401k Investing - In most 401(k) plans, participants tend to fall into two categories that we can refer to as, “the frustrated” and “the unaware”. The “frustrated” are savvy and relatively well educated. They are aware that their plan’s investment menu offers mostly high-cost mutual funds that the offerings are generally limited and under-performing. The “unaware” don’t realize they are paying fees at all. A recent AARP study showed that 7 out of 10 participants in 401k plans thought their plan was free. In other words, they thought they were paying no fees at all.
The main problem is if participants stick to choosing from the limited menu of funds offered in most plans, the cost can be quite high. A major reason why the funds offered are so expensive is that they are by-and-large, actively managed, which countless academic studies have shown often under-perform their index fund counterparts. According to Morningstar, the average “retirement share class” mutual fund carries an expense ratio of 1.15%. A recent Deloitte study revealed that smaller plans, with under $1M in assets, carry an average expense of 1.80%. Then there are what are called “Group Annuity 401k plans”, sold by insurance companies, that can charge asset based fees ranging as high as 2%-3%. In all cases these expenses are deducted directly from the invested assets of the plan participants.
401k Investing: The Brokerage Window
There is a solution. Participants can significantly reduce their costs and at the same time reduce their overall investment risk and even increase their expected rates of return. First they need to take advantage of a feature that currently exists in or can be added to virtually any 401k plan called the “Self-Directed Brokerage Account” (SBDA) or sometimes referred to as “the Brokerage Window”. This feature is like having access to an online discount brokerage account attached to your 401k. With the Brokerage Window, participants can purchase just about any type of security they want including stocks, bonds, and low-cost Exchange-Traded Funds (ETFs). Due to this increase in investment choice flexibility, this feature is in increasingly high demand by participants. Today 30% of 401k plans offer the Brokerage Window feature up from 18% in 2007, based on an Aon Hewitt study.
401k Investing: Access to Exchange-Traded Funds (ETFs)
Some argue that the Brokerage Window gives the average 401k plan participant too much latitude in choosing investments, essentially giving employees enough rope to hang themselves and believe that plan participants should only play in the sandbox of the limited menu of options. We disagree. We believe that empowering investors with a little guidance can make all the difference in the world. Virtually anyone can be shown how to build their own low-cost, diversified, portfolio using exchange-traded funds (ETFs). ETFs are an excellent way to purchase asset classes that mirror market indexes (i.e. S&P500 Index) at an extremely low cost. Asset classes meaning, large companies in the US, small companies in the US, international stocks, stocks from emerging market economies, etc. Today, an investor can build a broadly diversified portfolio comprised of 60% equities and 40% fixed income, where the fund expenses total no more than 0.12%. That is an enormous savings over the 1.15% to upwards of 3% mentioned earlier. Like the Brokerage Window, the ETF market has seen significant growth in recent years. Today there is approximately $1.8 trillion invested in ETFs compared to about $200 billion ten years ago.
401k Investing: Why Should You Care?
Let’s take an example of an investor who is 40 years old and has saved $100,000 thus far. If he or she, is contributing $10,000 per year and is able to shave 1% from their fees and average an 8% return (rather than 7%) over the next 25 years of their working career…they will have made an additional $200,000 in return over that time!