401(k) vs Index Mutual Funds - Which Will Cost You Less

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Last updated on January 22, 2022 Comments: 6

A few years ago, new regulations mandated that 401(k) retirement plan administrators change quarterly statements to include more information about expenses about each fund in which the employee is invested. This was a good move.

I have mixed feelings about 401(k) plans. Today’s world of employment is different than that from a generation ago. For those in the middle class, having a career meant, for many, sticking with the same company for a lifetime. Even after retirement, that company would take care of its employees with pensions and health benefits. With a growing middle class and some difficult periods of economic uncertainty, companies were unable to meet their pension obligations.

Wall Street stepped in. The financial industry pushed the idea of personal responsibility for retirement — it’s difficult to argue against that concept. While the industry introduced products to help individuals invest for their retirement, the government enacted legislation that created tax incentives for those who were able to put aside some of their income for later.

Today, many companies automatically enroll new employees in 401(k) plans. This can be described as an advantage, encouraging younger employees to create a more secure retirement without much effort. The first steps — deciding how much to set aside for retirement and choosing the investments — are often the hardest, and they stop many people from enrolling in retirement savings plans as early as they should. Sometimes the stopping point is just the idea that someone — particularly young employees — aren’t earning enough to set aside anything for retirement. Automatic enrollment solves these problems and moves employees forward with their retirement savings quicker than any other options.

The same automatic enrollment approach to 401(k) is a great benefit to investment companies — particularly, the managers of mutual funds, the companies they work for, and the companies that administer plans (third parties standing between investment companies and employers offering the 401(k) plans). The default enrollment often includes an investment allocation that includes funds that are more expensive than necessary.

Index mutual funds outperform actively managed mutual funds over long periods of time. Managers who attempt to beat the market just can’t. Index mutual funds, for the most part, are also much less expensive to manage than actively managed funds. Index funds change their underlying investments less often than other funds, and those other funds quickly rack up transaction fees. Add that to compensation for the mutual fund managers — which they receive whether their funds perform well or not — and the total cost of these funds doesn’t justify their performance or lack thereof.

CNN Money recently referred to a recent study that showed that some employers cost their employees $100,000 more than others for their average employee’s retirement.

“For example, let’s say Employee A works for FedEx, while Employee B works for Best Buy. The employees are the same age (25), have the same salary ($55,000), same annual wage growth (3%) and put the same chunk of their salary in their employer’s 401(k) plan each year (10%).

After 40 years, Employee A would have a final account balance of nearly $830,000… Employee B, meanwhile, would start retirement at age 65 with a nest egg of roughly $743,000 — almost $100,000 less.”

You can beat these averages by getting more involved in your retirement allocation. Choose the lowest cost index fund available. And if there isn’t one, raise the issue with your human resources department.

A few years into my first major job out of college, working for a non-profit organization, the company finally began offering enrollment in a 403(b) plan — the non-profit version of the 401(k). You would expect this type of fund to have better low-cost investment options than the average 401(k), but that wasn’t the case. A small organization like the one I worked for didn’t have many options for working with those third-party retirement plan administrators, and didn’t have the standing to negotiate lower fees or better deals for employees.

Although I wasn’t as experienced with personal finance as I am now, I still saw the plan as a raw deal for the employees.

Sometimes even the best investment option in a retirement plan isn’t very good. But if you’re still living with whatever the company decided you should be invested in, or if you followed your company’s automatic guidance based on your risk profile, as I did when working in the financial industry, chances are you’ll either be retiring with less money in your nest egg or you’ll be waiting longer to retire.

The other option includes evaluating your investment options, choosing low-cost index mutual funds, and doing more to take control of your retirement investments than just allowing your employer to automatically enroll you in something that benefits the financial industry more than it benefits yourself.

As I’ve seen in my own 401(k) plans, it can be hard to determine the true cost of your investments. My former company offered its employees a small-cap index fund, which seemed to be a good choice for balancing retirement funds between a variety of company sizes. Of course, what I should have done would be sticking to the low cost index fund that matches the S&P 500 or a similar index without concerning myself with company sizes, but I was strongly influenced by the company’s own model portfolios used in its risk models.

I liked the idea of balancing my investments with a small-cap fund. What I didn’t realize is that the account was actually an annuity — or a mutual fund that had some annuity features. The expense ratio, the typical measurement of a fund’s management expenses, was listed as 0%, and I thought that was a great deal.

I should have known an expense ratio of 0% was too good to be true; there were expenses built into this fund that were not disclosed in the expense ratio.

Over time, I’ve moved all of my retirement funds into low-cost index mutual funds. While the investment choice is no guarantee that I’ll have the biggest nest egg possible when I reach the age at which I’ll begin withdrawing these funds, it puts me in a better position to have a higher investment balance than I would had I remained in high-cost investments.

Keep your retirement expenses low:

  • Check your quarterly 401(k) statements.
  • Read your investment prospectuses occasionally, and understand how the fees are communicated.
  • Don’t blindly accept the default investment allocation.
  • Select low-cost index mutual funds over other options.

Article comments

Anonymous says:

Luke a few thoughts as both a financial advisor to individual clients and as an advisor to several 401(k) sponsors:

The 401(k) is imperfect, but it is still one of the best retirement savings vehicles around. I have several individual clients who have amassed ( or who are on track to amassing) considerable nest eggs in large part via their 401(k) plans. Their secret: regular and substantial contributions and a sensible investment strategy.

Any rule such as only invest in index funds is, in my opinion, unwise. Don’t get me wrong I love index funds and a substantial portion of my individual client’s portfolios are invested there. Likewise every 401(k) plan that I advise includes at least several low cost index choices for participants. However, there are a number of very solid actively managed funds available. I generally include several in client portfolios and in investment menus of the 401(k) plans that I advise. That said I do have access to the lower cost institutional shares of many of these funds.

Lastly I think auto-enrollment is a positive thing for retirement savers, especially when combined with auto-increase (a feature that a growing number of plans use to allow participants to automatically increase the percentage of salary deferred each year).

Luke Landes says:

I’d be interested in what you think of this Marketwatch article, where the position is that 401(k) plans that offer actively managed funds, which underperform and are more expensive than the index funds that track related benchmarks, could be viewed as illegal.

Using actively managed funds in asset classes where index funds are cheaper and perform better, Kwak argues, “violates the existing fiduciary duty of employers and plan trustees to invest participants’ money prudently,” making it theoretically illegal under the federal pension law known as ERISA.

Source: http://on.mktw.net/YT2QqB

Anonymous says:

Luke I caught that article and found it interesting. One key point was “Using actively managed funds in asset classes where index funds are cheaper and perform better,…” I’m a huge index fund fan, but they don’t always outperform. As a financial advisor who is agnostic about which fund family I recommend I am often able to put plans into lower cost shares of both index and active funds than those that might be available to the general investing public. Contrary to what the press likes to report, there are many actively managed funds that have reasonable fees and year in and year out provide top level performance. As I said in my last comment any rule that mandates index only or anything else only is just silly and presumptuous in my opinion. Worse yet it will ultimately prove detrimental to retirement savers in the long run.

Anonymous says:

I only invest in low cost mutual funds and a few individual stocks. My current employer offers some low cost companies, but there can be some significant fees. I managed to workaround the fees by going self directed. If I did not , I would incur a percentage fee on top of what ever the mutual fund company charged. I saved hundreds of dollars a year.

Luke Landes says:

Sounds great — those hundreds of dollars add up not only by themselves but thanks to all the earnings you’d achieve on that money that you wouldn’t have otherwise.

Anonymous says:

My return rates have skyrocketed since I made the switch to index funds!