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401(k) Fees Can Drastically Reduce Nest Egg

A recent report conducted by Demos -- a New York City-based public policy organization -- points out that the high fees charged by 401(k)'s can cut nest eggs by 30% for median-income two-wage family.

Company-sponsored 401(k) plans often include a list of mutual funds in which employees can invest. Although these fees are disclosed on the individual fund prospectuses, the account statements from 401(k)'s generally do not include such fees (only the result of the fund performance net of fees). The report enumerates the many fees mutual funds can levy, including: administrative fees, asset management fees, marketing fees (12b-1 fees) and trading fees.

Trading fees are the result of commissions paid to brokers when transacting fund assets as well as the bid-ask spreads surrounding the market prices of the fund assets: funds must sell (buy) at a price lower (higher) than the market price. Generally speaking, the more illiquid the fund assets, the larger the bid-ask spread.

It has been pointed out in the literature that Exchange Traded Products (ETPs) such as ETFs and ETNs offer 401(k)'s more bang for their buck. In a November 2009 working paper from the Center for Retirement Research at Boston College, Kopcke, Vitagliano and Karamcheva note that

[b]y shifting investment options from managed mutual funds to exchange-traded funds (ETFs) or commingled trusts, 401(k) plans can align the fees they pay more closely with the expense of the services they use. This realignment can allow an average plan to reduce its administration and management fees between 0.20 and 0.40 percent of assets. In addition, the shift to ETFs and commingled trusts that hold ETFs can reduce average trading costs 0.50 percent of assets or more for participants holding managed equity mutual funds.

It remains to be seen whether 401(k) plans will replace mutual funds with ETFs, or what other potential problems might arise from that change. However, this issue highlights the fact that fund expenses are one of the most overlooked aspects of index investing. Investors with long time horizons should strongly consider minimizing those fees by choosing low-cost index funds, and ETFs may be able to offer better rates than currently available mutual funds.

Hat tip to Alex Ulam over at IndexUniverse for drawing our attention to the report.