Today, I ‘d like to talk about 401(k) fees. Some time back, I saw an interview with John Bogle and read the transcript regarding the high expenses within 401(k) accounts. When this came up in a financial news group, I was told that the data was old, that the fees had come down from the levels John suggested.
In Forbes’ 2007 investment guide was an article titled “Retirement Ripoff” which discusses the same issue, high fees that negate the value of investing in a 401(k) vs a post tax account.
A Business week article which quoted HR Investment Consultants of Baltimore’s “401k Averages Book” said that for plans of 5,000 participants, the average cost was 1.12% (and it went up from there, to 1.4% for 50 participants). If 1.12% is the average, there are certainly some plans charging more and some less.
My next question was this: “How much higher must the fees be (on the 401(k) vs post tax account) to negate the tax savings of the 401(k) and therefore advise a client to put her money in either an IRA or post tax account?” Simple question, and after spending some time with Excel, found the answer to be 0.79-0.86% as the range for concern. To try to avoid any bias, I first assume that money is going in to the 401(k) and coming out in the same tax bracket. Of course, an individual’s situation will vary, some extreme savers will find they have saved themselves into a higher tax rate. I also chose to look at a 20 year period since this is a reasonable time horizon for this exercise. For the post tax account, I assume 15% rate on dividends and on capital gains upon the sale of the assets. Using a growth rate of 10%/yr, I find that 0.86% in higher fees within the 401(k) is enough to make the post tax account have the same final value. If we assume a lower growth rate of 8%, the break even is 0.79%.
If your employer provides any matching, then you should still contribute enough to capture that match even with the high fees. If there is no match, look at the fees very carefully. Keep in mind there are many good index funds which offer a low 0.10% – 0.20% expense ratio. If your 401(k) annual expenses are 1% or higher, consider instead an ordinary taxable account holding index funds.
History has shown that tax rates for earned income, dividends, and capital gains have changed, and are likely to change again before you retire. Diversifying among pre-tax and post tax accounts can help you avoid the tax trap of over loading the wrong type of account.