How to minimize the impact of 401(k) fees

  • Retirement plan fees vary substantially across firms.
  • Annual fees appear trivial but small differences in the annual fee have a substantial impact on retirement wealth.
  • A median-wage worker at a firm with a high-cost retirement plan can pay more than $100,000 in retirement plan fees over her lifetime.
  • Workers can reduce lifetime retirement fees by moving to a job at firm with a low-fee plan, moving retirement funds to a low-cost IRA when changing jobs, greater use of IRAs, and greater use of investments outside retirement plans.

Background on impact of high retirement plan fees:  A report by the Center for American Progressrevealed that 401(k) fees are a substantial expense and drain on retirement income for many workers.  On average, annual 401(k) fees are 1.0 percent of assets.   

There is substantial dispersion in the annual fee percentage across firms.   A 2011 survey cited in the report found the average annual 401(k) fee for firms with fewer than 100 participants was 1.32%.   The report found that a well-managed retirement account could have a fee as low as 0.25%. 

The report calculates lifetime 401(k) fees for workers at three different annual fee rates – 0.25%, 1.0%, and 1.3%.   The scenarios assumed the worker contributes 5% of salary and receives a 5% employer match. The findings indicate that relatively small annual differences in fees as a percent of asset leads to large differences in lifetime fees paid by workers to the sponsor of their retirement plan.

  • Lifetime 401(k) fees for a median-wage worker starting her career are $42,000 at a 0.25% annual fee, 138,000 at a 1.0% annual fee, and $166,000 for a worker at 1.30% annual fee.  

The report also contained lifetime fee calculations for a higher wage worker.  Results were proportionate to income.

Higher retirement fees were associated with a higher likelihood of ending up with insufficient retirement income.

  • An increase in retirement plan fees from 0.5% of assets to 1.0% of assets will reduce the likelihood a worker will have sufficient retirement income from 69% to 57%.

The reported annual fee as a percent of retirement plan assets appears to be small, almost trivial.   However, the fee is applied each year.    The annual fee becomes large for older workers with larger amounts accumulated in the account.   

High retirement fees are an especially important issue when interest rates are low.  When the fee percentage is larger than the bond interest rate, the de-facto interest rate is negative. This is currently the case with a two-year Treasury rate stands at 0.16% below the level of even a low-cost retirement fund.

The Center for American Progress argues that a key solution to problems created by high retirement plan fees is better information about the fees.  Workers are not explicitly billed for retirement fees.  The retirement plan fee is an indirect charge deducted from investment returns.   Workers would be much more cognizant of retirement fees if they were directly charged the service.

Investment managers charging high fees claim their fees are justified because their fund realizes higher returns.  The finance literature indicates that passive funds with low returns tend to outperform active funds with higher fees.  Moreover, Warren Buffet, arguably the best active stock picker of all time, argues sticking with the S&P 500 will lead to better returns than active management.

Workers would be better served if they were automatically placed in low-cost funds unless they opted out.  The current default retirement plan is the plan chosen by the worker’s employer.   However, workers at firms that choose a high-cost retirement plan with inadequate options can and should take several steps to reduce fees and work towards a secure retirement.

Mitigation of the adverse financial impact on high retirement fees:

A worker who is aware that a retirement plan at her current or prospective job imposes high fees can take several steps to reduce fees.   These steps include, moving to a job with a better retirement plan, rolling over funds from the high-cost plan to a low-cost IRA when changing jobs, greater use of individual retirement accounts, and increased savings outside of retirement plans.

Moving to a firm with a better retirement plan:  A person with multiple job offers should consider the quality of the retirement plan when weighing different offers.  Factors determining the quality of a firm’s retirement plan include – whether the firm matches employer contributions, the level of the match, whether the firm offers a Roth 401(k) option and as shown above the level of fees.

Change jobs and rolling over retirement funds:  The existence of high retirement fees should motivate a person with assets in a retirement plan to look for a new gig.  Preferably the new job would have a retirement plan with a lower-cost plan; however, even if it does not the worker can take her funds out of the high-cost plan and place them in a low-cost IRA.   

