Your 401K Plan Is Ripping You Off

Don’t Be A Blockhead About Your 401K

I recently received my company’s annual 401K performance and expenses disclosure packet.  This is super secret information that 401K providers don’t want you to know about, but they’re obligated by law to mail it out at least once a year.  Mine came in a very innocuous looking white envelope.  The packet inside presented “Investment Related Information” in tiny 10 and 8 point fonts.  It seemed like it must be something unimportant like an advertisement or a standard legal disclaimer.

It was all so boring looking that I was tempted to immediately throw it in the trash.  That’s probably their hope.  Instead, I decided to get out my magnifying glass and investigate this bland little document.  It seemed to contain:

  1. The performance of each fund in the 401K plan as compared to its benchmark on 1, 5, and 10 year intervals, and since fund inception.
  2. The fees charged by the 401K provider for any interactions with them, like requesting a hardship withdrawal.
  3. The fees and expenses charged by each fund, even though you can’t interact with them.

This sounds like pretty interesting information after all.  How surprising!

The Business of 401Ks

Well, maybe it’s not that big a surprise.  Many personal finance bloggers have discussed the hidden costs and other issues associated with most employer 401K plans.  If you really want to get depressed about your company’s 401K plan, at the end of this post is a list of additional articles on the subject.  From a business perspective, 401K costs and fees aren’t in the least surprising.  After all, 401Ks are run by finance businesses, and they’re in the business of making money from money, not handing out free candy.

A Mindful Analysis

I’m not going to tell you whether you should participate in your company’s 401K or not.  This is already covered by the by some of the articles I reference below.  My rule-of-thumb is that if you get a substantial match from your company, then it probably makes sense to participate in your 401K plan.  A match is free money, and even if the 401K provider takes a cut of that free money each year, whatever’s left over is still free money.  Just be sure to do the math and make sure there’s something left over!

Instead, I want to conduct a mindful analysis on the super secret data from my 401K plan, because I think it provides a good example of 1) what to watch out for and 2) how to get the best deal possible from your 401K plan.  I’ve never seen an analysis of performance versus expenses for a set of funds offered by one 401K plan, although perhaps someone has done that somewhere in the vast blogosphere.  So, my hope is to contribute something new to the discussion.

The Critical Stats

First, we need the key facts.  Because I’m only examining my 401K, there may be tons of 401K plans out there that are much worse in terms of performance and expenses.  I don’t want anyone to accuse me of taking unfair potshots at this particular 401K plan.  So, I’m sanitizing the names of my 401K provider and fund offerings in this analysis.

This table provides a summary of the each fund’s one-year performance and total annual fees (as a percentage), as well as a comparison to the fund’s benchmark performance for the same period.  “Total fees” is my short-hand term for all fees and expenses.

All performance data are after 401K plan fees are subtracted out.  The fund performance is compared to benchmark performance in the third column titled “return difference”, which is just the fund performance in the first column minus the benchmark performance in the second column.

Where the values in the “return difference” column are positive, the fund outperformed its benchmark, which is also called “excess return”.  Where values in the “return difference” column are negative, that means the fund had a lower return than its benchmark.  Right away, you can see quite a few negative numbers in the “return difference” column.  This means that most of these funds provided no excess return above the benchmark performance, which in turn, means that I’d have been better off just putting my money in an index fund that tracks the benchmark.  However, most of these benchmarks aren’t offered as index funds in my 401K plan.  That’s our first sign that the 401K plan may be exploiting investors.

The table highlights (in green) three rows representing low-cost index funds, because, as summarized in mindfully investing Article 7.3, low-cost index funds are usually the most mindful way to invest.  The table also highlights (in light red) the four bond funds in the plan, for reasons that will become apparent in a moment.

Picking Winners

You can get a better sense of these data in a graph.  This graph shows green dots for index funds, red dots for bond funds, and blue dots for actively managed stock or stock/bond combination funds.

The graph plots excess return (the difference between the fund performance and benchmark) on the horizontal axis and the total fees on the vertical axis.  The green dot index funds are at the bottom of the plot, because their fees are so low.  We can also see that only four funds beat their benchmarks and had excess returns (positive values on the horizontal axis).  These four are all red dot bond funds.  Not a single one of the blue dot actively managed stock funds was able to beat its benchmark in the last year.*  This is our second clue that 401K plans may be cheating us, or at least that’s true of this particular plan.

