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.

Outline of an Alternative Financial Plan for the New Generation

  • Traditional financial strategies, which prioritize accumulation of wealth in a conventional retirement plan, as soon as people enter the workforce are not working for many households.
  • The alternative financial strategy outlined here involving — aggressive elimination of student debt, greater use of 15-year mortgages, the use of Roth retirement accounts instead of conventional accounts, and additional investments outside of retirement accounts — will reduce financial stress and lead to a more secure retirement than the traditional financial plan.

Many households are struggling with historic levels of debt.

Average student debt for college graduates in 2019 was 26 percent higher in 2019 than 2009.  Around half of bachelor’s degree recipients in 1992-1993 borrowed to finance their education, compared to around 65 percent today.

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. A study by the Employment Benefit Research Institute (EBRI) reveals that 40 percent of terminated participants elect to prematurely takeout 15 percent of plan assets. A poll of the Boston Research Group found 22 percent of people leaving their job cashed out their 401(k) plan intending to spend the funds. 

Statistics presented in a recent Business Economics article show that people who tap 401(k) plans prior to retirement were more likely to have taken out consumer loans, were more likely to have a poor credit rating and were more likely to be underwater on their mortgage than people who did not tap their 410(k) plans prior to retirement.   

A CNBC portrayal of the financial status of millennials nearing the age of 40 found many members of the age cohort highly leveraged struggling to pay down student debt, using innovative ways to obtain a down payment on a home and barely able to meet monthly mortgage payments.

2019 Congressional Research Service Report found that the percent of elderly with debt rose from 38% in 1989 to 61% in 2021.   The Urban Institute reported that the percent of people 65 and over with a mortgage rose from 21% in 1989 to 41% in 2019.  A 2017 report by the Consumer Finance Protection Board found that the number of seniors with student debt increased from 700,000 to 2.8 million over the decade.

The standard financial plan, proposed by most financial advisors, emphasizing large contributions to traditional 401(k) plans instead of aggressive reduction of consumer and mortgage debt often fails to provide a secure financial outcome.  Future outcomes will be worse, barring a change in strategy in financial strategy, because people are starting their careers with higher debt burdens.

The aggressive pursuit of long-term investments in stocks and bonds instead of rapid reduction in debt is especially problematic in the current market environment where stock valuations are stretched, and interest rates are at historic lows.   The purchase of expensive securities inevitably leads to subpar returns when valuations return to more normal levels.

The alternative financial strategy proposed here differs from the traditional financial strategy in four important respects.   

First, the alternative approach prioritizes the establishment of a solid credit rating, the creation of an emergency fund and the rapid reduction of student debt for individuals leaving school and entering the workforce.  The achievement of these goals usually requires new entrants to the workforce delay or reduce 401(k) contributions for a number of years when starting their careers.

Second, the alternative financial strategy places a high priority on the growth of house equity and the elimination of all mortgage debt prior to retirement. 

Many households with less than stellar credit purchase a home with a subprime mortgage.  Subprime mortgages tend to have high interest rates, adjustable rates with short adjustment periods, a balloon payment, and restrictions on prepayments.  The alternative financial strategy opposes the purchase of a home with an unfavorable interest rate or subprime features.

Most households currently use a 30-year fixed rate mortgage.   The alternative financial strategy recommends the use of 15-year mortgages, either through the original home purchase or through a refinancing, to reduce lifetime mortgage payments and to accelerate growth in house equity.  

Many financial advisors currently recommend additional catch-up payments to 401(k) plans for workers nearing retirement even when the worker will retain a mortgage in retirement.   The alternative financial strategy prioritizes mortgage payoffs over additional 401(k) contributions.

Third, the alternative financial strategy utilizes Roth retirement accounts instead of conventional retirement accounts. 

The decision to use Roth rather than conventional retirement accounts can increase tax burdens in working years; however, there are multiple other ways for working-age households to reduce current tax obligations.  In particular, contributions to health saving accounts linked to high-deductible health plans reduce current-year tax obligations, reduce insurance premiums and like retirement accounts increase income during retirement.

The use of Roth rather than conventional retirement accounts directly reduces tax obligations in retirement, reduces the marginal tax rate for people with other sources of income and indirectly reduces tax on Social Security benefits for some households.

The use of Roth rather than conventional retirement accounts reduces the amount of money a person must park in stocks inside a retirement account because the investor no longer needs to save for taxes on disbursements.  The lower taxes from use of Roth accounts reduces financial exposure to market downturns.   

Retirement account fees will be lower on Roth accounts because the total annual fee is a percent of total invested assets, which is lower because tax on Roth accounts is paid prior to contributions.   

The use of Roth rather than conventional retirement accounts will substantially reduce tax on inherited IRAs.   This savings is larger today because of recent changes in tax rules governing inherited IRAs.

Fourth, the alternative financial strategy makes greater use of investments outside of retirement accounts including investments in stocks and investments in inflation linked bonds. 

