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Smart Money Magazine
June 21, 2010
Nicole Bullock and AnnaMaria Andriotis
10 Things 401(k)
Providers Won't Tell You
1. “We’re making
money on your 401(k) — even if you’re not.”
With a growing awareness of the importance of preparing for
retirement, the number of 401(k) investors has soared in recent years,
peaking at 60.6 million in 2007, according to Cerulli Associates, an
asset management research firm. But that torrid growth also left
millions of investors in the lurch when the market crashed in 2008 and
the value of their plans sank, in some cases dramatically. In fact,
following the market downturn, the number of 401(k) investors dropped,
settling at an estimated 50.5 million this year.
Regardless of a 401(k)’s performance, most providers still get
a cut of the expense ratio on the funds. In this practice, known as
revenue sharing, there can be money left over after certain costs
— for recordkeeping, administration and marketing — are
covered. In most cases, this excess revenue stays with the plan
providers and at times is used to market their investments to other
companies rather than going back into investors’ 401(k) plans,
says Matt Gnabasik, managing director at Blue Prairie Group, an
institutional retirement and investment consulting firm.
2. “You may not have
full disclosure about where all your money is going.”
By the end of 2009, 401(k) plans, IRAs and pension plans had more
than $15 trillion in assets under management, says Yannis Koumantaros,
principal and director at Spectrum Pension Consultants. With most of
these plans charging participants fees, a lot of money is at stake.
It’s often difficult for an investor to know the exact fee
breakdown of their 401(k) plan. That could soon change. In May, the
House passed the American Jobs and Closing Tax Loopholes Act, which could
provide additional fee disclosure to participants in
defined-contribution plans, including administration and recordkeeping
fees and investment management fees.
“Plan costs will continue to become more transparent,”
says Gnabasik. And, “anytime you have more transparency, it tends
to lower fees.” Up until five years ago, “record keepers
rarely divulged their cost structure to the plan sponsors; they now,
for the most part – especially with larger
plans – tell the plan sponsor how much they need to
make in order to pay for day-to-day administrative costs.”
Still, even if an investor knows the fee breakdown of his or her
401(k) plan, it can be very difficult to know what portion of that is
left over as excess revenue. “Nobody is saying that people
shouldn’t be paid; all we’re saying is they should be paid
fairly and consumers should know what they’re paying for,”
says Koumantaros. Also, consumers should keep in mind that you
can’t tell how much revenue is shared simply by looking at the
expense ratio of a mutual fund .
3. “You’re buying
wholesale, but we’re charging you retail.”
When it comes to your 401(k) plan, you shouldn’t be paying the
same fees for a fund that you would if, say, you bought it on your own.
But you might be. Asset managers sell mutual funds in different share
classes, each of which has a different fee structure. From the most
expensive to the cheapest class of funds, the range can be as much as a
full percentage point, says Koumantaros. That works out to an extra
$1,200 a month in retirement for a 30-year-old with $50,000 in his plan
and contributions of $3,000 annually. “You’re talking about
a difference in your quality of life at retirement,” Koumantaros
says. The cheapest investment options with 401(k) plans are often index
funds, since they’re not actively managed, he says.
The plans with the highest fees are usually those with the fewest
investors. Small plans are expensive to run, so they often have to
accept costlier fund classes. But your employer can renegotiate cheaper
options as the plan expands.
4. "Our 'target-date
funds' may miss the target."
Target-date funds came under immense scrutiny for
their performance during the market downturn in 2008. These funds have
an asset allocation that becomes more conservative as the investor
nears retirement, and they're supposed to address the worst mistakes
401(k) investors make: investing too conservatively, too aggressively,
or not rebalancing. But many had investors close to retirement with too
much exposure to risk and few conservative investments to help balance
out their 401(k) losses.
The fund companies say some target-date funds are designed to carry
an investor to retirement while others carry investors through
retirement. They say many glide down following age 65 but typically not
past age 80. They're designed "for employees who don't have the
time, interest or knowledge to make informed decisions about their
401(k) plan," says Pam Hess, director of retirement research at
Hewitt Associates. But that doesn't mean investors shouldn't completely
ignore their 401(k); instead check up on its performance periodically
and ask if there are other target-date fund options that may be better
suited to your needs.
5. “We offer tons of
investment options. Too many, in fact . . .”
When it comes to picking funds for your 401(k), plans that offer
more choices aren’t necessarily better. On average, 401(k)
investors are given 18 fund options, a number that is likely to drop to
17 soon, according to the Profit Sharing/401(k) Council of America. But
even 17 can be too many. More choices can lead to participant paralysis
or intimidation, says David Wray, president of the council. In some
cases, there can be a link between choice overload and poor investment
decisions, which can lead to an undiversified allocation that may be
cash- or bond-heavy reducing the eventual accumulated balance at
retirement.
There aren’t necessarily a specific number of fund options
that can derail plan participants, says Emir Kamenica, assistant
professor of economics at the University of Chicago Graduate School of
Business. Ideally, a plan should offer a handful of core funds
including a money market, bond index, domestic equity index, and
international equity index, with extra choices for those who want them.
This can be especially helpful for sophisticated investors who can
differentiate between, say, a large-cap value and growth fund, on their
own. “Nobody will be worse off by allowing investors who are more
sophisticated to select from a wider range of options,” Kamenica
says.
