Laura Rowley Money & Happiness

Members of Congress, the Department of Labor, and financial experts say some companies that manage 401(k) plans are siphoning off billions in excessive fees. Because the fees are extracted before investment returns are reported, buried in "bundled services," or not disclosed at all, employers may not even be aware of the true costs of their plans, experts say.

The average fee charged to manage a plan is 1 percent of plan assets, and can run as high as 2.25 percent, according to the Government Accountability Office (GAO). But Matthew Hutcheson, an independent fiduciary who testified at Senate hearings last March, says he's seen plans with costs of more than 5 percent annually. Yet the companies that sponsored the plans thought they were paying less than 1 percent.

Nest-Egg Robbery

How do excessive fees hurt the estimated 60 million workers who currently have more than $3 trillion in defined contribution plans? Over 30 years, an extra 1 percent in fees can devour 20 percent of an individual's nest egg.

Here's an example from a recent Congressional Research Office report: A single person earning the median income saves 6 percent of his earnings over 30 years, investing two-thirds of his account in equities and the rest in fixed-income. If annual plan expenses were 0.8 percent of plan assets, the worker would end up with $176,639. Raise the cost to 2 percent, and the employee would accumulate just $138,344 -- or 21.6 percent less.

"If someone is on track to make $1,000 a month in retirement, that extra 1 percent means they'll end up with $800," says Hutcheson. "That $200 is very meaningful to somebody who needs food or medicine." The toll is worse on participants who aren't properly diversified -- for example, those who leave funds in low-interest money market accounts.

Legislating 'Financial Fast Food'

Most plan participants are clueless about plan fees. When asked in a 2007 survey about the costs of their 401(k) plan, 65 percent of Americans responded that they don't pay fees at all. Of those who knew they paid something, 83 percent had no idea how much.

Senators Tom Harkin (D-Iowa) and Herb Kohl (D-Wis.) introduced legislation last month that would require complete disclosure of 401(k) fees to plan participants. A similar bill was introduced in the House by Rep. George Miller (D-Calif.). And the Labor Department has proposed new regulations that require more fee transparency.

In a letter to the Department of Labor, Fidelity Investments, the nation's largest plan sponsor, says ample information is available on fees, and additional disclosure will confuse workers and deter participation: "The complexity of the choices presented to participants when deciding to participate in a 401(k) plan already represents a barrier to enrollment. Overwhelming participants with even more information could discourage participation further."

Hutcheson disagrees, arguing that the core of the problem is a profit-oriented industry that creates unnecessary and costly services and sells them to plan sponsors as valuable. "One of the hallmarks of the current 401(k) industry is to give people a perception of disclosure," he says. "They swamp people with colorful brochures, and bells and whistles that get everyone's attention, but have nothing to do with providing a secure retirement. It's financial fast food -- it looks good, but there's not a whole lot of substance."

Where the Money Goes

Investment fees, which cover all costs related to operating the mutual funds and other investment options offered in a 401(k), comprise the largest fees. These are typically deducted from the investment returns of the funds you choose as a fixed percentage of assets.

At the plan level, plan administrators charge fees for record-keeping, trustees, audits, legal and investment consulting, communication with participants, monitoring services to prevent misuse of employee funds, and sales fees, including advertising expenses and sales commissions.

Then there are a variety of hidden fees, critics charge. For example, plan administrators may receive compensation from mutual funds for recommending their plans to a plan sponsor, which may lead to higher costs for participants.

Even worse, says Hutcheson, are potential conflicts of interest: "A plan sponsor can go into a bank and say, 'We need a $3 million operating line of credit to survive this year.' The bank says, 'Your financial statements don't look good, but you have $10 million in your 401(k). If you give us that [to manage], we'll give you the loan and shave a half-point off the interest rate.'" Meanwhile, the bank's plan may be loaded with fees.

The Law Steps In

Attorneys are smelling blood in the water, filing class-action lawsuits against the directors of major corporations for breach of fiduciary duty. Last year, suits were filed against a number of large companies, including Northrop Grumman, Lockheed Martin, General Dynamics, United Technologies, Bechtel Group, Caterpillar, Exelon, and International Paper.

While the lawyers chase Fortune 500 firms, it's companies with 100 employees or fewer in their plans that get hit the hardest, because they lack economies of scale. "The smaller the plan is, the more apt they are to be paying higher fees and possibly egregious fees," says Rick Meigs, president of the informational web site 401khelpcenter.com. "They usually aren't as well-serviced because of the asset base."

Hutcheson estimates that companies with just over 100 employees pay an average of 3 percent in fees. In introducing his legislation, Harkin spoke of a constituent in a small plan who realized her 401(k) account was earning nothing after fees were paid.

Protecting Yourself

Meigs says part of the problem is that small company sponsors typically don't have the adequate resources to research, choose, and monitor the plans. "You may have a small machine-shop owner who will spend two hours a year looking at the plan," he explains. "Also, there are a limited number of places you can go. Usually insurance companies are highly active in that marketplace, and tend to have lot higher fees because of kinds of products they are offering."

Hutcheson suggests that employees ask their plan administrators or employers what the real economic cost of their 401(k) account is, the risk-and-return profile, and how participants can improve it. "The law requires the participant to know if the return is sufficient to justify the cost," says Hutcheson. Here's a list of fees to inquire about.

If you discover your plan is expensive, don't bail out if you're getting an employer match, experts say. Contribute enough to the plan to get the match, and route additional dollars into an individual retirement account (IRA), either Roth or traditional. (The IRS allows contributions of up to $4,000 in 2007 and $5,000 in 2008; for people 50 and older, it's $5,000 and $6,000, respectively.)

You won't be able to deduct a Roth contribution from your gross income, but it will grow tax-free and can be withdrawn tax-free in retirement. If you choose a traditional IRA, the ability to deduct contributions phases out when you're also covered by an employer plan. See "Limit If Covered by Employer Plan" on page 15 of IRS publication 590.

"If you're getting no match in your plan, then it's an easy decision -- contribute $5,000 pre-tax to an individual retirement account, and invest in low-cost options such as index funds," says Meigs.