The 401(k) account came into being quietly, as a clause in the Revenue Act of 1978. The clause said employees could choose to defer some compensation until retirement, and they would not be taxed until that time. In 1981, the IRS clarified that 401(k) plan participants could defer regular wages, not just bonuses, and the plans began to proliferate. By 1985, there were 30,000 401(k) plans in existence, and 10 years later that figure topped 200,000. As of 2013, there were 638,000 plans in place with 89 million participants, according to the Investment Company Institute. And assets in defined contribution plans totaled $6.6 trillion as of the third quarter of 2014, $4.5 trillion of which was held in 401(k) plans.
The 401(k) plan was never meant to be a mainstream pension plan and is a poor substitute for one. It's a voluntary program that was intended to supplement retirement savings -- one of those quirky little options in the byzantine tax code that employers seized upon as a way to save money while pretending that they were doing the right thing by their employees.
Your 401(k) may be your biggest retirement asset. When it comes to fees, contribution matches, and eligibility, don't just trust: verify.
There are several common 401(k) administrative issues that can creep in unnoticed and chip away at your retirement savings. Losing a portion of your retirement savings is certainly scary, but often avoidable. Read on for common issues, and tips to avoid each of them.
1. Rampant Fees
Although you may think you are only paying the underlying expenses of your mutual fund or ETF selections, that may not be the case. It is very common for plan sponsors to charge recordkeeping administration fees to the plan, which means you (the participant) are paying the fees with your 401(k), resulting in a lower investment return. In fact, some service providers charge an additional asset-based fee (or annuity fee) on top of the underlying mutual fund expense. In general, if your plan sponsor is charging fees to the plan (meaning you), the smaller the asset base in the plan, the more fees you are paying. So, if you work for a company where few employees are participating in the 401(k) plan, be especially watchful about fees.
If you are in a 401(k) where fees are charged to the plan, it’s important to keep an eye on how and when those fees are charged. Watching the consistency of the amount and the timing is important to ensure you are not paying a higher percentage of fees compared with the other plan participants. If your recordkeeping service provider or plan sponsor failed to charge fees to the plan or trust on a consistent basis, participants who cashed out of the plan during that time may not have paid their fair share of the fees.
For the sake of simplicity, employers can offer funds that charge less than 0.10 percent annually. These are available in off-the-shelf mutual or exchange-traded funds. But far too many plans charge employees "retail" rates of 1 percent or more annually. Why such a disparity? Because employers can pass along the costs and there are no minimum standards for a 401(k) other than it be "prudently" managed. Even more criminal are small-company plans set up by insurance companies, which charge more than 2 percent annually.
Several attempts at legislation have been floated to offer universal, low-cost options similar to the program offered to federal employees, but it always gets shot down by employer and financial service lobbies.
If you think this happened to you, the plan sponsor or the recordkeeping service provider should determine the fees that the participants should have paid if processed on a timely basis (usually monthly or quarterly) and make sure your account is credited for those amounts.
Another area to review if your plan charges administrative fees is how the fees are charged to you. It can be by asset balance, a per-participant fee (where every participant pays the same fee each quarter) or a combination of both. If you have a large asset balance compared with most of the participants and the administrative fees are charged based on your asset balance, you will be paying higher fees than most of the plan participants. Plan participants do have some influence over the decision-makers in the plan, so if you see something that seems unfair, speak up.
We have heard stories about companies that are terminating their plans is a way such that the owner takes their money first and the outstanding fees are charged to the rest of the participants. At least in this case, if the plan is audited they will be caught—as they were not acting properly as a fiduciary.
All 401(k) plans must deliver an annual fee disclosure to participants, but the easiest way to review any fees charged to your account is by checking your quarterly participant statement, which is required to detail all fees charged to your account.
New Department of Labor regulations went into effect requiring plan providers to disclose the amount of fees that both companies and their workers pay for their 401(k) plans. The intention was to shed light on notoriously murky 401(k) fees. It’s one of the few instances where the consumer of the product—both employers and employees alike — often have little idea what they’re paying for, thanks to buried fees. For example, a fund’s “expense ratio” can encompass everything from marketing fees paid to the investment firm to commissions paid to the broker who recommends particular funds.
Some statements “disclosed” a wide range of fees, as in “your expenses range from 0.25% to 2%,” leaving companies wondering where exactly their fees stood. What’s more, the fees came without any guideposts on industry averages. So even if a company was told it paid, say, 1.25%, executives would have no idea how those fees stacked up against other plans. This is no accident, critics charge.
2. Fewer choices does not mean better ones.
Just as drug stores have pruned their shampoo offerings to prevent shoppers from getting overwhelmed, plan providers have recently reduced the number of fund options in 401(k) plans. The number of large employers that offer 20 or more funds declined by 8% from 2010 to 2012, and the number of sponsors that offer nine options or fewer increased by 3%.
But the choices that remain are still too expensive overall, consumer advocates agree. The average plan has approximately 60% of assets in stocks, according to the Plan Sponsor Council of America. Twenty-five percent of assets are invested in actively managed U.S. stock funds and just 9% are in indexed U.S. stock funds. Actively managed funds, where a fund manager picks stocks in an attempt to beat the market, are more expensive than passive index funds that aim only to mimic market returns.
Brokers who advise companies on plans often don’t have an incentive to choose the lowest-cost option, since they get compensated through commissions paid out by investment firms for pricier share classes. Companies often don’t realize this and think their broker’s advice is “free,” since the compensation fee is bundled into the expense ratio, even under the new DOL fee disclosures.