Consider, a 45-year-old worker with $300,000 in a retirement plan charging a 1.3 percent annual fee.   The person is paying $3,900 in retirement fees in her current year.  She could quit her job and move the retirement funds to a low-cost IRA with a fee at perhaps 0.5 percent.   The current-year annual fee would be $1,500.

The annual leakage from high fees grows over time in tandem with the growth of assets.  One of the worse mistakes a person can make preparing for retirement is to leave assets in a high-cost plan once you move to a new position or retiring.

Investment related fees at reputable firms like Vanguard, Fidelity and Schwab have fallen in recent years and with a little research you can roll funds into a low-cost IRA when you leave your current position.    The impact on your retirement wealth is considerable and I see no advantages in keeping funds with a high-cost retirement funds after you move to a new position.

Use of IRAs to replace or complement firm retirement plan savings: The person who accepts a job at a firm with a high-fee retirement plan must decide whether to contribute to the retirement plan, contribute to an individual retirement plan instead of the IRA or contribute to both the firm retirement plan and an IRA.

There are some limitations with IRAs.  Contribution limits are lower for IRAs than for 401(k) plans.  The contribution limit for IRAs in 2020 is $6,000 for people under 50 and $7,000 for people 50 and over.  The contribution limit for 401(k) plans in 2020 is $19,500 for people under 50 and $26,000 for people 50 and over.   

Tax rules link eligibility for Roth IRAs to household income.  Tax rules also link the tax deductibility of traditional IRAs to both household income and whether a person and/or spouse contributes to a 401(k).  These rules limit but do not eliminate advantages associated with a strategy of complementing investments in a firm-sponsored retirement plan with investments in a lower-cost IRA.

A person at a firm with a high-cost retirement plan might choose to contribute to the plan if the firm matches employer contributions.   The employee could take full advantage of the matching contribution and divert any additional savings to accounts outside the retirement plan. The employer match will lead to a generous return in the year the contribution is made, however, the annual fee will erode the fund over time.  The use of the IRA for contributions over the match can result in increased retirement wealth if the IRA has lower fees.   

The employee contributing to both the firm 401(k) plan and an IRA may have to place funds in a non-deductible IRA rather than a Roth or deductible IRA depending on her household income.  This allows for deferral of tax.  The worker may be able to convert the conventional IRA to a Roth IRA in a future year but this is a topic for another day.

Once the worker leaves the firm, the entire retirement fund should be rolled over to a low-cost IRA.  Brokerage firms may allow you to combine funds in the two accounts.

A person with at a firm with a high-cost retirement plan that does not match employer contributions should consider and should probably choose a low-cost IRA instead of the firm’s high-cost retirement plan.   This strategy limits contributions and retirement income for some workers because as noted contribution limits are substantially higher for firm-sponsored 401(k) plans than for independent IRAs.  However, the difference between IRA and 401(k) contribution limits may not matter for most workers because many companies, in. a response to IRA non-discrimination rules, limit contributions to a 401(k) plan to a percent of income.

Use of Low or No-Fee Bond Purchases Directly from the U.S. Treasury:  The current market environment is challenging.  The valuations of popular stocks like Microsoft and Apple are at historic highs.  Interest rates are low and for some maturities below the annual 401(k) fee. The actual investment return on many bonds in 401(k) accounts after accounting for the annual fees is negative.

Investors improve outcomes by purchasing I and EE Bonds directly from the Treasury.  The purchases can be done inside or outside of retirement accounts.

There are several advantages associated with the greater use of I-Bonds and E-Bonds directly from the U.S. Treasury.

  • There are no fees on bonds purchased through Treasury Direct and no fees on the purchase of I and EE bonds as stated in these FAQs.  
  • Tax is deferred on I and EE bonds until the instrument is sold.   
  • The tax on matured bonds is limited to deferred interest or capital gains while all funds distributed from conventional retirement accounts are fully taxed as ordinary income.  
  • Individual bonds can be redeemed at maturity at their par value while the value of the bond fund is determined by the prevailing interest rate.

