How to grow your savings

Jeff Gardner, 58, started his first job in 1979, the year after a new retirement plan called a 401(k) made its debut. Gardner, an insurance executive from Bensalem, Pa., took advantage soon after, setting aside $100 a month at first. By the late 1990s, he had socked away a sizable nest egg, but his returns were under par. “I was getting 4.2 percent, compared with 12 percent for the market at the time,” he recalls.

Gardner consulted a colleague—an actuary—who unmasked the culprits. Numerous tiny, compounding fees, like termites, were eating away at his returns. Aghast, he gradually changed his investments to index funds, which are known for low fees. But he estimates that those earlier up-front loads, management expenses, 12b-1 marketing fees, and other charges compounded over decades eroded at least $100,000 of his nest egg.

“You don’t see it happening because it’s small,” Gardner says. “But that’s a lot of money that went out the door.”

Are you paying too much in 401(k) fees? Until recently, it was difficult to know. But as of last year, 401(k) plan sponsors are required to send participants annual disclosures outlining fund fees and their effects on savings over time.

Those disclosures, newly mandated by the Department of Labor’s Employee Ben­efits Security Administration, which oversees private retirement plans, must be delivered by Aug. 30 each year. In fact, they may be sitting on your mail tray or in your e-mail inbox right now. Investors can now see what they’re spending—and how much they may be losing—on what is arguably the most crucial investment of their lives.

At the same time, a steadily increasing flow of class-action lawsuits is targeting employers that sponsor 401(k)s. The suits contend that by charging high fees, improperly passing costs on to participants, and even engaging in conflicts of interest, plan sponsors violate their fiduciary duty to act in the sole interest of participants.

The two developments represent a turning point in a consumer movement that 35 years after the 401(k) was written into law may finally make plan sponsors accountable to the people they’re bound by law to serve.

In this report, we’ll discuss how high fees can dramatically affect what you have available in retirement. We’ll outline what you can do within your own account to improve your returns. And if you have a bad 401(k) plan to start with, you’ll also learn how to push your employer to make changes to the funds within the plan—or even to dump the company that administers the plan—to improve your odds for retirement security.

• No index funds.
• Fund expense ratios of 1 percent or more.
• Delayed vesting of employer match.
• Matches only in company stock.
• Funds not diversified.
• Low or nonexistent employer match.

An American wage-earner pulling in about $50,000 in adjusted gross income each year will need seven to 10 times that—up to $500,000—to maintain a similar lifestyle in retirement, financial planners estimate. But a survey this spring by the Em­ployee Benefit Research Institute found that 57 percent of American households have less than $25,000 in savings and investments, not including the value of their homes or a traditional pension. In about two-thirds of households with 55- to 64-year-olds—the group closest to retirement age—the average saved amount was not even equal to a year’s income, says a study by the National Institute on Retirement Security released in June.

Why this dire reality? For one, only about 60 percent of workers younger than 65 have access to a workplace retirement account. Among workers 18 to 34 years old, 56 percent are not saving for retirement at all, says a 2012 study by LIMRA. Of those who are saving, many defer just 3 percent of income to their 401(k)s, the typical default option, says a 2012 report by the Employee Benefit Research Institute. Many don’t elect to automate increases in contributions each year and so don’t ratchet their savings further.

With a 401(k), you invest now and defer your taxes until you withdraw the money, presumably when you are in a lower tax bracket. But employees who make poor 401(k) fund choices, with high, built-in investment fees, can lose out on tens or even hundreds of thousands of dollars in returns over their working lives without even knowing it. Last year, the progressive think tank Demos estimated that two median-income earners will pay, on average, almost $155,000 in 401(k) fees over a lifetime. IRA plans that individuals set up themselves were included in that figure.

You might think the most important element in picking a mutual fund in a 401(k) is past performance or the experience of the fund’s manager. But the best predictor of a fund’s performance is fees, says the investment research company Morningstar. No matter what type of fund—large-cap, small-cap, value, or growth—lower fees correlate with better performance. That’s because although stocks go up and down, fees are a constant. Over the long haul, higher fees drag down a fund’s overall return.

