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You're doing your 401(k) wrong 

Hundreds of thousands of retirement dollars could be at stake.

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If you're among the 79 percent of American workers whose employers offer a 401(k)-style retirement plan, you may have a foggy memory of someone, maybe in HR, explaining the plan to you. It's possible that soon after you heard "401(k)" your eyes crossed and you started daydreaming about lunch. Even now, you may be close to abandoning this article because you can tell there are going to be numbers involved. But first read this: If you are not putting money away in a 401(k) or some other retirement vehicle, you will regret it one day. Retiring with no source of income besides Social Security means you will grow old in relative poverty or be forced to work well past 65, and that's assuming Social Security survives in its current form for the foreseeable future. If you are taking advantage of a 401(k), especially if your employer matches some portion of what you are contributing, you're getting free money (!) to invest alongside your own pretax income that will put you on the path to getting to do what you want after retirement. Unfortunately, among eligible employees of companies that offer plans, only 41 percent participate.

But if you do indeed put money aside in a 401(k), don't relax just yet. Many people with 401(k)s are unwittingly paying fees that add up to hundreds of thousands of dollars lost from their retirement savings. If, say, you're contributing 10 percent of your salary to your 401(k) for most of your working life, it may well be the biggest purchase you ever make. How much will it cost? Most people don't know the answer.

Forty or 50 years ago, many American workers knew they could retire one day because they had a pension waiting for them along with their Social Security benefits. Employers were responsible for saving and investing money, so that when their workers reached retirement age, they received a specified amount, usually based on length of employment and salary history. This pension model is known as a defined benefit plan.

But pensions were expensive for employers to maintain, and in the 1980s and 1990s, many companies eagerly ditched them in favor of 401(k) plans. Named for an obscure addition to section 401 of the federal tax code in 1978, the 401(k) allowed workers a tax-free way to put money aside, but the idea didn't catch on until the early '80s, when a retirement consultant came up with an idea to incentivize participation through a match from employers.

Today, only 10 percent of workers over 22 have a pension, and the 401(k) has become the dominant retirement savings vehicle. With a traditional defined benefit pension, employees got stability and predictability without having to take any action. In contrast, a 401(k) plan is what's known as a defined contribution plan. Employees who take advantage of the plan determine a percentage of their salary to defer from their paycheck, pretax, into mutual funds or other investments (the IRS-defined contribution limit is $18,000 for 2017). Often, employers match some portion of the contribution. Compared to a pension, a 401(k) is more like do-it-yourself retirement, even if it's facilitated and often incentivized by employers. Workers have to make a number of decisions: Should they participate at all? If they do take advantage of the plan, how much can they afford to contribute? How should their investment be spread between stocks and bonds? What specific funds should they select?

Few people answer all these questions correctly, Tim Quillin, of Aptus Financial, says. Not that he blames them.

"Everyone seems to feel like they're supposed to know more than they do," he said of investing in 401(k) plans. "We don't have any problem going to other professionals, to doctors or lawyers, but when it comes to this area, a lot of people feel like, 'I can figure out those fund choices, no problem.' They say, 'Bonds, oh yeah, I've heard of those, I need bonds, or 'Growth, yeah, gimme some growth.' " Or they get lost early in the process and make random selections. Complexity, apathy and embarrassment are three of the main forces of evil working in the 401(k) ecosystem, Quillin says.

Aptus sees the typical 401(k) plan as almost obsolete. It's working to reinvent the model. Sarah Catherine Gutierrez founded the Little Rock firm in 2011 as "a response to how the rest of the industry gives advice." Most financial services companies take money from clients, invest it for them and charge a percentage fee on that investment — or assets under management. Another, increasingly popular model is to invest clients' money for them on an hourly, fee-only basis. Rather than holding and investing clients' money, Aptus recommends a financial plan and directs its clients to execute the plan themselves. For its advice, Aptus charges a flat fee or hourly rate.

Financial advisers who make money based on the assets they manage are often faced with conflicts of interest, and their services cost more than they should, says Gutierrez, who has a master's degree in public policy from the John F. Kennedy School of Government at Harvard University and spent years working at Stephens Inc. as an analyst. "If you look at the average fees someone would pay up front or over time, we're just a small fraction. When you charge a fixed fee, you're kind of agnostic. We don't financially benefit if you pay off student loans or invest."

