LAST REVIEWED Sep 18 2019 12 MIN READ
By Damian Davila
Most Americans have a 401(k) as the pillar of their retirement saving strategy. According to the latest data from the U.S. Department of Labor, there are over 560,000 401(k) type plans helping workers save for retirement. While setting up a 401(k) is a great first step, some plan holders are falling short of the fullest potential of their nest eggs. From high management fees to missing out on employer matches, here’s a list of the reasons why 401(k) plans are underperforming – and how to change that.
Your 401(k) fees are eating up your gains
There’s no such thing as a free lunch – and 401(k)s are no exception! Thinking that your 401(k) is free and has no fees is at the top of the list of 401(k) myths that need to be debunked. 71% of 401(k) holders aren’t aware that they pay fees to their plan providers to maintain their account. Annual fees have a great impact on any 401(k). Let’s imagine that you’re 35 years away from your target retirement age and you were to contribute $5,000 every year to your account with an annual return of 7%. Assuming no fees, you would accumulate $469,000 at the end of the 35-year period. On the other hand, a 1.5% annual fee would set you back $124,000 by your target retirement age. Here are three key fees to watch out for:
Front-end load fees
A sales charge at the time that you “load” a fund, typically a mutual fund. For example, a $1,000 deposit in a mutual fund with a 4% front-end load would lead to only $960 actually landing on the final balance. Front-end loads can’t be over 8.5% of your investment. What to do: When comparing similar mutual funds, go for the one with the lower front-end load or, ideally, the one without such a charge. Research suggests that no-load funds generally outperform those with a load charge.
Back-end load fees
Also known as an exit fee or contingent deferred sales charge, this fee gets you when you dump a fund before a minimum holding period (ranging from 30 days to one year). What to do: The first rule of thumb to use is that the average holding period is about 60 days, so avoid funds with holding periods far above that threshold. Make a note of the minimum holding period to avoid triggering this fee. The second rule of thumb is that back-end loads range from 0.01% to 2%, so choose the fund with the lowest one.
Total expense fees
By taking a look at the total expense ratio, you can find out the total costs associated with managing and operating an investment fund. While a total expense ratio of 0.50% may not sound as much, consider this scenario. Over a 10-year period, the same $10,000 in an investment fund with a 6% annual return would yield $17,408 and $17,081 with an expense ratio of 0.30% and 0.50%, respectively. What to do: The rule of thumb is to keep the total expense ratio below 1% as much as possible.
Most passively managed funds outperform their actively managed counterparts
Everybody loves reading the headlines about the super investment managers, including Vanguard Health Care Fund’s Ed Owens and Fidelity Magellan Fund’s Peter Lynch. However, the fact is that only 20% to 35% actively managed fund beat the benchmark for their category. This is a humbling reality for anybody trying to beat the market. Even the Oracle of Omaha believes that investing in passively-managed funds yields better results in the long term than the ones from most investors with high-fee managers. In his 2013 letter to shareholders, Buffett revealed that his will advises his trustee to allocate 10% of the cash in short-term government bonds and 90% in a very-low cost S&P 500 index fund. And he suggests Vanguard’s for good reason, the total expense ratio of the Vanguard 500 Index Fund is 0.16% as of June 2016. (Disclaimer: the author of this article owns shares of this index fund.) What to do: To minimize fees, consider including index funds (like Warren Buffett) on the investment mix of your 401(k).
Plan administrators stick to their own underperformers for too long
Mutual-fund companies that administer 401(k) plans are more likely to include their funds among the investment options. The problem with this practice is that those mutual-fund companies tend to retain those funds even when they’re underperforming. According to the research from assistant professor at Indiana University, mutual funds in 401(k) plans are more likely to underperform by an average of 3.6% every year. Among mutual funds, the worst-performers are target-date funds, which have become the default options in most 401(k) accounts since the Pension Protection Act of 2006. In a review of more than 1,700 target-date funds, the average expense ratio was 1.02%. What to do: Blindly sticking to the default target-fund from your 401(k) can be a double whammy to your nest egg: lower returns and higher fees. Make sure to review all the investment options within your plan. If you have no options other than target-date funds, consider rolling over your 401(k) to a retirement account that better meets your financial needs. To find out more on roll over, read How to Roll Over Your 401(k).
Forgetting to readjust your 401(k) asset allocation
Once upon a time, you choose a target asset allocation (e.g. 80% in stocks and 20% in diversified fixed-income). Chances are that was the last time you ever checked that asset allocation again. Market valuations will make your asset allocation change over time, so you need to keep track of it. Unless there is a major shift in the asset allocation, there’s no need to rebalance your 401(k) more than once or twice per year. For example, assuming the target allocation of 80% in stocks, a range of plus or minus 5% is acceptable. One of 10% isn’t. Not keeping your asset allocation over a long period of time decreases your chances of beating the selected benchmark for your retirement account. What to do: Talk with your financial adviser and choose a date once a year, such as the first days of the year, tax day, or your birthday, to check your asset allocation. If the online portal of your 401(k) allows you to set up alerts, set one for when the asset allocation is over or under a specific threshold. More detail on how to do this yourself: How and Why to Change Your 401(k) Setup Percentages.
You’re not contributing enough to maximize your employer match
Besides minimizing investment fees and optimizing asset allocation, you also need to maximize your contributions. One key to achieve this is to meet the requirements set by your 401(k) to receive an employer match. The average worker misses an estimated $1,336 per year, or an extra 2.4%, in employer matches. What to do: The majority of plans require you to wait between one to twelve months to become eligible for an employer match. Once you’re eligible to receive an employer match, meet the minimum requirement contribution, ranging from 3% to 5% for most plans. Plan ahead to contribute as much needed to receive a full employer match, up to 7% of your annual salary.
Taking out too many loans
Even when you’re meticulously minimizing your investment fees, you’ll throw all your hard work away by taking a loan out of your retirement account. Here are a couple reasons why: Taking a loan from your 401(k) triggers an individual service fee. The National Bureau of Economic Research (NBER) found that about 90% of 401(k) plans charge fees for loans, including origination fees ranging from $25 to $100 and maintenance fees of up to $75. Failing to pay back loan triggers taxes and penalties. Generally, you have up to five years to pay back a loan. However, missing several payments or separating from your employer can make the remaining balance due within 60 days. When you’re unable to pay back the loan, remaining monies are considered a distribution subject to applicable federal and state income taxes and penalties, such as the 10% early distribution charge for those under age 59 1/2. Paying a loan interest rate below your fund’s return reduces your nest egg. Plan administrators charge about 1% to 2% over the prime rate on loans. If that interest rate is consistently below your fund’s rate of return, then you’re actually fighting against the tide and missing out on the value your 401(k) is gaining. What to do: Don’t take out loans from your 401(k)! To learn more, read: Why it Doesn’t Make Sense to Take a Loan from Your 401(k) In sum, boosting an underperforming 401(k) is possible. By choosing investment options with lower fees, refraining from taking out loans, including index funds when appropriate, rebalancing your asset mix consistently, and taking advantage of employer matches, you’ll be in a better position to meet or exceed the benchmark of your retirement strategy. Recommended reading: Should You Really “Invest in What You Know”?
Damian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.