Just in case you think I’m biasing the data somehow by using the “excess return” metric.  Here’s the same graph, but showing the total net return on the horizontal axis.  Total net return dispenses with any comparison to benchmarks.  It’s just the return you’d get in your 401K account at the end of the year by investing exclusively in any of these funds.

This shows even more starkly the relative poor performance of most of the blue and red dot actively managed funds.  If your just looking to maximize your net return, your still usually better off with one of the green dot index funds.  There was one actively managed fund that attained returns similar to the index funds, at just above 15%.  However, it’s benchmark got 17.3% returns, which means you’d still be better off with an index fund mimicking that benchmark, if one was offered.  Maybe you were thinking that those red dot bond funds were looking appealing in the first graph.  But this second graph shows those bond funds are all lagging the pack of actively managed fund performance.  So, actively managed bond funds wouldn’t be a great choice either.

Just to drive home the point, here is one more graph comparing total fees in dollars per $1,000 invested on the horizontal axis to the total net return per each dollar in fees on the vertical axis.

This graph is one way to illustrate the value you get (vertical axis) for the money you spend (horizontal axis).  The value is investment performance, and the money spent is the hidden fees you pay to the funds.  Clearly, the three index funds maximize performance for each dollar paid to the fund managers.

Mindful Conclusions

At the outset I said my example would help illustrate 1) what to watch out for in your own 401K plan and 2) how to get the best deal possible from your 401K plan.  Let’s take each in turn.

  1. What to Watch Out for
    • Closely examine both the total fees and total returns of each fund in your 401K plan.
    • Compare the performance of each fund to its benchmark.
    • Compare the performance of each fund to its fees.  Typically, you’ll find that higher fees means lower or equivocal performance.
    • Make sure your 401K plan has some index fund offerings.  If it doesn’t, ask your employer whether they can be added for the reasons illustrated here.
    • Make sure the “index” fund fees are appropriately low.  From my example, we see the index fund fees should be about an order of magnitude lower than actively managed fund fees (something like 0.1% instead of 1%).
  2. How to Get the Best Deal Possible
    • Put all your contributions into the low-cost stock index funds available in your 401K plan.
    • If more than one stock index fund is available, spread the contributions over several types of index funds to get some diversification from what’s available.  In my case, I contribute to the large cap, mid cap, and small cap stock index funds in my plan.
    • The mindful investing approach suggests that investing solely in stock index funds is sufficient for most people.  Despite the apparent “risks” associated with stocks, you probably won’t benefit from using bond index funds, if they’re available.  This assumes you are emotionally confident enough to execute the mindful approach.
    • You might be tempted to invest part of your money in more expensive funds in an attempt to get more diversification.  If you feel you need more diversification than offered by your 401K index funds, then it’s probably more cost-effective to obtain that additional diversification outside your 401K using other taxable or tax advantaged accounts.

You don’t have to create graphs like I did here to make these determinations.  In most cases, a simple but close examination of the data table provided in your 401K packet will allow you to easily determine which funds are giving the best value for the fees charged.  If you don’t want to expend even that level of effort, you can probably just look for the word “index” in the fund names and then verify that the total fees for those funds are correspondingly low (less than 0.1%).

Finally, I said I wouldn’t divulge the names of any of the funds, but I feel it’s important to mention that all the index funds in my example are from Vanguard.  It’s pretty easy to see why Vanguard has been in the news recently for virtually taking over the investing world.  In the last three years, $823 billion has been invested in Vanguard funds, as compared to just $97 billion for the rest of the entire mutual fund industry.  Vanguard is outpacing the entire industry by a factor of 8.5.  Assuming more people hear the news about low-cost indexing and start to examine their annual 401K information packets, I can’t see Vanguard’s dominance diminishing anytime soon.

Further Reading

*I don’t present the performance data for 5 and 10 years or the data since fund inception, which were also provided in my packet.  However, I evaluated these additional data and verified that the vast majority of actively managed funds failed to outperform their benchmarks across all these time frames. 

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