Consider the impact of a margin of just 1 percentage point in fees on a $25,000 investment growing at an average 7 percent annually. Subtracting annual fees of 0.5 percent, that investment grows to $227,000 over 35 years, with no additional contribution. With annual fees of 1.5 percent, that nest egg is only $163,000. That’s $64,000, or 28 percent, less.

As a rule of thumb, you shouldn’t pay more than 1 percent in expenses, or fees, for any mutual fund if your 401(k) is with a large company that has thousands of employees. Your company should be able to use its size to negotiate significant discounts with mutual-fund companies. Even small companies without much bar­gaining power should be able to find low-cost funds for their employees. Mutual funds that follow indexes such as the Standard & Poor’s 500, for instance, should cost far less because the managers have to do less work. The Schwab S&P 500 Index, for instance, has an expense ratio of just 0.09 percent, or 0.0009 annually. On a $1,000 investment, you’d pay a mere 90 cents. Policy analyst Robert Hiltonsmith, author of the Demos study on 401(k) fees, estimates that about 40 percent of 401(k) participants pay excessive overall fees. “And we have a conservative bar—1 percent of assets—for what’s considered excessive,” Hiltonsmith says.

Fund fees: The little things add up

Mutual funds that sound similar or have identical investment goals can vary widely in cost within 401(k) plans. Here’s how much $50,000 will cost if invested over 20 years in certain target-date or life-cycle funds common in 401(k) plans.

Source: Morningstar, FINRA. Assumes average growth rate of 7 percent.

The impact of investment fees is outlined in the annual disclosure sent from your plan each August. You’ll see the performance of your funds over one, five and 10 years, as well as how much you pay in fees for every $1,000 you invest. Every quarter, by the middle of February, May, August, and November, your investment statement should show the dollar amount and description of fees and expenses you paid. The disclosures highlight the costs that funds pass on to their customers.

Investment management fees. These are the largest component of 401(k) fees for individual funds. They’re ongoing charges to manage the funds in your account. Also known as investment advisory or account maintenance fees, they’re generally stated as a percentage of assets, or expense ratio. A 12b-1 fee pays the fund’s costs to market itself. Other administrative fees cover maintenance of customer-service numbers, and accounting and other services.

Plan administration fees. These include record keeping, accounting, legal services, and other costs to run your 401(k). They also include the costs of maintaining, for example, a plan website, telephone voice response systems, and investment education. Your plan might charge your account a flat fee or a percentage of your assets to cover those expenses. Or it may deduct your share of the costs from your investment returns. You’ll find that information in the quarterly statements from your 401(k) plan.

Insurance fees. If you own a variable annuity contract within your account, you might also pay a “mortality risk” fee to cover the insurer if you die earlier than anticipated. You’ll also pay surrender and transfer charges if you withdraw investments prematurely. Those are included in the expense ratio.

Individual fees. They might include what you pay for individual services, such as taking out a loan and obtaining documents in a divorce proceeding.

For the first time, employees are beginning to flex their muscles, influencing employers to make changes in their 401(k) fund lineups and other features (see below). But change takes time, and in the short term, employees with high-cost plans often have to fend for themselves. In the meantime, here are ways to make the best of a bad hand and build the retirement fund you’ll need:

Take the free money and run. Invest the minimum needed for the full company match (often 6 percent of your gross income, for a 3 percent match). Put other savings in a Roth or a traditional IRA composed of low-cost funds. At 59½, you might also be able to use what’s known as an in-service, nonhardship withdrawal from your current employer’s 401(k). You roll over balances into an IRA with more choices; you still defer taxes while avoiding an early-­withdrawal penalty. With this tactic, you can still contribute to your 401(k) to take advantage of the match.

Diversify but simplify. Consider a target-­date fund composed of low-cost index funds or a simple lineup of four funds—a large-cap equity, a small-cap equity, a bond, and an international—offering the lowest expenses compared with comparable portfolios. Target-date funds, sometimes called life-cycle funds, are actually collections, or “funds of funds.” They give diversification and will rebalance, or reallocate, your holdings automatically. Those that invest in low-cost index funds are a good default investment for many people. If the expenses of available target-date funds in your 401(k) are higher than a diversified basket of other options, though, go with the latter.

