan or to buy and sell investments offered by the plan. That average 1.55 percent in plan fees is not disclosed on employees' 401(k) statements.
Beginning next year, improvements in reporting and transparency will be required under new federal rules. To the extent that these changes raise employee awareness of fees, they are expected to push plan providers toward lower-cost investment choices. Schwab, for one, believes index funds will begin appearing among those choices.