6. “. . . but you
still might not be diversified enough.”
The two most popular holdings in 401(k)s are premixed portfolios and
stable-value funds, says Hess. But neither may be appropriate.
“Investing a significant portion of one’s savings in stable
value funds is not appropriate for investors with a long time
horizon,” she says. Stable-value funds protect your savings but,
by design, don’t take enough risk to create as much return as
bond or stock funds. Young workers in particular should not have big
chunks of their 401(k)s in them.
As for company stock, many planners will tell you not to put any of
your retirement money there. Your company pays your salary and provides
health benefits, so you already have enough exposure there. Plus, you
shouldn’t have the bulk of your portfolio in one stock. If a
large portion of your 401(k) match is in company stock, consider
selling it; in general, company stock shouldn’t comprise more
than 10% of your portfolio. A target-date fund or mix of large- and
small-cap equity, international investments, and fixed income is a
wiser way to go, Hess says.
7. “If you quit your
job, you’ll have to pay to keep your 401(k) here.”
A Hewitt study shows that 29% of people who left their jobs left
their 401(k)s with their old companies. That may seem easier than
hassling human resources for the paperwork involved in transferring a
401(k) to an IRA, but you’ll end up paying for it. Some employers
foot an upfront fee for costs associated with running your plan while
you work for them, but an increasing number are pulling the plug once
you’re off the payroll, says Sean Waters, co-founder of Cook
Street Consulting, an investment consulting firm. This may or may not
be obvious to employees. “It’s not like you get an invoice
saying, ‘Hey, you owe me $40 a year now,’” Waters
says. It makes a case for consolidating your various 401(k)s, because
that cost will only increase for those who have multiple plans.
“It generally doesn’t make sense to have 401(k) accounts
all over the [place],” Waters says.
What if you love your new job, but hate the shoddy funds offered for
your 401(k)? Employees should ask their new company to improve their
401(k) lineup. “Many don’t pay attention to it despite the
enormous fiduciary (or personal) liability associated with offering a
plan, and with a little help they can improve it markedly,” says
Waters. (This, of course, is no easy feat and at a minimum will require
similar requests for many co-workers.) Another option is to leave your
old 401(k) account where it is if possible. Or consider an IRA
rollover, which means a separate account with an extra set of fees but
also the flexibility to pick the investments you want.
8. “You may ’d
be better off in a Roth 401(k) — but your plan probably
doesn’t offer it.”
In a traditional 401(k), taxes on your investments are deferred
until you begin withdrawing your money in retirement. With the
increasingly popular Roth 401(k), however, you pay the taxes upfront
and then make withdrawals tax free. The Roth isn’t for everyone,
but it can be more favorable to individuals who make less money now
than when they retire since they’ll be taxed less now. But, fewer
than three in ten company plans, or 29%, offer it, according to Hewitt.
Since Roth 401(k)s first appeared in 2006, the primary obstacle to
their rollout has been the fact that they were supposed to disappear
after 2010. Now, they’re permanent — but retirement plans
have yet to catch up. Companies cite reasons, like lack of evidence of
significant employee usage and administrative complexity, for not
offering Roth 401(k)s out of the gate, according to a Hewitt study.
9. “You want to see
some outrageous fees? Try a variable annuity 401(k).”
Small businesses that have 401(k) plans often offer them packaged as
annuities. This is also common with 403(b)s, which are geared to
teachers, professors, and employees of nonprofit organizations. These
plans can be more expensive than traditional 401(k)s. That’s
because the insurance company that sells the annuity adds a mortality
and expense fee for the cost of the insurance, which could range from
1% to 3%, depending on the insurance benefits that the participant
selects. In return, plan participants can get additional protection
such as guaranteed withdrawal benefits – which allow participants
to withdraw money even if their balance is zero dollars, says Karen
Alvarado, vice president of regulatory affairs and compliance at the
Insured Retirement Institute, an annuities trade group. However, this
fee is on top of the expense ratio you pay for each subaccount (e.g., a
bond fund, mutual fund) in the annuity.
Insurance companies have the clout to haggle successfully with asset
managers for lower expense ratios on the underlying funds, but the
combined total of the expense ratio and the insurance fee could still
be higher than the cost of other plans. Investors should take a close
look at the fees, which are explained in the prospectus.
10. “Your nest egg
could be a whole lot bigger.”
In many ways, 401(k) plans are getting better. As lawmakers and
regulators continue to scrutinize fees, some providers are offering
participants access to a more attractive suite of investments and
refunding money to plans when expenses exceed costs and a set profit.
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"But
it’s still hard for 401(k) investors to grasp how a small
difference in expenses can make a big one for their retirement.
“We are typically able to reduce total plan expenses by 20% to
40% and at the same time dramatically enhance plan services,”
says Brent Glading, managing partner at the Glading Group, who used
to sell 401(k) plans for Merrill Lynch and Dreyfus but now negotiates
better plans for company clients. That doesn’t sound like much,
but it can translate into $100,000 per employee over 20 to 30 years.
He says some plan sponsors think that by reducing a service
provider’s revenue, they’ll have to protect their profit
margins by delivering fewer services. “This is clearly not the
case,” he says. “In every situation we have ever been
involved in, if properly negotiated, a service provider will always
throw in more services to make their offer that much more
compelling.”
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