Avoid too much company stock. If your plan match is in company stock, rebalance regularly to shift those shares to 5 to 10 percent of the total; it’s unwise to depend on the same company for your investment gains and your livelihood.

Up your ante. Most people younger than 40 should have a combined contribution—what’s taken from their pay plus what the employer provides—of at least 10 percent of their income. If you’re older than 40 and behind on your savings goal, put away at least 15 percent. The maximum allowable 401(k) contribution for 2013 is $17,500; for those 50 and older, it’s $23,000.

Even workers without the benefit of time can fatten their bottom line by slightly enriching their investment. A 57-year-old doubling a $3,000 contribution to $6,000 could raise his savings from almost $47,000 to $94,000 in 10 years, given an 8 percent annual growth rate. That’s not enough to sustain anyone for more than a few years, but it’s a start.

Wal-Mart practically owns the word “discount.” But the behemoth retailer, well known for muscling its suppliers to provide goods at the lowest possible cost, apparently didn’t try so hard to rein in costs in its own 401(k) plan, to the detriment of thousands of current and former employees.

In 2012 Wal-Mart and its brokerage, Merrill Lynch, which was trustee and administrator of its 401(k) plan, agreed to pay a $13.5 million settlement in a class-action suit that accused the retailer of breaching its fiduciary duty by failing to negotiate lower fees for the plan’s mutual funds. As a result, excess fees had cost 401(k) participants about $60 million over six years, the suit charged. Plaintiffs also alleged that Wal-Mart should have told participants how they’d be affected by the high fees. They also alleged that Wal-Mart should have divulged that mutual-fund companies in the plan used part of the fees they earned to reward Merrill Lynch for including them in Wal-Mart’s lineup. That common practice is called revenue-sharing. (The suit called the payments “kickbacks.”) In the settlement, neither Wal-Mart nor Merrill admitted any wrongdoing.

Jerome J. Schlichter, a St. Louis lawyer who has brought more than a dozen class actions against large 401(k) plan providers, says any large plan sponsor that isn’t providing reasonable-cost investment options is shirking its fiduciary duty. “If you have a $1 billion company, you should not be paying retail fees,” he says.

Schlichter is at the forefront of a small but growing movement to force large plan sponsors to address revenue-sharing and other hits on participants’ retirement assets.

Those class actions, combined with more-transparent fee disclosures, have begun to have an impact. Sponsors of 401(k) plans are proactively changing, hiring independent fiduciaries to watch over their plans, and choosing more reasonably priced investments such as index funds, says Ary Rosenbaum, a lawyer who advises on compliance with the Employee Retirement Income Security Act (ERISA), the federal law that governs retirement plans. And because of the litigation and fee-disclosure regulations, more ERISA and Department of Labor officials are paying attention to plan sponsors’ actions, Rosenbaum says.

Smaller employers in the dark

Most large employers can employ consultants, lawyers, and other professionals to correct those shortcomings. But small and medium-sized businesses often don’t have those resources. And the evidence shows that they’re often clueless about fees, to workers’ detriment.

Consider, for instance, investment-management fees, or expense ratios. They are usually the largest mutual-fund expense. In a study last year by the Government Accountability Office, half of small and medium-sized employers surveyed about 401(k) expenses didn’t know whether they or their plan participants paid investment-management fees. (The GAO says participants paid.)

Sponsors of more than half of those small and medium-sized plans told the GAO that they hadn’t asked their plan providers about fees for marketing and distribution (called 12b-1 fees), reimbursements to record keepers for certain expenses (sub-TA fees), extra broker commissions, trading and transaction costs, and “wrap” fees, which are associated with annuities. About half of plan sponsors who provided investment reports to GAO researchers didn’t realize their 401(k)s had revenue-sharing arrangements like those in the Wal-Mart 401(k) plan.

