NerdWallet was recently featured on ABC’s Real Money, where we helped one family save over half a million dollars in retirement fees. How did we do it? We’ll walk through how we evaluated the family’s 401(k) and the recommendations we made.
Graeme is a chiropractor with Queen Anne Chiropractic Center, a small family business owned by Graeme’s father. A few years ago, the family’s financial advisor offered to set up a 401(k) for the company. Greame faithfully contributed and found other ways to improve his finances including paying off debt and doing work with a second company, Dental Departures. As he worked to minimize expenses across his entire budget, he began to wonder if his no-fee 401(k) was actually charging any hidden fees and if there were simple changes he could make to maximize his long-term savings.
- Switch 401k providers – Graeme’s 401k provider is charging outrageous fees in the form of high expense ratios that will cost him over $500k more than a low cost provider by the time he retires. Every 401(k) should offer a stock fund and a bond fund with expense ratios lower than 0.50%. If yours does not, ask your employer to switch 401(k) providers.
- Contribute to an IRA – For as long as he has this 401k, he should contribute only enough to get the employer match before contributing to a low-cost IRA. This small change will save him $100k in unnecessary expenses over the course of his career.
- Choose better funds – His mutual funds invest disproportionately in foreign funds. This is unnecessarily risky and since foreign markets have underperformed the U.S. market recently, this mistake has been costing him approximately $400 per year.
Action Plan for Viewers at Home:
1. Ask Your Employer to Switch 401(k) Providers
This is the most important thing you can do. If you start with nothing and contribute the maximum to your 401(k) each year ($17,500/year) for 35 years, earn 7% return and pay zero fees, you will reach retirement with $2.6 million. A high cost retirement plan, like Graeme’s 1.62% expense ratio plan, will reduce this nest egg by $786k while a low cost retirement plan at 0.50% will reduce it by only $277k, a savings of over $500k. Frankly, you may even be able to do better than 0.50% if you really shop around.
Get out your Annual Report
Your 401(k) administrator is required to provide you with this document annually. This is where you will find all the fine print.
Read the Fine Print
Look at the “Administrative Fees” section. This will tell you who pays for the overhead costs of your plan. There are 3 main scenarios you are likely to encounter:
- Employer pays fees – Your employer pays a fee. Congratulations!
- Employee pays fees – A fee will be taken out of your account funds. Divide this annual fee in dollars by the amount you have (or plan to have soon) in your account. For example, if the annual fee is $50 and you have $10,000 in your account, you are paying 0.50% in annual fees. If you contribute regularly and come close to maxing out your contributions, this expense should be close to zero as a percentage.
- Fees are covered by the plan’s fund expenses – This is very common because it allows the plan to be marked as “no-fee” or “no-cost” to the employer, but the truth is that this type of fee structure is one of the most expensive for employees. Instead of charging a flat dollar administrative fee, the provider instead takes a portion of the expense ratio of every fund you invest in. As a result, the 401(k) provider has an incentive to only offer mutual funds with high expense ratios.
Check Your Funds
Look at what funds are offered to you and what expense ratios they are charging. If you know the name or 5 letter ticker of your funds, you can look up the expense ratio and other relevant info using NerdWallet’s Mutual Fund Tool. Having trouble finding this info, but have a login to your 401(k) plan? Try the Personal Capital investment analyzer. You can link your accounts and it will reveal your total expenses and the impact they will likely have on your future nest egg. The Annual Report should also have this information.
Decide if Your Plan is Bad
Is the total amount you are paying in fees (administrative fees plus expense ratios) less than 0.50%? If not, could you get your fee percentage down by choosing better options from the funds offered or contributing more to get your administrative fees down as a percentage of assets? If there’s nothing you can do to get your total expenses down to 0.50% or below, then it’s time to talk to your employer about switching plans.
Talk to Your Employer
There is no excuse for a 401(k) plan not to offer at least one Stock Market Index Fund and one Bond Market Index Fund with an expense ratio of 0.50% or less. If your plan doesn’t have these, talk to your employer about switching to a lower cost retirement plan.