Advantages of use of bonds as part of an overall retirement strategy and advantages associated with the purchase of bonds from Treasury Direct deserve and will get future analysis.

The point stressed here is that investments in bonds at Treasury Direct can reduce lifetime retirement fees.

Concluding Remarks:   Virtually all financial planners emphasize the importance of taking full advantage of retirement plans.  The advice starts as soon as a person enters the workforce even if the person has substantial student debt and a strategy of rapid repayment of student loans would substantially reduce costs, financial risk and stress for the new worker.  The financial planners often don’t worry nearly enough about paying off the mortgage prior to retirement.

Financial planners often don’t mention or stress the importance of high fees, which as discussed here have a large impact on retirement wealth and the likelihood a worker will have a secure retirement.   

The message presented in this post is that workers need to be aware of the retirement plan fees and the overall quality of the plan and come up with an alternative solution if the firm’s plan is inadequate.

Paying off the Mortgage Prior to Retirement

Financial Tip:   Pay off all debt, including the mortgage, prior to retirement.   This requires planning, the use of 15-year mortgages on the last purchased home, and prioritization of debt payments over additional contributions to 401(k) plans.

Discussion:   According to CNBC, experts differ on whether you should retire mortgage debt in retirement.  My view is that the retirement of debt in retirement is too little too late.  Mortgage debt has to be eliminated prior to retirement to reduce taxes and the risk of outliving your resources.

The goal of mortgage elimination prior to retirement is most important for people with most or all of their wealth inside a conventional retirement account because funds disbursed from 401(k) plans are taxed as ordinary income.  People with a mortgage and all funds in a 401(k) plan must disburse funds to cover the mortgage payment and tax on the disbursement.  Moreover, the increase in reported income from the larger 401(k) disbursements will subject a greater portion of Social Security income to tax.  (A portion of Social Security income is subject to federal income tax for single individuals for income starting at $25,000 and for married individuals for income at $34,000.)

The elimination of all mortgage debt prior to retirement requires some financial planning.  The goal could be achieved by the selection of a shorter-term mortgage for the final home purchase, refinancing from a long-term to short term mortgage, or by making additional payments towards the mortgage when nearing the end of your career.   A person over the age of 50 should, at a minimum, prioritize additional mortgage payments over catch-up contributions to 401(k) plans in order to meet this goal.   The worker might even consider further reductions in 401(k) contributions to eliminate the mortgage.

Action must be taken to eliminate the mortgage prior to retirement. A person already in retirement with a substantial mortgage and with most funds inside a 401(k) account does not have many good choices.

Consider, the case where a retired person has all of her wealth in a 401(k) plan.  She took out a 30-year $450,000 mortgage 25 year before retirement and has five more years of mortgage payments before the mortgage is retired.  The interest rate on the loan is 4.0%. Her mortgage payment, principal and interest, add up to $2,148.  (This was obtained from the PMT function in Excel.)   The annual payment on her mortgage is $25,780.   The outstanding balance on her mortgage is $116,654. (This was obtained from the FV function in Excel.)  

She could continue to live in her house and make her monthly mortgage payments.

She would have to withdraw funds from her 401(k) plan to cover her mortgage expense and other living expenses including her federal and state tax bills.  The larger disbursement to cover the mortgage increases her tax bill because the entire distribution from the mortgage is taxed as ordinary income.   She likely has Social Security benefits to cover some of her other living expenses.  However, the higher income from the larger 401(k) distribution to cover the mortgage increases the likelihood a portion of the Social Security benefit is subject to federal income tax.

It makes sense for people to reduce spending and 401(k) disbursements during market downturns to prevent rapid use of 401(k) funds. The person with a mortgage must withdraw funds from her 401(k) plan to meet the mortgage obligation regardless of the performance of the market.  The existence of the mortgage limits the ability of this person to reduce distributions in response to a market downturn.

