In a 401k plan, your account balance will determine the amount of retirement income you will receive from the plan. While contributions to your account and the earnings on your investments will increase your retirement income, fees and expenses paid by your plan may substantially reduce the balance of your account.
Assume that you're an employee with 30 years until retirement and a current 401k account balance of $25,000. If returns on investments in your account over the next 30 years average 8% and fees and expenses reduce your average returns by 0.5%, your account balance will grow to $218,874 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5%, however, your account balance will grow to only $165,359. The 1% difference in cost would reduce your retirement account by approximately 30%.*
The table below illustrates how increasing investment costs can impact the growth of the hypothetical 401k plan account after 30 years, assuming a $25,000 starting balance, 8% annual return before expenses and fees, and no additional contributions.
First it is important to differentiate between the two different types of costs charged by your 401k plan, and the way they are allocated to plan participants. The best way to do this read the fee disclosure information that is part of the 401k Plan Document.
Cost #1: Investment Expenses
The largest portion of 401k plan cost is associated with the investment options themselves. Your disclosure statement should clearly indicate the total annual operating expenses of each investment option. For example, in the case of a mutual fund, these operating expenses may include investment management fees and 12b-1 fees. These fees are charged against the assets of the fund and reduce the fund's total return. The annual operating expenses will be shown both as a percentage of assets (expense ratio) and as a dollar amount for each $1,000 invested. For example, a fund may have an expense ratio of .50%, or $5.00 for each $1,000 invested. In this case, the $25,000 invested in the fund would cost $125.00 annually (25 times $5.00). It is also important to note that many funds with the same names sometimes have different share classes (or expense structures) for investments that are part of a 401k plan, so always use your Plan Document to determine expenses.
This disclosure material will also disclose any transaction type fees that may apply to investment options. These could be cost such as sales charges and loads, withdrawal fees and surrender penalties, or costs to transfer between investment options.
These differences in costs may help you choose between multiple portfolio options that are otherwise similar in investment objective and performance.
Cost #2: Administrative fees
The daily administration of a 401k plan also involves expenses for basic operations (activities such as plan record keeping, accounting, legal and trustee services) that are necessary for running the 401k as a whole. These fees can either be paid by the employer directly or paid by the plan participants. If they are paid by plan participants you will see the fees assessed one of two ways. Either as a flat fee to each participant’s account (so that each person pay’s the same fixed cost) or charged on a proportional basis (so that participants with larger accounts pay more of the overall expenses). Your plan’s fee disclosure is required to contain an explanation of all costs and charges that will be applied to an individuals accounts.
Fees and expenses are just one factor in determining which investments in your 401k will help you meet your retirement planning needs. However, it is important to consider your fees and expenses when calculating your return needed to achieve your goals. The higher the cost, the higher the required return and most likely the higher the risk that needs to be taken. Check with your financial advisor to review your 401k plan and determine if you retirement savings in on track.
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