How to take control

You don’t have to resort to litigation to improve your 401(k) plan—and your individual account. To change elements in your 401(k) lineup, follow these steps:

•  Find the fiduciary. The plan fiduciary, an individual named in plan documents, is your primary contact for all correspondence. Ask your employee-benefits manager for the correct name. Or search for your company plan online at BrightScope. The fiduciary’s name will be on your plan’s page under the tab for Form 5500 Data. (Form 5500 is a federal disclosure that all retirement plans must file.)
• Collect documents. Find fund expense ratios in the annual disclosure of your funds’ expenses, which your plan must send to you by Aug. 30 (most will arrive by mail). On the report you’ll see an explanation of each fund’s average annual returns over one, five, and 10 years; the comparable returns of a benchmark fund; and average annual operating costs as a percentage of assets and as a dollar figure per $1,000 invested. You also should receive a quarterly fee statement showing additional expenses specific to you, including loan-administration fees.
• Research new funds. “If they don’t have any index funds, that’s your first thing to ask about,” says David Loeper, an investment manager and author of “Stop the Retirement Rip-Off!” (2009, Wiley). Such funds simply mirror the portfolios of broad market indexes such as the Standard & Poor’s 500. Managers don’t need to do a lot of research to pick index portfolios, so costs are low.
• Draw up comparisons. You’ll need to show what makes your choices better than the plan’s current lineup (see “Want Changes in Your 401(k)?” below).
• Write to the fiduciary. Include your research. Mention how the costs affect not only you but also everyone in the company who invests in those plans. “Make it easy for them to see the high fees,” says Stuart Robertson, president of ShareBuilder 401k by Capital One, an investment company that provides 401(k) plans to small and medium-sized businesses.
• Enlist others. Ask co-workers to sign your letter. “If the plan sponsors get one person, it’s one squeaky wheel,” Loeper says. “If they get three, four, five, they start wondering, how many people are worried about this?”

Waging a bigger campaign

Replacing the company that provides the funds and record keeping for your plan takes more work. Here’s how to get started:

• Get more documents. Ask your fiduciary for your plan’s summary plan description and summary annual statement. Ask, too, for the 408(b)(2) plan level disclosure, which shows total plan fees.
• Determine your plan’s expenses. Using your summary annual statement, look under the “basic financial statement” section for “total plan expenses.” From that figure, subtract “amount of benefits paid” to arrive at your plan’s net administrative expenses. Divide that figure by the total value of the plan. The result, a ratio, is the percentage of the plan’s assets that go toward expenses that are above and beyond the investment expenses charged directly against your account and a valuable figure to show to the fiduciary. (Multiply that ratio by your own account value to see how much of your plan’s expenses you’re subsidizing.)
• Call in a professional. You and your colleagues might want to contact an independent financial adviser with no ties to particular investment companies to do more analysis.
• Contact the federal government. If you get nowhere after several months, write a letter specifying your concerns to the Department of Labor’s Employee Benefits Security Administration, which monitors 401(k) plans. The EBSA’s job is to ensure that plan fiduciaries meet all requirements. At dol.gov/ebsa you’ll find links and phone numbers.

Lots of new tools to analyze your 401(k) plan and its fees make it easier than ever to get your employer to pay attention and act. These resources are free, except as noted:

Shop for funds. Plug the name of a fund you’d like to replace into the search box at Morningstar’s website. You’ll get a report identifying the type of fund—small-cap value or large-cap blend, for instance—and a comparison of the fund’s performance to a benchmark. Then search the site for other funds of the same type—or better, just select an index fund. Morningstar’s pay service, which includes more comparison tools, is free for a two-week trial; subscriptions start at $195 per year or $23 per month.

Compare the effects of fees on your savings. With the free Fund Analyzer offered by FINRA, the securities industry’s self-regulatory body, you can plug in the ticker symbol, estimated return, and investment period for three funds at a time; the tool shows you the lowest-cost option. The 401(k) Fee Analyzer at Personal Capital (personalcapital.com) shows you how much you’re paying in fees from your entire account.

Compare your 401(k) plan with others. BrightScope rates 401(k) plans on factors including total cost and generosity of the company match, based on IRS information. It shows how your plan stacks up against plans from similar employers and against all 401(k) plans. (For a more detailed report, you’ll have to pay $100 and get access permission from your fiduciary; contact BrightScope for details.)

Get advice from the trenches. Bogleheads.org, a free website for index-investing fans, has a very helpful forum on how to change your 401(k). The site also features a form letter you can send to your plan sponsor to request changes. You’ll need to register to post a question or comment.

This article appeared in the September 2013 issue of Consumer Reports magazine.

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