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The Fight Over 401(k) Fees

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Retirement plan fees can cost participants nearly $155,000 over the lifetime of the plan, a white paper released May 29 by Demos, a liberal think tank, stated. The American Society of Pension Professionals and Actuaries, however, says the paper’s conclusions are based on assumptions that result in “sensational,” but ultimately incorrect, findings about 401(k) fees.

“There’s been a great deal of concern about fees” in 401(k) plans, Brian Graff, CEO of ASPPA, told AdvisorOne on Thursday. “That’s why we started lobbying for disclosure 10 years ago. To suggest that most Americans are taken advantage of is an outrageous and unfounded claim.”

In the white paper, “The Retirement Savings Drain: Hidden & Excessive Costs of 401(k)s,” Demos concludes that a median-income, two-earner family will pay an average of $154,794, or 30.3%, in total fees over the lifetime of their retirement plan.

To come to that conclusion, the white paper considered a hypothetical household wherein a man and a woman, both of whom earn the median income for their age and gender every year of their 40-year working lives, invested in a separate but identical 401(k). The working lives were assumed to begin in 1965 (even though 401(k)s weren’t available until the early ‘80s) in order to avoid having to estimate future earnings and market returns, and so that the hypothetical couple’s returns wouldn’t be affected by an economic expansion or recession.

Both workers began their career by saving 5.3% of their salary, gradually increasing the rate to 9.2% at age 65, without ever taking a withdrawal or missing a contribution. The 401(k) has two identical investments: a stock index fund and a bond index fund. The expense ratio for the bond fund is set at 0.72% based on the asset-weighted average expense ratio for its asset class. The stock fund expense ratio is set at 0.95%.

Robert Hiltonsmith, Demos

“Our fee numbers are actually conservative estimates,” Robert Hiltonsmith (left), policy analyst at Demos and author of the report, told AdvisorOne in an e-mail, “because they use the current (i.e., 2011) weighted-average expense ratio cited above for every year of the working lifetimes of the couple in our model (who work for 40 years between 1966 [and] 2005, chosen to be a midpoint in the business cycle), while in reality, expense ratios have declined by over 50% in the past two decades, meaning that our couple would have likely paid higher fees on their retirement savings in nearly all of the years they saved.”

The white paper assumes the trading fees for the stock fund in its hypothetical 401(k) are equal to the explicit expense ratio of 0.95% and trading fees for the bond fund are 0.50%, or 70% of its expense ratio. ASPPA, however, argues that “the assumption that trading fees are equal to the expense ratio has no basis in reality,” adding that “trading costs vary significantly based on the frequency with which the underlying investments are traded.” As such, it says, the paper’s assumptions are based on inaccurate data.

“In response to their criticism on trading costs (for which they provide no evidence whatsoever),” Hiltonsmith said, “we actually try to account for two different types of trading costs in our model: both the commissions paid by mutual funds to execute trades, and the bid/ask premium they must pay each time they buy or sell shares. We believe that, in fact, the assumption that the sum of both of these costs (which we refer to collectively as ‘trading costs’ in our paper) is equal to the explicit expense ratio is a reasonable one.”

Hiltonsmith referred to a white paper by Brightscope that cites four studies on trading costs. “Three of those studies estimate total trading costs for equity mutual funds to be over 100 basis points, greater than the average expense ratio. So yes, we believe that our assumption of 0.95% trading costs for our hypothetical ‘stock fund’ in our model and 0.5% for the hypothetical bond fund are reasonable ones. (Note that we don’t, as ASPPA claims, assume trading costs equal to the expense ratio, since the expense ratio for our hypothetical bond fund is 0.7%.)”

ASPPA also takes issue with the type of data used in the white paper’s assumptions. For example, to determine fees on the funds in the hypothetical 401(k), the paper used the asset-weighted average expense ratio for each fund’s asset class in 2010. Using March 2011 data from the Investment Company Institute, the paper assumed a 0.95% expense ratio for its hypothetical stock index fund based on the average fees and expenses paid by a stock fund investor in 2010, and a 0.72% expense ratio for its bond index fund. ASPPA argues, though, that expense ratios for index funds are “typically significantly lower than the 95 basis points stated in the white paper.” According to the 2012 ICI Fact Book, the asset-weighted average expense ratio for index equity funds in 2011 was 14 basis points. For index bond funds, it was 13 basis points.

However, Hiltonsmith said that he didn’t use expense ratios for index funds only, because not everyone is invested in index funds. “We’re trying to model the actual fees paid by households invested in the current retirement market, not hypothetical or optimal fees (i.e., if everyone were invested in index funds—an outcome, by the way, retirement experts do not agree is necessarily optimal, since there are some actively managed funds that consistently outperform indexes),” he said. “So, this is why we chose 0.95% and 0.72% expense ratios of the stock fund and bond fund, respectively, in our model: because they’re the actual asset-weighted average expense ratios paid for stock and bond mutual funds, i.e., those are precisely the average expense ratios currently being charged to assets invested in stock and bond mutual funds.

“It’s ridiculous to suggest that our model should use the (not-so) typical index fund expense ratios suggested by the ASPPA, when that’s not what participants are actually paying,” Hiltonsmith concluded. “Not everyone has access to index funds through their employer plan (particularly not such low-cost ones).” 

The white paper calls for a “complete overhaul” of the individualized retirement system that replaces 401(k)s. “The multitude of risks and excessive fees are in reality consequences of the 401(k)’s individualized, inefficient structure, and are an inherent part of that structure,” the paper states.

ASPPA countered by saying “401(k) plans have enabled countless workers to have adequate retirement savings.” The organization points to data from the EBRI/ICI 401(k) Accumulation Projection Model, examines how 401(k) assets might contribute to retirement income for future retirees. According to the model, which is a collaboration that the Employee Benefits Research Institute and the Investment Company Institute first undertook in 2002, workers have an income replacement rate of more than 106% when they combine Social Security benefits and their 401(k) accumulations, compared with a replacement rate of less than 52% by depending on Social Security alone.

Brian Graff, ASPPA“The lead up to transparency has made the industry significantly more competitive,” Graff (left) told AdvisorOne. “The tragedy of misinformation is that it may discourage consumers from saving, which is the last thing this country needs.”


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