Retirement accounts are an effective way to defer taxes until retirement.  However, the existence of assets outside a retirement account reduces tax obligations during retirement years.  

Disbursements from conventional retirement accounts are taxed as ordinary income while taxes on capital gains and dividends are currently taxed at preferential rates.   (The tax preferences for capital gains and dividends may be reduced by the Biden tax plan.) 

The availability of funds outside a retirement account are especially important when retirement accounts have high annual fees and interest rates are low.  The effective interest on some bonds held in retirement accounts is negative when the retirement account has a high annual fee. 

There are no fees associated with the purchase bonds directly from the U.S. Treasury.  These bonds have relatively low market risk.  The purchase of Treasury bonds with specific maturity dates is an effective way to hedge against market down turns impacting consumption during retirement.

The traditional approach to retirement often centers on the question – How much money should be placed in a 401(k) plan in order for you to retire?   There are even calculators that create estimates of the amount people need to place in a 401(k) to retire with adequate income.

The actual amount of wealth you need to place in your retirement account is indeterminate.  The amount you need to save depends on several factors including whether the retirement account is Roth or conventional, retirement account fees, amount of debt, whether you plan to downsize, the quality of your health insurance and the tax status of assets outside your retirement account.

The alternative financial strategy outlined in this introductory memo recognizes that financial security cannot be summarized by the dollar value of a 401(k) plan.  A person with large net worth dominated by large equity holdings in a conventional 401(k) plan is faced with large future tax obligations and is perpetually exposed to a market downturn, especially if she has a monthly mortgage bill to meet.  The person could be better off with a lower 401(k) balance if she had paid off her mortgage, put money in a Roth rather than a conventional retirement account, and purchased some inflation-indexed bonds.  

Several features of the alternative plan presented here will reduce the amount that you must contribute to a retirement plan and the amount you pay over your lifetime in retirement plan fees.  Fees charge by retirement accounts are not a trivial matter.  This report by the Center for American Progress reveals a median-wage worker might pay $138,000 in retirement fees over her lifetime.

The traditional goal of financial planners is the construction of a portfolio that will allow retirees to initially distribute 4 percent of the 401(k) balance and maintain that distribution level though out retirement.   The 4 percent rule often fails to provide a sustainable level of consumption in retirement with the largest failures occurring when portfolios are closely tied to the market and the market takes a downturn early in retirement. 

Some financial advisors advocate a more flexible distribution rule that mandates reductions in distributions during market downturns.  It seems as though a strategy calling for sharp reductions in distributions during retirement is an admission that the financial strategy planning for retirement was a failure.  An alternative financial strategy which includes alternative investment including, I-Bonds, E-Bonds and perhaps annuities, will lead to more stable consumption patterns in retirement.  The alternative financial strategy would include a more stable and sustainable rule determining monthly distributions of funds.

The upcoming blog posts presented here and a larger formal paper will describe the potential benefits of the alternative financial strategy in greater detail.  A detailed discussion on how to best rapidly reduce student debt and the potential advantages of the debt elimination strategy will be available at this blog soon.

Complicated rules for inherited retirement accounts

The 2019 Secure Act changed rules governing distributions from inherited IRAs and 401(k) plans.  The new rules prevent some beneficiaries from stretching withdrawals across their lifetime.    This CNBC article does a good job explaining the rules.

The new rules require many people who inherit a 401(k) plan to take disbursements within a 10-year period. However, there are some exceptions for minors and spouses.   

The clock for disbursements over a 10-year period starts at 18 for minors inheriting a Roth IRA.  However, prior to becoming 18 the minor must make a required minimum distribution RMD based on life expectancy.  The RMD for minors should be really small because minors have a large future expected life.  This rule might make sense if the IRA or 401(k) is huge but is it rational for people who inherited a small account?

The distributions from Roth accounts are tax free while the distributions from conventional accounts are taxed as ordinary income.   I guess the Treasury will gain some tax revenue from accelerated Roth distributions if the funds are invested in assets with taxable interest, dividends or capital gains.

The distributions over the 10-year window can occur in any year.  Since Roth accounts are not taxed it may make sense to distribute the funds in year 10.  Conventional accounts are taxed; hence, taxpayers may want to spread distributions across years.

Funds not distributed by year 10 are subject to a 50% tax.  Ouch!

Spouses who inherit an IRA do not have to take distributions until age 72.

The time frame for distributions for people who inherit an account through probate is 5 years not 10.  Hence, it is important to name a beneficiary on your 401(k) or IRA.

Many people who inherit IRAs or 401(k) plans have modest income.  This bill requires distributions even when the person might be better off saving for retirement.    Many people inheriting a small IRA or 401(k) are not wealthy.

The bill was passed during the Trump Administration.     Trump Administration and Republican tax policy was in general very generous to high-income people but not averse to using complicated rules to get a bit more tax from some people who may be middle income.