Aptus' model requires more volume than other financial advisers because many of its clients are one-time only. So, in six years, Gutierrez and her colleagues have seen hundreds of people. One common theme: Many clients' 401(k) plans include fees that, over the course of an investment, could cost hundreds of thousands of retirement dollars — and they have no idea.

click to enlarge GUTIERREZ: Since founding Aptus Financial in 2011, she's seen hundreds of clients with 401(k) plans with high fees.
  • GUTIERREZ: Since founding Aptus Financial in 2011, she's seen hundreds of clients with 401(k) plans with high fees.

Take Jennifer, a young attorney at a large Little Rock law firm, who makes about $95,000 and whose work involves reviewing financial transactions (her name has been changed). A risk assessment test — with questions such as, "If you had a vacation planned and you suddenly lose your job, would you cancel the trip even though you might never be able to take the trip again?" — told her that she's conservative for her age when it comes to money matters. She's read books by celebrity financial advisers like Suze Orman and Dave Ramsey, and followed their advice to pay off her highest-interest loans first. When she became eligible for her firm's generous 401(k) plan — it matches two-thirds of contributions up to 6 percent of its employees' salary — she elected to defer 12 percent of her salary. "I remember hearing that 10 percent was standard, so I thought I'd do 12 to get a little bit ahead," she said.

But when Jennifer asked Gutierrez to review her 401(k), Gutierrez noticed that Jennifer was solely invested in one fund that cost 1.44 percent in fees. That might sound like nothing, but compound interest adds up over the years. Gutierrez recommended another fund offered by Jennifer's firm, with fees totaling 0.25 percent. Considering a rate of return of just under 6 percent, the fees in Jennifer's original fund could cost her almost $300,000 by the time she retires at 65. It could mean the difference between her annual income in retirement being $37,000 per year vs. almost $49,000.

"I was kind of embarrassed," Jennifer said when Gutierrez explained the cost of her plan. "I felt like I should have known better. I knew I needed to look at it sometime, but I figured if I was putting a certain percentage in every month, I'd be fine."

click to enlarge THE GAP GROWS WIDER: After 30 years, the difference between a mutual fund with fees of 1.44 percent and one with fees of .25 percent could amount to almost $300,000 for Jennifer.
  • THE GAP GROWS WIDER: After 30 years, the difference between a mutual fund with fees of 1.44 percent and one with fees of .25 percent could amount to almost $300,000 for Jennifer.

Jennifer isn't alone in not considering fees. "Most Americans don't know [fund fees] exist," said Sheryl Garrett of Eureka Springs and the CEO of the Garrett Planning Network Inc., a network of 240 hourly, fee-only financial advisers. Garrett's experience is supported by a 2011 study by AARP, which found that 71 percent of Americans don't think they pay any fees at all. Or if they do know about fees, Garrett says, "They say, 'Oh, my employer must pay those." But the industry is fees, Quillin says.

"Because we've had a stock bull market over the last 35-40 years, some of the problems have been masked. This whole industry is set up to generate fees for the companies that service 401(k)s. But [people] will never know. There's no counterfactual. It's not like buying a house and someday selling it and realizing you paid too much."

Another problem with Jennifer's plan? Too many options. "To do what's in a client's best interest is to eliminate the crappy choices," Garrett says. "You want to have fewer, better choices," Quillin echoes.

Quillin joined Aptus earlier this year after almost two decades as an analyst, mostly with Stephens Inc. He was Gutierrez' boss at Stephens and they became friends and stayed in touch when she left. He came to Aptus after the firm successfully bid on managing a small company's 401(k) plan, and Gutierrez and Quillin realized a different take on the 401(k) model could be a growth opportunity. Much like its other individual financial counseling work, for a 401(k), Aptus charges fixed fees, offers a lineup of low-cost funds and focuses on individual financial wellness.

To understand how that model might be different from a more typical plan, consider the three main players with their hands in the 401(k) cookie jar:

There's the adviser, who is chosen by the employer and who selects a lineup of mutual funds and meets with employees to explain the mechanics of the plan. Advisers typically make money based on a percentage of the plan's assets under management, but they could get paid through sales commissions or 12b-1 fees, which are annual marketing or distribution fees paid out of an individual fund's net assets to advisers. Critics call these kickbacks that amount to a conflict of interest.