The person could pay the entire outstanding mortgage balance of $116,654 in one year.  This would put her in a high marginal tax rate and would subject 85 percent of her Social Security benefits to tax in the year the large distribution was made.   

The person could sell her house, pay her entire mortgage and move.  Most elderly want to age in place.  

The viability of the downsizing option depends on the price the person could get on her current house, the amount of equity in her house and the cost of alternative housing, which depends on the price of the new house or the rent.   Hopefully, the new house would be purchased with cash not a new mortgage.

A person with a large amount of liquid assets outside of her retirement account could more easily pay off her mortgage.  The tax from the sale of assets outside a retirement account are substantially lower than taxes on funds distributed from conventional 401(k) plans because only the capital gain portion of the disbursement is taxed and under current law capital gains are taxed at a preferential rate. 

The problems described here could have been avoided by use of a Roth retirement account rather than a conventional retirement account.   A post on the potential advantages of Roth retirement accounts will be available shortly.

Financial Priorities for New Entrants to the Workforce

  • Students entering the workforce tend to have high expenses and relatively modest income.
  • Young adults need to prioritize the establishment of a good credit rating, the creation of an emergency fund, and investments in their job search.  
  • Contributions to 401(k) plans can wait.
  • A strategy of rapid reduction of student debt immediately upon entering the workforce will substantially improve credit scores and borrowing costs and reduce lifetime student loan repayments, by tens of thousands of dollars.   
  • Student borrowers with low-cost federal loans and higher cost private loans should prioritize repayment of the high-cost loan. It may be possible to refinance the federal debt once the private loan is eliminated, further reducing lifetime student loan payments.
  • The rapid repayment of student loan debt can lead to increased contributions to retirement plans once some or all student debt is eliminated.

Many financial planners and firms with solid reputations urge new entrants to the workforce to start their career by aggressively contributing to their 401(k) plan and saving for retirement.  Fidelity, a leading investment firm, recommends young adults have a 401(k) balance equal to their annual salary by the time they are 30.  

My view is that this objective is unrealistic for the vast majority of young adults entering the workforce with limited liquidity and substantial debt.  

My financial advice to young adults entering the workforce can be summarized in three tips – (1) maintain a solid credit rating, (2) create an emergency fund, and (3) rapidly reduce student debt to a manageable level.   The achievement of these goals often requires that student borrowers entering the workforce either entirely forego contributions to their 401(k) plan during their first few years in the workforce or at least substantially reduce contributions for some time.  

The importance of an emergency fund and a solid credit rating:

The first few years after a person completes school and starts a career are often financially challenging.  People leaving school often starts their job search with limited funds in the bank.  Starting salaries are often lower than expected and relatively few students immediately get their dream job. The process of searching for a good job is expensive and time consuming.  The successful job candidate often has some moving expenses.

Student debt repayment obligations generally start 9 months after full-time student status ends.  Moreover, the proportion of students with subsidized federal loans has fallen. The increased use of unsubsidized federal loans and private student loans has increased interest costs on student debt early in the borrower’s career. 

Contributions to a 401(k) plan should be an extremely low priority for a person starting a career with a low starting salary, in full search mode for a better job, without substantial savings and with immediate student debt obligations.

The financial planner will tell the financially strapped person with no funds to take the employer match on 401(k) contributions because it is “free money.”  Employer matches to 401(k) contributions are not free money if the diversion of money from current needs results in late payments and a deterioration of the person’s credit rating

The highest, perhaps only, financial priority of the new entrant into the workforce is to build a financial buffer in order to maintain a solid credit rating.

The failure to maintain a good credit rating will lead to extremely high costs for borrowers.

A search was conducted for likely interest rates for good and poor credit risks for four different types of loans – (1) credit card loans, (2) car loans, (3) a private student loan, and (4) a mortgage.  Assumptions were made on the likely maturity and initial balance of each loan and these assumptions were used to generate estimates of the monthly cost of bad credit.

