The Hidden Fees in 401(k)s

Even if you've so far managed to avoid sitting through a company benefits meeting, you’re probably at least vaguely familiar with the concept of a 401(k). Even those workers with the most cursory grasp of investing have heard the term, and have a general understanding that a 401(k) is a savings vehicle that's supposed to take care of you in your retirement years.

More formally, a 401(k) is a defined contribution plan, which means that payments into it are fixed and not arbitrary. You put in $x per paycheck, your employer may match some percentage of that amount – and years later you're enjoying some degree of financial independence instead of begging for meals.

It warrants repeating that you should accept that employer match-up to the maximum allowed. Otherwise, you're rejecting free money.

Unfortunately, investor naiveté is such that millions of people never stop to ask how much the 401(k) provider – the mutual fund company that devises the baskets of holdings into which your money goes – is making off the cash you give them to invest. Their services aren't free; your 401(k) company collects a fee every month. The cumulative size of those fees can shape your eventual returns.

Thanks to a 2012 mandate of the U.S. Department of Labor, your 401(k) provider is now required to disclose all its fees in the prospectus statement that it sends you every year. So fees are no longer hard to locate, and it pays to pay attention to them.

The most firmly entrenched of these fees even have a name or at any rate a sequence of letters and numerals: 12b-1 fees are named after the relevant section of the Investment Company Act of 1940, which was enacted decades before such investments had been popularized and democratized to the extent that they are today. Generally filed under "marketing fees," 12b-1 fees are ostensibly earmarked for the intermediaries who sell the specific 401(k) plans to your employer. These fees, capped by the Act at 1% of assets, constitute a commission, which is to say an expense (as distinguished from an investment in the fund's possible returns.)

Note that 12b-1 fees are separate from investment management fees, which are the cut the 401(k) company takes for itself. For instance, Fidelity Investments is America's biggest provider of 401(k)s. A typical advisory fee for a Fidelity portfolio account starts at 1.7% and decreases from there, by as much as half, depending on how much you put in. So there's a surefire way to avoid at least some fees: have a large balance.

There are essentially four major categories of fees. To illustrate the point, here's a sample account summary, not from a 401(k) provider, but rather from a third-party firm that administers plans and keeps records. If your company happens to do business with this third-party firm, you'd see this table (or a prorated equivalent) in your quarterly statement:

That is on a contribution of $3207.70. Curiously, that's 1.4% to the penny, which makes it seem as though the expenses are retrofitted to the ratio.

Is it reasonable that only 98.6% of your contributions find their way into the designated investments? That's not a rhetorical question.

Despite the complaints about "hidden fees," fees aren't "hidden" so much as they're judiciously disclosed – thanks to that Labor Department rule. And the unavoidable mathematical fact is that expense ratios exist in a narrow band. In one survey, expense ratios for equity funds ranged from 1.55% to 0.5%. Doing a rough calculation on a mutual fund calculator using these two numbers, the fund with the lower fee would earn 11% more over 10 years and 37% more if held for 30 years. Finding a 401(k) fund with a lower fee could save you money.

Fees, regardless of how conspicuously they're disclosed, should be but one criterion you pick for your 401(k) investments. Each fund is different and the most important factor in how much you make is its overall return. Look at asset class, management's relative competence and track record first. Each of them will have a far greater impact on your long-term returns than fees. And don't forget to factor in whether you are more comfortable with an index fund or an actively managed fund.