There's the recordkeeper or custodian, which keeps up with the nuts and bolts of the plan. The recordkeeper is often selected by the adviser. It deposits and withdraws money in accounts and generates all the paperwork associated with a plan. Recordkeepers typically charge per participant, but in some instances charge as a percentage of assets. "That doesn't make sense," Quillin says. The cost of the administration they have to do is only a function of the number of people they keep track of; the work doesn't get harder as a plan's assets grow.

There's the cost of the individual mutual funds or other investment vehicles themselves, for the research or tools the fund managers use to beat or match the market. That cost is often reflected as an expense ratio on a plan's lineup of funds, but there could also be sales commission charges, called front- or back-end loads, which could be charged when participants first buy or sell funds.

click to enlarge COMPLEXITY, APATHY AND EMBARASSMENT: They are three of the primary forces of evil in the 401(k) ecosytem, says Aptus' Tim Quillin.
  • COMPLEXITY, APATHY AND EMBARASSMENT: They are three of the primary forces of evil in the 401(k) ecosytem, says Aptus' Tim Quillin.

Those three parties often work together in ways that obscure what they're charging in a 401(k). Another Aptus client we'll call Amber was a teacher at a private school when she received an email from the school's finance department about her 401(k). It said that one of the funds in the school's 401(k) lineup would no longer be offered and assets in it would be transferred into a new fund if participants didn't act before a certain date. That move would affect Amber — and she chafed at the idea of being forced into a new investment — so she forwarded the letter to Gutierrez, who noticed right away that the fees mentioned on the letter looked off. The plan said it was moving from a Vanguard fund with a 1.04 expense ratio to a Blackrock fund with an expense ratio of 1 percent. "They were saying, 'Hey, tada, we're giving you lower fees,' " Gutierrez said.

The mutual fund company Vanguard popularized low-cost investing and pioneered the idea of so-called passive investing through index funds, where rather than buying a mutual fund made up of a collection of assets assembled to beat the market, an investor buys a specific sampling of the market, such as the S&P 500 index. Because there's no research or staff to speak of necessary to buy the market, Vanguard and other passive funds have much lower fees than actively managed funds. Gutierrez knew that Vanguard charged significantly less for that particular fund, somewhere between .10 and .16 percent. Meanwhile, the BlackRock fund that Amber was being forced into was greatly underperforming the Vanguard fund. With Amber's permission, Gutierrez contacted the administrator in the school's finance department whose name was on the email Amber received. The administrator said she had never seen the email and couldn't explain the rationale for the change and referred Gutierrez to the plan adviser. He also said he didn't know about the change and couldn't explain it. That, at best, was "odd," Gutierrez said.

It's unclear exactly what the motivation for the fund switch in Amber's plan was and who stood to profit by it, but the lack of transparency bothered Amber. "It didn't seem right," she said.

Aptus isn't alone in Arkansas in seeing the inflated costs of an average 401(k) plan as a business opportunity. Allen Engstrom is managing director of CFO Network, a North Little Rock company that provides financial consulting for businesses. Several years ago, he noticed on his own 401(k) statement that his funds were underperforming the market. The more he looked, he found that his embedded fees — "small percentages, each one seemed innocuous," he said — were eating up his return. He took an average salary at his firm and modeled out the cost of fees over the course of the hypothetical employee's career. It amounted to over $420,000, or 38 percent of 401(k) return at retirement. In searching for a better way to have a plan, he researched a range of advisers, administrators and investment platforms. "We ended up with a solution that my employees are happy with that brought our fees down, on average to 5 percent" over the course of their career, he said.

That experience led Engstrom to add 401(k) evaluation as one of CFO Network's services. "Nobody out there that has a vested interest in telling the [401(k)] story. They're all conflicted to some extent. We're totally independent. We don't have a dog in the hunt. Companies hire us as independent consultants. We facilitate the process of understanding what kind of plan they have, model out the fee-impacts on employees, and do a discovery process, where we go through and interview the employees and employer to understand what they want out of their plans. Every one we've done, we've found similar results. Fees were all well north of 30 percent, and we've gotten them down into the mid-single digit range."

