Ted Benna, the inventor of the 401(k) retirement plan, famously once stated that the system he created should be “blown up.” Why? It’s not the fundamental structure, which he still believes in. What he doesn’t like is the complexity and the costs that characterize today’s typical 401(k). The original 401(k)s, he likes to point out, had just two fund options. Today it’s more like twenty, and because of that, it’s all too easy for bad investments and high fees to sneak their way in. That’s what Benna doesn’t like.
In my work as a financial planner, I often see the innards of different 401(k) plans. While each has its pros and cons, this week I saw a particularly glaring example of what Benna dislikes so much. Below I’ll describe that example, and then I’ll offer five recommendations to help you avoid things like it.
Here’s what I saw: In the retirement plan of one of Boston’s preeminent institutions, the only option for employees to maintain assets in cash is a money market fund that charges 0.37 percent per year. While that may sound like a tiny, fractional number, I’ll try to put it in perspective to illustrate why such seemingly small fees can have such a destructive effect on your wealth.
To assess the fee’s fairness, we want to ask, “What portion of the fund’s profits did the fund managers take for themselves, and how much did they leave for investors?” Here’s how we calculate this: After fees, this fund’s return last year was 0.67 percent. If we add back the fee of 0.37, we can calculate that the fund gained 1.04 percent before fees (0.67 + 0.37). That was the total amount of profit that was available to split between the fund manager and the fund’s shareholders. So, let’s look at how they chose to split it. The fund manager took 0.37 out of that 1.04. As a percentage of the total profits, that translates to 36 percent(37/104). That’s right — the fund manager took 36 percent of the profits for himself. That’s a galling figure, the kind of thing you’d expect to see in a hedge fund, not in a simple money market fund and certainly not in a retirement account.
It gets worse. When I pointed out this fee imbalance, the employee contacted the firm that runs the fund. Their response: That fee, they said, is “relatively normal.” This I found particularly surprising. Instead of acknowledging that the fund isn’t a great deal, they tried to explain it away as normal. Or relatively normal. I suppose if you’re riding in a clown car, it’s relatively normal for the guy next to you to be acting like a clown. But that’s certainly not who you want safeguarding your retirement savings.
So, how can you protect yourself from things like this? Here are five ideas, and please feel free to call me any time if you’d like me to review your specific plan:
1. The first step is to eliminate from consideration all non-index funds. Yes, some actively-managed mutual funds can outperform, but it’s just a minority. So, always start by stacking the odds in your favor.
2. Find out what each fund costs. This is important because, as the example here illustrates, fund costs can vary widely. It’s not enough for a fund just to be an index fund; it has to be an appropriately priced index fund. Oftentimes the cost information (called “expense ratios”) is listed only in supplemental documents, but your HR department can provide them for you.
3. Get the actual ticker symbol for each fund you are considering. This is important because many funds have similar sounding names. The ticker symbols, however, are unique, allowing you to research funds using objective, third-party resources like Morningstar, which is a free, online database of mutual fund information and commentary.
4. Be cautious of target-date funds. While these are a great idea in concept, fund companies also know how much consumers like them and, as a result, I often find them loaded up with fees. You can often achieve the same objectives as a target-date fund, but at much lower cost, by combining two separate, simpler funds.
5. Don’t settle. In many cases, a 401(k) menu will offer a handful of good, low-cost funds, but not enough to create an ideal portfolio. That’s OK. Just buy what you can within your 401(k) and then compensate with supplemental purchases in another account outside your 401(k).