Your 401k Fees are Higher than You Think.

These are the hidden fees you should look out for in your retirement (and other investment) accounts.

Before I go off on my tirade, let me start with the good. If you are reading this, odds are you're already better off than the vast majority of Americans when it comes to saving for retirement. I've had this same conversation with dozens of friends, family, and co-workers, and the bottom line is this: kudos for thinking about you and your family's future.

Now let's talk about how to squeeze that last 10% out of your retirement investments, and that last ounce of juice isn't where you think it is. I'm not going to talk about the differences between a Traditional 401k and a Roth 401k. I'm not going to talk about HSA's. I'm not even going to tell you that you need to be contributing more of your paycheck to your retirement savings. Those are all good things to think about and there's a wealth of information on the web for your own research. Instead what I'm going to talk about is something that is not often mentioned in the investment world (and for very good reason): expense ratios.

At least once a year you should be receiving detailed information about your 401k accounts electronically or by mail. Within that package of information there is a detailed account of all transactions taking place, whether it be purchases, sales, dividends, transfers, or fees. If you're savvy, you've probably looked over this information in detail to determine whether your investments are being properly cared for. If this is the case, you've no doubt noticed that the fees are relatively small compared to the size of your account. For example, a 401k account worth $70,000 may have fees totaling $100 for the entire year. Not a huge price to pay, especially considering you are worry free and confident your funds are being appropriately managed, right? Now let's get to the expense ratio.

From investopedia in the link above, the definition of an expense ratio is "a measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual calculation, where a fund's operating expenses are divided by the average dollar value of its assets under management. Operating expenses are taken out of a fund's assets and lower the return to a fund's investors."

If you read the above definition carefully you might have picked up on the key piece of information regarding how an expense ratio is accounted for: "Operating expenses are taken out of a fund's assets and lower the return to a fund's investors."

So let's give an example of how this works. Let's say I buy $100 worth of a fund with an expense ratio of 2%. After one year the stocks composing that fund increase by 10% to create a true valuation of $110. The expense ratio is 2%, so the value of my fund only goes to roughly $108. That's the cut taken by the fund managers, and it's typically not very well advertised. This fee doesn't appear in your account transactions anywhere so you have no idea what the funds you are invested in are actually costing you unless you know what to look for. The fee occurs in good years and bad, regardless of whether the fund goes up or down.

So how much is a typical expense ratio? I've seen expense ratios anywhere from 0.1% to over 2.0% at well known 401k brokerage firms (Vanguard, Edward Jones). Now here's the sinister thing... since 401k brokerage firms require you to use their specific funds, you've typically got a mild assortment of investment options that are actually very limited in terms of how much they can charge you in hidden operating expenses. For example, at one large 401k brokerage firm, if I want to invest in aggressive domestic mid-cap stocks, I've got the choice between two funds that both have expense ratios of roughly 0.5%. That's not horrible, but it's not great either. Compare this to exchange traded funds that are actually having to compete for your business outside of the 401k account world by keeping expense ratios low at a fraction of the cost (around 0.06%).

A call to action.

Step 1

Determine how much operating expenses you are being charged in your current funds by looking them up using the tools provided by your 401k broker. If it's difficult to find, you can always call and ask for the specific expense ratios or you can also look up expense ratios on generic stock market tracking websites such as yahoo or google finance. Again the key term to look for is expense ratio. If you discover an expense ratio much higher than say, 0.5%, you should try and determine if there is another fund option among your choices that fulfills the role of the current fund but has less expenses. Also in my opinion an expense ratio over 1% is ethically questionable and anything over 2% should be considered criminal. But that's just me.

Step 2

If there aren't any good options to minimize expense ratios among your 401k funds, you'll have to do the best you can and consider reducing your 401k contributions to the maximum amount matched by your employer. If you want to save more that's great, a Roth IRA is easy to create and you can take the amount you are no longer contributing to your 401k and put it in the IRA instead. As I mentioned previously there are hundreds of ETFs out there that actually have to compete for your business and keep expense ratios low. In this sense a low-fee Roth IRA will significantly outperform a high-fee 401k account.

Also consider bringing up high expense ratios to your HR team. It's very possible they aren't aware of them and it may be what is needed to start a great conversation about high expense ratios among the large 401k brokerage firms.