Ever wonder how Wall Street makes money off of your 401k? Why are they so interest in the few thousand dollars that you put away each year. Well it adds up trillions of dollars invested and they take their piece of it each year.
First there are fees associated with the 401k plan itself, the company that administers the plan. You can find out those fees by asking your HR department to get a disclosure of those fees, but even on a more basic level the mutual funds themselves that are options in your 401k plan cost money.
Next time you log into your 401k plan’s website, and click through the selection of mutual funds look for something called an expense ratio. This is the percentage of your money that the mutual fund grabs each year to pay for the administration of the fund, including the salaries of the portfolio managers as well as the marketing, bookkeeping, and other costs of the fund and a healthy profit margin. These fees can be anywhere of 0.04% all the way up to 1.5% or even higher.
Obviously, you want to stick to the lower end of the spectrum. If you find a fund with a ratio of less than 0.2% you are probably dealing with an index fund. An index fund is one that tracks a basket of pre-determined stock (like the S&P 500 which are simply the 500 largest publicly traded companies). These do not take a lot of work to manage and are therefore cheaper for the mutual fund company to run – passing the savings off to you. We at Frugalbrag recommend making these as the basis of your portfolio as they provide some built-in diversification and major cost efficiency.
There are of course mutual funds that are actively managed, with portfolio managers who try to pick the right stocks and the right time in order to beat the market. Refer to this article for a write-up on when and if we should consider this type of mutual fund, but in general you should consider these for a smaller percentage of your portfolio – perhaps 20% or less.
These actively managed mutual funds are where you want to be really careful with fees as they can get really high. As a general rule, you should avoid ones with expense ratios above 1%. The reason being is that not only do these funds have to outperform the market (a feat that is very difficult to do), but they have to outperform it by 15-20% consistently (even harder to accomplish) in order to break-even once you factor in the higher fee charged.
One percent might not seem like much, but if the market gives you a 7% return on average, 1% represents 1/7th or 15% of your total return. Let’s remember how important those returns are to your compounding returns – making either 7% or 6% (if one percent is given away to the fund manager), can result in huge differences over two or three decades. This can mean tens of thousands (or even hundreds of thousands depending on balances and duration) in lost earnings on your investments due to high expense ratios. Here is a handy calculator that you can play with that shows the impact of expense ratios – it’s scary.
This is why investing in index funds that don’t try to be heroes and just match the market, but also let you keep the majority of your returns by charging miniscule expense ratio fees of 0.04 – 0.2% are the way to go for the bulk of your 401k investments.
