No, this is not another Enron, WorldCom, or other corporate scandal but a perfectly legal way that many 401(k) and 403(b) plan advisors and administrators charge excessive fees that can cost the plan participants a big chunk of their retirement savings. The real shame is most employers and plan participants never realize what has happened or how much it has cost them.
In the beginning . . .
In 2003 the 403(b) plan at a non-profit organization I volunteered for was typical of high cost plans. It was invested in variable annuities sponsored by a large insurance company. Many of the employees suspected the plan might be costing them a lot of money but did not know how.
How High Are the Fees
They were right. According to Morningstar the average variable annuity has an annual fee of 2.08%. This fee does not include any one-time sales charges known as loads of up to 5.75% that many funds in charge, or additional annual fees of up to 1% or more charged by the plan advisor.
These fees significantly reduce the overall investment return to the plan participants. In the example above, if the underlying investments in the plan returned 9% and the total fees were 3.08% the participants would receive a return of 5.92%. In addition, the fees would not be disclosed on the statements provided to plan participants. This insidious practice is very common in employer sponsored retirement plans.
What does this mean to the average participant?
If a particiapant invested $10,000/year (adjusted for inflation) for 40 years with a 9% return (before fees), she would accumulate approximately $2,400,000 but pay fees of almost $875,000, assuming an annual annuity fee of 2.08% and an additional advisor fee of 1%.
Contrast this dismal example with a plan composed of low-cost index funds with an annual fee of 0.25% in which the plan advisor and plan administrator charge a flat fee which is not based on the assets in the plan. For an organization with 100 employees, this could be around $13,000/year. In this case, the employee would have almost $4,800,000 and paid total fees of only $120,000.
In the variable annuity plan the participant would only have accumulated half of the retirement assets that she would have in the low-cost index fund plan.
Click below to see a graph of estimated retirement savings
Retirement Savings Comparison
Next Blog — Part 2: How do “Bad” investment options end up your retirement plan?