Contributing to a 401K is a smart financial move and often the only retirement account options available for most employees. But if your 401K is invested in mutual funds, the expenses could be dragging down your potential earnings more than you think.
What Are Mutual Funds?
When you set aside money from each paycheck in your 401K, hopefully, it’s not just sitting in cash. If you have a managed 401K through an employer, the most common investment vehicle is mutual funds.
Mutual funds combine investor money to purchase stocks, bonds, and other short-term investments. They are a simple way to diversify when compared with investing in an individual stock or bond.
Mutual fund companies employ a team of fund managers who spend their days researching securities a fund will buy and use a pool of investor money to make the best investments.
This means the mutual funds are actively managed, as opposed to the passive management i.e. index funds, generally carry hefty internal expenses.
How Costly Are Mutual Funds?
While mutual funds are the most common 401K investment option, they also tend to be laden with fees and underlying costs. All of which are passed on to you.
The expenses of a mutual fund generally fall into two larger buckets.
- Operating costs – The companies responsible for mutual fund management also need to make a profit. They do this by charging their investors specific fees to cover operational costs, like an annual management fee, service fees, and marketing fees, among others. Details about total annual fund operating expenses are available in the fund prospectus.
- Shareholder costs – This bucket contains transactional fees that are passed directly to the shareholders. The majority of shareholder fees are incurred when brokers or fund managers buy or sell securities. These shareholder fees are also outlined in the fund prospectus.
The overarching issue with mutual fund expenses is that they’re practically baked into your 401K pie. Instead of requiring investors to pay fees separately, the costs are deducted from your account on a daily basis (it’s designed so you won’t notice).
In turn, that means you, as the investor, rarely feel the implications of mutual fund expenses, making them a silent destroyer of long-term portfolio growth.
What Are The Implications of High Fees?
While it may seem that fees are simply the price you pay for investing, it turns out that they can have a dramatic effect on your 401K over time. Say you’ve been contributing to your 401K for a few years, and you now have $25,000 invested.
Your 401K management company invests in a mutual fund with an expense ratio of 1.50% per year. After 20 years, if you continue to invest $5,000 per year, with a 5% annual return, your account could be worth around $191,000. Not too bad!
Now consider if your $25,000 investment, with the same annual contributions and returns, were invested in a mutual fund with an expense ratio of .50% per year. You would be saving and re-investing more money each year, and after 20 years, you’d be looking at around $211,000.
That’s about $20,000 more in your pocket at retirement, all as a result of lowering the fund’s expense ratio by a measly 1% per year.
Sacrificing your money to higher fund expenses means there is less available in your portfolio as it grows, which also means less money to realize the benefits of compound interest over the years. But if your company’s 401K is invested in mutual funds with a hefty cost, is there anything you can do?
How Can You Protect Your Investment?
One of the principal rules of investing is to ensure that you get the most profit by keeping fees, taxes, and other expenses as low as possible. But with a company-provided plan, it can be challenging to figure out precisely what you’re paying for and even more of a challenge to try and change it if it doesn’t align with your investing goals.
The below tips can help you take a step in the right direction to limit the influence of high mutual fund expenses.
Read the Prospectus
The brochure you get when you decide to participate in the fund and receive annually is called the fund prospectus. This is dry reading at best, but it can help you understand the fund’s overall objectives and how much you’re paying towards annual operating costs and shareholder fees.
With prospectus in hand, you can use a tool like FINRA’s fund analyzer to compare various funds’ performance and costs over time.
If you feel like your company’s 401K is underperforming due to high fees, it’s essential to speak up, ask questions, and find answers.
Your company has a fiduciary responsibility to make sure their employees are getting the best investment options available. As such, they should take the time to listen and then relay information to or get you in touch with the mutual fund company directly to discuss lower-cost options.
Consider Other Investments
A good rule of thumb is to participate in a 401K to get an employer match. But if mutual fund expenses are too high to handle and your employer isn’t willing to help lower them, it could be time to consider other options for the remainder of your investment.
You could potentially get more bang for your investment buck by looking to an IRA or taxable brokerage account. It’s best to consult with a financial advisor to understand the best move for your unique situation before making any significant changes.
The Bottom Line
While a 401K is an account offered by your employer, you are still the investor and have a right to understand and fight for the lowest fees possible.
Take the time to understand costs and their impact on your investment over the long haul. You may be able to help your situation and that of your co-workers by bringing to light the extraordinary costs of expensive mutual funds.