In 401(k)s, the Problem Is Fees, Not Complexity

It’s a recurring theme among financial advisors and the personal finance media: 401(k) savers have too many choices. They are overwhelmed.

Admittedly, most normal people are not plugged into the arcana of retirement investing. They don’t know a value fund from a money market, an ETF from a traditional mutual fund.

Bonds funds are plain mysterious, and stock funds are sold on misleading three- and five-year returns.

So the plans try to “simplify” by limiting choices. Often, you can buy just 10 to 12 types of investments, ranging from cash-like stable value funds to bonds and a collection stock funds.

So far, so good. But here’s where the problems really begin.

Yes, retirement savers get a pretty nice carrot to incentivize saving in the form of tax deferral and company matches. But they also get a huge stick alongside it: punitively high fees.

The Wall Street Journal reviewed comparative data and came up with the best characteristics of a well-run, affordable 401(k) plan.

Total expenses, they concluded, should come to less than 1% and hopefully no more than 0.75%. Target-date funds, the kind that automatically change to lower-risk investments as a worker gets older, should cost less than 0.6%.

The newspaper gave a “red light” rating to plans that charge more than 2%, which is often the case with small-company plans.

Comparatively, BrightScope, a firm which rates 401(k) plans, figures 0.5% is the cost investors should aim to pay. That’s four times less!

Nevertheless, some plans charge even more — up to 3% — but break the fees up to reduce the “sticker shock” effect, 0.77% for a stock fund then another 1% for plan management, plus various pass-through fees for commissions and the like. Like signing a mortgage closing, the checklist of small-seeming 401(k) charges adds up fast.

The Labor Department this past year enacted new rules requiring 401(k) plan administrators to bring fees into the light for retirement investors.

Meanwhile, the big consumer brokerages have made moves to cut the costs of their exchange-traded fund (ETF) offerings. Many trade commission-free and fund management fees have been falling for months, across the board.

This should be the solution that 401(k) savers need, but we’re not there yet. The 401(k) administrators need to offer inexpensive ETFs inside their plans, and savers need to get smart about using them correctly to build appropriate portfolios.

Alternatively, target-date funds should begin to rely more heavily on ETFs and index funds to build their models. That should bring the cost of using such automated funds down to reasonable levels in short order.

It can’t happen fast enough for savers, who will need every penny working for them in order to retire on time.