The other thing Engstrom learned in his research into his own plan: As the trustee, he was potentially liable for excessive fees. In the last decade, 401(k) investors have filed a number of lawsuits, many of them successful, against large corporations that offered plans with excessive fees under the Employee Retirement Income Security Act (ERISA) of 1974.  

click to enlarge SAW A BUSINESS OPPORTUNITY: After realizing how much his own company was paying in 401(k) fees, CFO Network's Allen Engstrom began to offer 401(k) evaluation as one of its services.
  • SAW A BUSINESS OPPORTUNITY: After realizing how much his own company was paying in 401(k) fees, CFO Network's Allen Engstrom began to offer 401(k) evaluation as one of its services.

On June 9, a new U.S. Department of Labor rule covering retirement plans, originally conceived in the Obama administration, went into effect. It requires the adviser on all retirement plans to be a fiduciary, which means she is required to put her clients' interests before her own. "One of the duties of the Department of Labor rule is not to waste clients' assets," Garrett says. "It's interpreted into the wording. I like using those words: We have a duty."

Garrett believes the new rule and more ERISA class-action lawsuits will have an impact on the industry. "I really think we're going to see a very dramatic change in qualified plans offered by employer groups, where the plans will either be changed or switched up. There will be better costs, better transparency and better recordkeeping."

But Quillin thinks real reform will only come from below.

"Nobody in this ecosystem really has a strong incentive to change it. Current providers have no incentive. The [employers], as long as they have a 401(k) and the villagers aren't storming the castle, they're pretty happy with letting things continue as well. Until people care, until employees care, the world isn't going to change. We can have regulatory reform — like this new fiduciary rule, which may or may not help, and may or may not be repealed or watered down by the new administration — but until people really take an active interest in their retirement plan, the world is not going to change."

So what do you do know?

The easiest way to figure out how much your 401(k) plan costs is to ask the plan's adviser or whoever is the point person for the plan in your company for a breakdown of all the fees levied. That might be the only way to truly know how much you pay.

Other routes: Look at your statement and note the expenses deducted from your balance. Virtually all plans offer participants a way to access information about their lineup of mutual funds (and possibly other investments) online. There, you can see an expense ratio — a collection of costs charged annually, expressed as a percentage of assets — for each mutual fund. To see a breakdown of those expenses, which could include 12b-1 fees, administrative fees, management fees and operating costs, you'll have to find the mutual fund's prospectus, which is often available on a 401(k) portal. The prospectus may describe certain fees, including front-end load commissions, which are charged at the initial purchase of an investment, in terms of maximum charges. So again, you're back asking for info from your adviser or administrator.

Another thing to look for on your company's 401(k) mutual fund lineup is how the funds have performed against a benchmark — usually an index of the broader market or a segment of the market — over the course of one, five and 10 years. Aptus Financial recommends that 401(k) plans offer passive target-date, low-fee index funds that reallocate among stocks and bonds as an investor moves closer to her target retirement date. Allen Engstrom, managing director at CFO Network, points to target-date passive investments and robo-advisers, which provide automated investment advice at a low cost, as among the ways companies can reduce the cost of their plan.

But true financial guidance can be worth the cost, James Alger, senior vice president and chief compliance officer at Simmons First Investment Group, says.

"When you look at retirement accounts, people's retirement dollars, one of the biggest mistakes that investors make, if they're long-term investors, is getting out of the market. They can be overcome by short-term fears, and fears make them react and they make the wrong move."

Behavioral management can be an important role of an adviser, too, Alger said. "What did you do in 2008, 2009? Did you stay put or did you get out? If you look back, you would have been better off staying put. ... If they got out, they really messed up."

Sheryl Garrett, CEO of Garrett Planning Network Inc., said that though she used passive investments to dramatically lower her own 401(k) plan's fees, costs aren't the only factor to consider. "Everything doesn't have to be less than X percent. Maybe having a little bit of exposure [to a certain market] is important for diversification."

But, Tim Quillin of Aptus said, "The passive vs. active debate is a little bit of a red herring. The issue is really fees." Research shows that actively managed funds have long underperformed their passive peers, Quillin said. It's hard enough for stock pickers to beat the market, but especially so when they have to beat the market and an assortment of fees.


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