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Study: 9 in 10 Americans Underestimate Their Hidden 401(k) Fees

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Monitoring these 401(k) expenses can reduce fee costs.

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What Is a 401(k) and Why Do You Need One?Americans should start saving for retirement as soon as they can, and contributing to a 401(k) is one of the most common ways to begin doing so. A 401(k) is a tax-advantaged retirement account set up through an employer that the government allows you to contribute to while you work, so your savings can grow tax-free. Your investment returns then compound significantly over time, making your initial investment worth far more in several years than if it had been left in a savings account not even beating inflation. Once an employee leaves a job, the money stays with them, and they can roll it into a rollover IRA to maintain its tax-advantaged status.

Once an employee has a 401(k) set up and there is money in the account, he or she must decide how to invest the money. Each 401(k) plan's offerings vary by provider and by company, but typically there will be a choice of index funds, actively managed mutual funds, target-date funds, bond funds, etc. An employee can select one or a mixture of these investment vehicles within the plan.

The State of Retirement Savings Today

The great retirement crunch is coming, and in light of this fact, 401(k) savings – or the lack thereof – can really make a difference to many American families. Many indicators show that Americans simply aren't saving enough for retirement:
  • The Federal Reserve found that the typical household with workers aged 55 to 64 had a combined $120,000 in 401(k) and IRA savings.
However, as the state of our future Social Security system is uncertain, Americans may be increasingly realizing that they need to save more – and sooner. A sign of hope, according to Fidelity, is that the average amount invested by the company's 12 million 401(k) plan participants is $77,300 as of the end of 2012 – setting a record high for the company.

Investor's Guide – How to Minimize Your Overall 401(k) Fees

Families saving for retirement should follow a three-part plan to optimize their 401(k) savings. By first figuring out the full extent of account fees, they can then be minimized to the extent possible.

1. Pick Funds With Low Expense Ratios

While a fund's expense ratio doesn't tell the whole story, studies have shown that the expense ratio is one of the best fund performance indicators. Conveniently, this is also the easiest fee group for the casual investor to control.

The proof is in the pudding: A fund's expense ratio has been shown to be the most reliable indicator of performance over time – a far better indicator than anything else, including Morningstar ratings. An August 2012 Morningstar study concluded lower expense ratio funds did better at predicting mutual fund success than Morningstar's own star rating system. The study went so far as to say, "In every single time period and data point tested, low-cost funds beat high-cost funds."

So what's a good, low expense ratio to look for? The NerdWallet mutual fund database compares over 13,000 funds to find that the average expense ratio paid to a fund is approximately 1.105%. However, don't feel pressured to pay 1% in fees, there's a large selection of mutual funds with expense ratios below 0.5%.

2. Compare and Rank Your 401(k)'s Fund Offerings

While casual investors are often tempted to look solely at a fund's past returns, keep in mind the number one rule in investing: Past performance does not guarantee future results. There are several other metrics that should come into play to determine the best mutual funds for each investor's needs, such as risk adjusted return, relative outperformance, and volatility.

For casual investors less well versed in these figures, NerdWallet's 401(k) screener tool allows investors to compare all the funds offered in your employer's 401(k) plan, so investors can pick the best ones for their portfolio.

3. Identify Hidden Fees – Then Take Action

Whether you're signing up for a new 401(k) plan or you have to dig through old paperwork to find the information on your old plan, it's worth taking the time to read your prospectus and identify all the fees listed – it could pay off big time.

Here are some tips for what to do if you identify excessive fees embedded in your plan:
  • Select index funds with low expense ratios; they are much lower cost on average.
  • Consider saving via other types of retirement accounts such as a Roth IRA, a self directed IRA, or your spouse's retirement account if the fees are more favorable.
  • Not all no-load funds are created equal, so check out the details of yours. Legally, FINRA allows a fund to charge up to 0.25% of its average annual net assets in 12b-1 fees and still call itself a no-load fund.
  • If your menu of 401(k) fund options is full of poorly performing mutual funds from the same family, you may want to find a new plan trustee. Ideally, your 401(k) plan provider isn't affiliated with the mutual funds offered. This is in large part because, as an Indiana University study found, "poorly-performing funds are less likely to be removed from and more likely to be added to a 401(k) menu if they are affiliated with the plan trustee."
  • If the terms and fees of your 401(k) plan provider are bad, consider getting fellow employees together to ask HR for a lower cost provider.
Hundreds of thousands of dollars worth of 401(k) fees are eating away at most Americans' retirement savings without their knowledge. By following these basic steps, many investors can capture much more value from their 401(k) plans and retire more comfortably.
Though not all fees can be avoided, following this process will help investors cut the wasteful fees in order to save more money for retirement.

Editor's note: This story by Susan Lyon originally appeared on NerdWallet.

To read more from NerdWallet, see:

NerdWallet's Dirty Dozen: The Worst Mutual Funds of 2013

Breaking Down Annuities: What They Are and How They Work

Tax-Efficient Investing: Easy Tips to Increase Your Retirement Savings
No positions in stocks mentioned.
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