- Determine the right type of plan – 401(k)? SEP IRA? Simple IRA? Depending on the size and structure of your business, any one of these could be the best solution. Vanguard has a useful tool to help you figure out what is best for your small business.
- Ask your employer to get competing quotes from providers like these:
- Vanguard – Known for very low expense ratio funds, but be sure to ask about administrative expenses since they will vary depending on your company size. Probably best for larger companies.
- America’s Best 401(k) – Founded by investment advisor Personal Capital with the mission of bringing down the cost of 401(k) plans for small businesses.
- Fidelity – One of the countries largest 401(k) providers. Probably too expensive for most small businesses, but worth getting a quote.
- Many, many more – Search for them and get as many quotes as you can
2. Contribute to an IRA
If you are stuck with a bad plan and you can’t convince your employer to switch to a good one, there is still something you can do. An employer-sponsored retirement account is just one form of tax-advantaged retirement savings plan. The other type is an Individual Retirement Account, or IRA. By choosing a low-cost IRA plan you can avoid your 401(k)’s high fees on a portion of your retirement savings.
Your Plan for optimizing retirement contributions:
1. Contribute enough to your 401(k) to receive matching funds
If your employer will match some of your contributions then you have immediately made a 100% return. This enormous gain trumps the negative of high expenses.
2. Contribute your next $5500 to an IRA
Open a low-cost, no-fee IRA and contribute to the IRA limit.
3. Contribute remaining funds to your 401(k)
This is controversial advice and there are some scenarios where the fees are high enough and the restrictions onerous enough that you might be better off just investing the remaining money in a taxable account. But these days people change employers frequently and when you leave your employer you can roll your 401(k) assets into a low-cost IRA and eliminate the negatives while getting all of the benefits of a tax-advantaged account. The government knows tax-advantaged accounts are valuable which is why they strictly limit how much can be contributed each year. Don’t miss an opportunity to get money into one, especially if you are young and have many years for the benefits to compound.
Further information on Individual Retirement Accounts:
- Roth vs Traditional IRA Accounts
- Best No-Fee IRA Accounts
- Think Your Income is Too High for an IRA? Not True
3. Improve Your Asset Allocation
Completely separate from the issue of fees is whether or not your 401(k) is optimized for peak performance. Many people spend great effort choosing the right fund or manager when the truth is that almost all investment performance in the long run is driven by asset allocation. Your asset allocation should take into account the length of your investment horizon and your ability to tolerate risk.
Optimizing your 401(k) portfolio allocation:
1. Determine your Optimal Allocation
A good general rule of thumb is to take 120 minus your age and invest that proportion in stocks and the rest in bonds, meaning a 40 year old should be 80% in stocks and 20% in bonds. Our asset allocation infographic has more detailed suggestions by age. There are also some great tools around the internet.
2. Determine your Current Allocation
Think you are 20% in small cap stocks because 20% of your portfolio is in a small cap fund? That’s what Graeme thought and it turns out only 3% of his money was invested in small companies. A fund’s name often doesn’t represent what it really holds. Use the Morningstar Portfolio X-ray to see exactly what you are investing in. Don’t want to enter this information manually? Use Personal Capital to link your accounts and monitor your asset allocation for free.
3. Determine how you will get to your optimal allocation
You should optimize your asset allocation across all of your holdings so put all of your assets from your 401(k), IRAs, and any other investments (even your spouse’s!) into the Morningstar X-ray. How far off are you? Try different allocations across funds in the X-ray until you find one that is roughly in line with your optimal allocation. This may involve adding funds that you don’t currently invest in or it may involve removing a few that are unnecessary. For most people, there is no need to have more than three different low-cost funds (stocks, bonds, international).
After the show Graeme let us know that he talked to his boss (his dad!) and they have decided to start the process of switching to a low cost 401(k). In just about a month, Graeme and the other employees of Queen Anne Chiropractic Center will be well on their way to one-third more in retirement savings in the future thanks to smart financial decisions today.