Historically 401K plans have only offered Mutual Funds and Group Annuities to Retirement Plans. Recently a new Investment has become available to 401K investors Exchange Traded Funds (ETF’s). So let’s take a deeper look at these 3 contenders for our investment dollars.
Traditional, actively managed mutual funds usually begin with a load of cash and a fund management team. Investors send their money to the fund, are issued shares, and the Porsche piloting team of investment managers figures out what to buy. Few of these stock pickers are very good at this, the other 90% of them, not so much. In fact in any one year over 80% of Mutual Funds will under-perform their index. Costs are the biggest problem with mutual funds. These costs eat into your return, and they are the main reason why the majority of funds end up with sub-par performance. What’s even more disturbing is the way the fund industry hides costs through a layer of financial complexity and jargon. Some critics of the industry say that mutual fund companies get away with the fees they charge only because the average investor does not understand what he/she is paying for. The Average No Load Equity Mutual Fund still ranged from 1.5%-2%. If you have an advisor who puts a load fee on the fund you could be paying fees as high as 4%-5% a year. Here is another reason to avoid many managed mutual funds – hidden fees. One culprit is the brokerage commission, the dollars paid to a broker to buy and sell stocks in the fund. The fund passes this expense along to the fund shareholders but doesn’t bother to include it in the published annual expense ratio. So in some cases a published annual expense ratio of 2% can translate into a 3% or 4% fee when you include the brokerage commissions.
Forbes magazine, January 31, 2005, published a table of 12 funds will high hidden fees. Nine of the 12 funds had hidden fees that were greater than the published annual expense ratio. So unsuspecting investors were paying more than double the advertised amount. Hidden fees pushed the real expense ratio to over 7% for one fund, over 6% for two funds, over 5% for four funds and over 4% for five funds
Estimated Trading Costs for an Average Mutual Fund (% of Net Assets per Year)
|Annual Turnover Rate||Brokerage Commission Costs||Effective Bid/Ask Spread Costs||Total Trading Costs|
|Average Mutual Fund||106%||.27%||.38%||.65%|
|Sample of 10 Highest Turnover Mutual Funds||498%||1.67%||1.91%||3.58%|
When You take into account that the average Mutual Fund has an expense ratio of 1.5%-2% plus additional hidden trading costs of 0.65% most investors are paying Total Fees of 2.15%-2.65% on average to own a managed fund that is most likely going to under-perform their index.
You may be lucky and you may not own Mutual Funds in your retirement portfolio or you could be even more unlucky and have unknowingly owned group annuities in your portfolio. Unfortunately, the hottest market for annuity salesmen is 401(k) plans. By slapping hidden fees on employees, even the tiniest firm can offer a plan that doesn’t cost it a penny to set up and run. Workers might never know theyre being gouged, because fee disclosures are so easy to shirk.
Insurance companies cater to the smaller, less sophisticated part of the market. When it comes to fee abuse in retirement plans, you can put group annuities at the top of the list. Among 401(k) plans with assets of less than $250 million, group annuity-style menus account for 55% of the market and are sold by AXA Equitable, Lincoln Financial and other insurers. One of the most expensive group annuities is a contract from John Hancock that charges annual fees of 5% as well as a 1.4% trailing commission. It is because of the surrender charges that insurers are able to pay salespeople such high commissions. Lots of mostly small companies are finding out the hard way that the 401(k) plans they bought from insurance companies, usually set up as “group annuities,” came with a variety of hard-to-find charges and lockups. Or, more aptly, the plans they were sold by people motivated by lavish commissions. Many hyped the product as a low- or no-cost proposition for employers while glossing over the fees charged to employees. A successful ruse it is. All told, insurers have lured 18,000 companies into parking $185 billion of 401(k) assets inside group annuities and similar insurance contracts.
Group Annuities work this way: Inside group annuities, legal title to the mutual funds belongs to the insurers. This ownership bestows on them the right to claim a corporate dividend received credit, an old feature of the tax code aimed at preventing the double-taxation of profits at the corporate level. Investors don’t get a special tax benefit. The fact that annuities may be tax-deferred is irrelevant inside a retirement account, which is tax-deferred no matter how it is invested.
The annuity trappings do, however, mean that investors get hit up for higher fees. John Hancock’s group annuity offers the JH American Funds Growth Fund of America at a cost of 0.91% annually. Other 401(k) investors can get an identical fund at less than half the cost.
An accountant at a five-person Texas firm was shocked to discover while looking through his 401(k) statements recently that AXA Equitable’s group annuity was charging 1.69% annually to own its version of an S&P 500 index fund. The 0.64% charged for the fund alone is four to five times what low-cost providers Fidelity and Vanguard charge.
Among 401(k) plans designed for small companies, the total fees on some group annuities can top $1,000 per participant every year, or three times what low-cost 401(k) plans cost, according to data provider 401kSource. Have second thoughts after signing up and you’ll discover that buying a group annuity is like joining the Sopranos with fees that may even double what a Mutual Fund may charge.
One other option for a retirement plan is using ETF’s in your portfolio. ETF’s trade like stocks, you can buy and sell them all day long. Though doing that, like any day trading, will likely land you in the gutter searching for loose change, it does have some advantage for the Foolish investor. Limit orders are one. You can tell your broker (or the computerized lackey) to purchase your ETF shares only at a certain price. If the market jumps 3% with excitement over some major world event — like a peace pact between Britney and Christina — you can use a limit order to make sure you don’t pick up your shares at the top of the soon-to-be-crashing wave of misguided enthusiasm. If you’ve ever viewed a table of no-load mutual funds, you might have sprinted away from the computer shrieking. Under the column titled “account minimum,” you see numbers as high as $50,000. That’s the price of entry for some mutual funds. ETF’s, on the other hand, have no minimums. You can purchase as few shares as you like. Want one lonely little share? You can get it. One other benefit of using ETF’s is that you can actually buy Options on your ETF’s to protect it against Market Downturns. ETF’s within a retirement portfolio have an average fee of around 1% and their performance is tied to an underlying index. In summary on average with an ETF you are likely to experience better performance on your investments while paying 1-3% less per year in fees on your portfolio.
Let’s now compare the 3 investment options available to employees in their retirement plans. If an employee invests $5,000 per year for 25 years in each retirement retirement plan and earns the same 10% gross of fees per year in each plan. What would the value of each account be after 25 years based on the following assumptions: a fee of 1.25% for an ETF Based plan A fee of 2.5% for a Mutual Fund Plan and a fee of 3.5% for a group annuity retirement plan.
Mutual Fund: $367,809
Group Annuity: $313,705
As you can see it makes sense for employers and employees to find out what they are being charged per year for their investments. Even if the extra fees only cost 1%-2% a year now, those fees will eat away at your portfolio and cause you to have much less in portfolio upon retirement.
Tim Bodnar is Managing Director of Huron Investments in Chicago, IL. Huron Investments is a full service financial consulting firm specializing in business and individual retirement planning. You can reach Huron Investments via email at firstname.lastname@example.org.