Are You Overpaying for your 401(k)?

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Boston College’s Center for Retirement Research Center has a study out this month about the cost of 401(k) plans, and they have found another flaw in the nation’s defacto retirement savings system: It is overpriced. So not only do 401(k) plans not meet the needs of the average American, they aren’t cost effective either. I wrote about the problem with 401(k) plans in a cover story for TIME last year.

The ugly truth, though, is that the 401(k) is a lousy idea, a financial flop, a rotten repository for our retirement reserves. In the past two years, that has become all too clear. From the end of 2007 to the end of March 2009, the average 401(k) balance fell 31%, according to Fidelity. The accounts have rebounded, along with the rest of the market, but that’s little help for those who retired — or were forced to — during the recession. In a system in which one year’s gains build on the next, the disaster of 2008 will dent retirement savings long after the recession ends.

One of the issues with the plans that I didn’t look into was fees. But given the many problems with the savings vehicles, it is not a surprise that they are higher than they should be. Here’s why:

The problem, according to the BC study, has to do with ETFs and actively managed mutual funds. Most of the money invested in stocks in 401(k) plans are in actively managed mutual funds, which cost significantly more than ETFs. That would be fine if actively managed funds outperformed ETFs, but they don’t.

These data show that the funds with the greatest expenses are essentially evenly divided between those that covered their costs and portfolio risks, thereby outperforming the market, and those that did not.  Therefore, on balance, actively-managed funds can entail a substantial amount of additional risk for investors, resulting from their failure to cover their transaction costs.

The problem is it is very hard to pick mutual funds based on past performance. Now it is always the case that most people would be better off most of the time in an low-cost index fund or ETF, rather than an actively managed mutual fund. And that’s true no matter how you are investing, be it in a retirement savings account or a regular brokerage account.

But 401(k)s magnify the problem. The BC study, which is co-authored by Richard W. Kopcke, Francis M. Vitagliano, and Zhenya S. Karamcheva, finds that not only are actively managed mutual funds more expensive on their own, but having them as choices in 401(k) plans make the plans themselves more expensive. So it’s a double expense whammy for 401(k) participants. On top of the higher expenses of the funds, the study finds that 401(k)s would be able to cut their expenses 0.3% to 0.45% a year if they were to cut out actively managed funds. And while that might not sound like  much, over 30 years the added costs of having actively managed mutual funds in 401(k) plans ends up being significant.

Within defined contribution pension plans, most of the money that is invested in equity mutual funds is held in actively-managed funds.  Without giving up the investment objectives offered by these funds, participants in 401(k) plans could pay significantly lower costs on their assets by shifting to ETFs and commingled trusts.  Together, the potential savings in explicit fees and trading costs can amount to 0.7 percent of assets or more for the average 401(k) plan. These savings boost the net return on balances in these accounts by the same amount.

The bigger problem with 401(K) plans that this study brings up is this: The market for 401(k) plans does not allow the consumers to shop around. And that drives up costs, rather than what our free market system is supposed to do. Employers pick their company 401(k) plans, but they are not the end user, and usually pass the cost of those plans onto their employees. Typically, your company offers a plan or it doesn’t. And you have the choice to take the plan or walk. And since 401(k)s are still the best available option, most of us decide to take it rather than go without. Yes, our employers are supposed to shop around for us, and find the plans with the lowest expenses. But as this study shows, clearly they don’t. Just another sign that our current 401(k) retirement system is broke (pun intended).

See 10 smart ways to reach your retirement goals.

See five big questions about retirement.

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