In Costs Matter If You Want to Maximize Investment Returns, I detailed what a big impact costs can have on your total investment return. Well, it sounds as if Congress has just found out this startling fact and is holding meetings on the issue. That ought to lock it away for 5-10 years before anyone does anything with it.
Seriously though, high fees are taking a big chunk of 401k returns. A few details:
The fees may seem small, a percentage point or two, but with $3 trillion now held in U.S. defined-benefit plans such as 401(k)s the total amount of money at stake is huge. Plus, over time, those fees add up for individuals: A one-percentage-point hike in fees can reduce retirement benefits by 17% at the end of 20 years, according to testimony at a hearing of the House Education and Labor Committee.
Barbara Bovbjerg, director of education, work force, and income security issues at the GAO, said an employee with 20 years until retirement who leaves $20,000 in a 401(k) will end up with $70,500 if the average annual net return is 6.5%. That same retiree's 401(k) will grow to only $58,400 if fees are one percentage point greater.
To compensate for the investment income lost to fees, employees would need to postpone retirement for up to three years, according to a statement from the Center for American Progress.
A few thoughts here:
1. 401k's are notoriously difficult for determining the true fees. I have yet to have an HR person in any company I've worked for adequately describe to me what all the fees are associated with a 401k.
2. That said, a 401k is still a great investment option. It's hard to beat a 50% to 100% return on your money (which is what you get if your employer matches all or part of your contribution.)
3. Yes, "even" a "small" 1% can make a HUGE difference in your total investment return over years or decades. Want an example? See $10k Challenge: Maximize Your Investments.
4. Postpone retirement for three years due to high fees? Yikes!!!!!
The premise may be correct, but when the article says "...defined-benefit plans such as 401(k)s..." they are mistaken. A 401(k) is a defined contribution plan, not defined benefit. To clarify the difference, annuities, social security and pensions are defined benefit and you get a prescribed pay out each month with possible survivorship rights to a spouse or heir. A defined contribution plan has rules on when to withdraw but the amount of funds available depends on the amount contributed and market conditions over the duration of the account.
Posted by: Duane Gran | March 15, 2007 at 08:13 AM
FMF, I've been struggling with this concept myself lately. I'm reading a book by John Bogle - Common Sense on Mutual Funds. Its a good read and what I've gotten out of it is that costs can severely handicap your returns. Over the long haul 30+ years, it is staggering. Since I am only in my late twenties and could easily see myself living to 80, I think that this long term view is essential.
My question: If I have money in a managed fund with a 12% annual return and expenses of about 2%, is that any better or worse than an index fund that has an annual return of about 10% and expenses of 0.01%. Taking the 'load' out of the picture (assume the money is already parked in the managed fund), does it make sense to move money to the new fund? What about new contributions? Perhaps make those to an index fund?
Understanding indexing and the effects of cost is great, but it really doesn't clarify what the best next step is in this situation. I'm interested to hear your thoughts. thanks, Easy Change
Posted by: EasyChange | March 15, 2007 at 09:14 AM
I read something in one of the personal finance magazines recently that gave a similar question. The magazine said that basically you couldn't count on the higher return (12% in your case) in every year though the higher cost would be there every year. As such, their opinion was that the lower return with the lower expense ratio was the best earner in the long term.
I would agree with them.
I'm not sure what you mean about the money being parked in the fund already. If the 2% is an actual annual expense, you'll have it even if it is parked. If it's a one-time sales load, that's a different story.
I'm a big index fund fan so I'll always lean that way. You should look at all the costs and expected returns, see what you feel comfortable with, and move your money as needed. That said, I would think future contributions put into an index fund would certainly be a decent move.
Posted by: FMF | March 15, 2007 at 09:31 AM
1- Excellent point from Duane. Remember to compare apples to apples.
2- EasyChange: There are many fund-fee-calculators out on the web with which you can plug in your actual numbers. I used 30 years & $10k with your numbers in a calculator at www.sec.gov to find that the 10% fund had a 6% higher return. But FMF's note about guaranteed return vs guaranteed fees is right on the money, so to speak.
3- As for the article, I think it's highly inflammatory to throw out a statement like "postpone retirement for up to three years" when they know full well that individual circumstances can account for big differences. I'm not remotely in favor of excessive fees, but I think there are too many other variables in the equation to justify that claim.
Posted by: tinyhands | March 15, 2007 at 11:55 AM