The interest rate assumption was obtained from WalletHub, the car loan assumption was obtained from Nerd Wallet, the private student loan assumption was obtained from Investopedia, and the mortgage rate assumption was obtained from this CNBC article. The differential between interest rates on people with good and bad were 9.8 points for credit card debt, 7.0 points car loans, 10.0 points for private student loans, and 1.6 points for mortgage debt.

The cost of bad credit depended on both the interest rate differential and the likely loan amount.  The analysis presented here assumes a likely loan balance of $10,000 for credit cards, $15,000 for a car loan, $20,000 for a private student loan, and $300,000 for a mortgage.

The analysis assumed the borrower only paid interest on credit card debt.   Assumed maturities were 60 months for car loans, 240 months for private student loans, and 360 months for mortgages.

Based on these assumptions, I found the monthly cost of bad credit was $82 for credit cards, $49 for car loans, $124 for private student loans, and $277 for mortgages.

The figures presented here show bad credit ratings can lead to substantial costs with costs depending on both interest differential and loan amounts.  The interest differential stemming from credit ratings is highest for credit card loans and private student loans.  

The payment differential associated with credit ratings is often highest for mortgage debt because mortgage loans are large. In today’s housing market with soaring home prices and tighter lending standards it is very difficult to purchase a home without good credit.

The cost of bad credit is not limited to one or even a few loans.   Most people take out multiple consumer loans or mortgages in their lifetime.  The lifetime cost of bad credit will be substantial for households that do not improve their credit rating. 

Poor credit ratings have other adverse impacts in addition to higher loan costs.   The Insurance Information Institute points out the insurance companies use credit ratings to set insurance premiums because actuarial studies have shown that credit scores are good predictors of the tendency for people to make insurance claims.  The credit rating agency Experian points out that employers can and sometimes do base hiring decisions on an applicant’s credit history.   Landlords use credit ratings to determine eligibility for an apartment.

The Importance of Rapid Student Debt Reductions Early in a Career:

Students leaving school with substantial federal and private student debt should rapidly repay the private student loan even if the rapid repayment of the private loan causes them to forego contributions to their 401(k) plan.

The rapid reduction after joining the workforce will drastically reduce lifetime student debt borrowing costs.   Rapid debt reduction may make it possible for the student borrower to refinance remaining debt at a lower interest.

Finance companies often attempt to persuade student borrowers to refinance their federal student loans to lower-interest rate private loans.   This article provides recommendations from CNBC on the best companies for refinancing student debt. 

Often student borrowers cannot refinance to a substantially lower interest rate immediately upon graduation because their work and credit history is short, and their initial salary is low.  A student borrower could improve their credit report by foregoing 401(k) contributions for a year or two and then refinance the remaining student loan at a lower interest rate.

There are advantages and disadvantages associated with refinancing federal loans to private loans.  The primary advantage is a lower interest rate, perhaps as low as 3.0%.  You must be careful when refinancing a fixed rate student loan to a variable rate loan because the student loan interest rate can rise substantially if Treasury rates rise.   In addition, the decision to refinance with a private student loan makes the borrower ineligible for forbearances in case of economic hardship and makes the borrower ineligible for income driven loan programs 

The potential financial gains from a strategy of rapidly reducing student debt upon entering the workforce are examined for two student borrowers – one with a large federal undergraduate loan and the other with a mix of federal undergraduate and graduate loans and a private loan.

Student Borrower Number One:   The first student borrow is starting her career with a $50,000 per year job and undergraduate student loans totally $30,000 with an interest rate of 5.05% around the 2019 average student debt level for undergraduates.   

A person in this situation will typically take out a 20-year student loan.   Her payments on the loan will $198.82 per month.  Her total payment over 20 years will be $47,716.   

