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Can Index Funds Fix Your 401(k) Fee Problem?

Chris Gay

Investors who were paying attention got a cold slap of reality this spring when the progressive think tank Demos released a study showing that the median household could expect to pay more than $150,000 in 401(k) fees over the course of a working lifetime, or about a third of potential investment returns. What's more, about two-thirds of 401(k) investors had no idea that they were paying such fees.

Fund fees can sound trivial when expressed in annual terms, but the same power of compounding that produces long-term returns also raises the ultimate cost of fees. Take the simple example of a one-time, $10,000 investment left to compound at 7 percent for 30 years. At the end of year 30, with no fees (admittedly an unrealistic assumption), it would be worth $76,123. With the 0.78 percent in expenses that the fund industry says was average for 401(k) plans surveyed in 2011, you'd have $60,185. Fees--whose dollar value, remember, also compounds every year--would have eaten up 21 percent of your "potential" portfolio.

[See 10 Things You Should Know About Your 401(k) Plan.]

If the problem is high management fees, are index funds the answer? Index funds are "passively" managed portfolios designed simply to mimic an index like the S&P 500 or the Russell 1000. Their fees tend to be lower than those for "actively" managed funds, which may use an index as a benchmark but can depart significantly from the weightings that the index gives to certain stocks. That requires trading, which runs up costs.

According to the Investment Company Institute (ICI), fees for equity-index funds averaged 0.14 percent in 2011, compared with 0.93 percent for actively managed equity funds.

So why doesn't every investor put his or her retirement money in index funds? For one thing, not every 401(k) plan offers them. According to the Plan Sponsor Council of America (PSCA), 82.4 percent of 401(k) plans offered index funds of U.S. stocks in 2010, and 49.7 percent offered index funds of domestic bonds.

Would participants in the other 17.6 percent of plans stand to gain much if they were offered index funds?

Quite possibly. "They do make a big difference on an individual plan level," says Robert Hiltonsmith, who authored the Demos fee study. Index funds have proved time and again to deliver better performance than actively managed funds, for lower cost. "If a plan doesn't have index funds or has very expensive index funds, getting some low-cost index funds in there could really help reduce the fee burden for investors in that particular plan. That is, assuming they actually invest in the index funds."

While index funds--Vanguard's in particular--have been widely credited with the general decline in fund fees over the past two decades, Hiltonsmith doubts they will fix the broader, systemic problem of high fees. For one thing, the plans that don't offer them tend to be smaller and less able to afford the cost of switching to a fund provider that offers index funds.

For another, it's hard to convince people that index funds are a better deal. Studies repeatedly show that people think higher fees buy better performance. "There's just no evidence for that, unfortunately," says Hiltonsmith.

[See How to Use New 401(k) Fee Reports.]

For better or worse, 401(k) fee costs are more a function of size: how big a plan is, how big the average contribution is, and how big the plan funds are. Large plans, which the PSCA defines as 5,000 or more participants, pay sharply lower "institutional" fees than smaller plans pay.

"The typical 401(k) participant is working for a large company, so even for actively managed funds, the fees are relatively low," says PSCA President David Wray. "On the other hand, most plan sponsors feel it's beneficial to give participants a range of alternatives that include actively managed and passive [funds] from which to choose."

The size of contributions matters too, according to a 2011 Deloitte study. For funds with about 1,000 participants, the study shows, the fees ranged from about 1 percent for plans with an average account balance of $10,000, to around 0.80 percent when the average is $150,000. The total spectrum of fees ranged from about 1.4 percent for very small plans (10 participants) and balances averaging $10,000, to about 0.40 percent for large plans (50,000 participants and higher) with an average balance of $150,000.

The reason is partly that there are certain minimum costs, some required by regulation, that plans pay regardless of how many employees participate. These costs are naturally higher relative to total assets for the smaller plans, though they shrink, in relative terms, as the plan grows and achieves economies of scale.

[See Understanding Your Mutual Funds' Portfolios.]

"The smaller employers are paying retail for their investment management, plus they have to pay for administration and compliance services on top of that," says Wray.

Another determinant of fees is the proportion of fund assets invested in equities, which typically entail higher expenses than bonds. Even actively managed bond funds, whose expenses averaged 0.66 percent in 2011, are cheaper than actively managed equity funds (the 0.93 percent mentioned above), says the ICI. (There's not much difference between the expenses on equity and bond index funds--0.13 percent and 0.14 percent, respectively, according to ICI data.)

So, want to get your 401(k) fees down? Buy index funds, and go work for a big company. Says Wray: "The people who are in plans with fewer than 50 employees are paying much, much higher fees than the companies where there are 5,000 or more participants."

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