The person could more rapidly repay her student loan if she foregoes contribution to her 401(k) plan.   Assume she currently pays 10 percent of her income to her 401(k) plan.  If she foregoes this contribution her annual income tax will increase by $600.  However, she could increase payments on her 401(k) plan by $4,400 per year to a total monthly payment of $565.48. 

Under this assumption the student borrower would totally repay her $30,000 student loan on the 61stpayment.   Her total student loan repayment costs would be $33,837, a savings of $13,879.

The strategy of rapidly repaying the student loan causes the student borrower to fall behind on her accumulation of 401(k) wealth.  However, her student loan is totally paid off after 61 months and she could now make larger 401(k) contributions than the person who immediately initiated 401(k) contributions after leaving school.

The student borrower in this example could forego 401(k) contributions and make monthly payments of $565.48 for two years and then attempt to refinance the loan at a lower interest rate for a 10-year period.

The outstanding balance after two years of payments would be $18,932.

The person after reducing the loan balance that quickly might be able to refinance at a 3.0% interest rate.  The total student debt payments from this strategy, rapid repayment for two years followed by a 10-year loan at 3.0%, is $35,509 or $12,207 less than under a 20-year term.

The rapid reduction of student debt will lower the probability the person experiences debt payment problems and will substantially reduce expenditures on student debt.   

The results are even more dramatic for a student borrow that has a combination of federal debt and high-rate private loans.

Student Borrower Number Two:   The second borrower has three student loans, a $35,000 undergraduate loan at 5.05%, a $40,000 graduate loan at 6.66% and a $25,000 private student loan at 10.00%.    Intuitively, it makes sense for this student borrower to prioritize rapid repayment of the higher interest rate private loan.  In most instances, the strategy of rapidly repaying the private student loan necessitates the borrower forgoing contributions to a 401(k) plan early in her career.

The student borrower who chooses to set the standard 20-year maturity on all three student loans has a monthly payment of $775 for 20 years leading to total student loan payments of $200,633 over 20 years.

The student borrower who chooses to set the standard 20-year maturity for the federal undergraduate and the federal graduate loan and set a 5-year term for the private loan will initially have monthly student loan payments of $1,065.   

The monthly payment will fall to $534 after the private student loan is totally repaid, which is lower than the $775 payment that exists if the person kept to a 20-year term on all loans.  This means the person who chose the rapid private student loan repayment strategy could after 5 years make larger 401(k) contributions for the next 15 years than the person who chose a 20-year private loan term.

The total lifetime student loan debt payments for the person who repaid her private student loan in 5 years instead of 20 years is $146,271, which is a total lifetime savings of $54,362. 

This student borrower is in a good position to refinance her federal student debt to a private lower interest rate loan after repaying her private loan.  The cost savings estimates presented here may understate potential benefits from a strategy of rapidly reducing private student debt.

Concluding Thoughts:  The student borrower entering the workforce is often under intense pressure from financial advisors to immediately contribute part of their salary to a retirement account.  This approach can lead to financial disaster.   

The young adult with a modest salary and high student debt payments who prioritizes saving for retirement can fall behind on her bills, which can lead to poor credit ratings.   The deterioration in credit ratings will lead to high borrowing costs and other problems including difficulties renting an apartment, loss of job offers and higher insurance costs.  

Eventually, many people who choose to aggressively save for retirement will raid their 401(k) and maybe even sometimes pay taxes and penalties.  Increasingly, young and middle-aged adults are tapping 401(k) funds prior to retirement to meet current needs.  A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan   

The wiser course of action for young adults entering the workforce saddled with student debt is to rapidly repay student loans, especially but not exclusively high-cost private loans.  This approach will secure a solid credit rating and will reduce lifetime student loan payments by tens of thousands of dollars.

This post is part of a series comparing the traditional financial plan, stressing 401(k) investments and house purchases with 30-year mortgages to an alternative financial plan, which prioritized debt reduction, use of Roth accounts and use of 15-year mortgages.   The first post provided an overview of the alternative financial plan.  The next post, available in a week or so, will look at some problems with conventional retirement accounts starting with high fees on some plans.