Retirement Income Blog

There can be no question that saving for your own retirement is a financially sound and important thing for you to do, and one of the most common and popular methods of doing this is by investing in a 401K plan at your place of work. But what you may not know is that not all 401K plans are the same.

If you are like many people in the United States, the chances are that you have had several jobs over your working life and, as a result, still have a number of 401K plans with different former employers. Or perhaps you have recently retired, but are not yet ready to cash in your 401K plan(s). Whatever your individual circumstances may be, you should be aware that your 401K plans could actually be costing you money.

Under the current laws, not only are the companies administering your 401K allowed to charge maintenance and service fees, but they are also not required to inform you what those maintenance and services fees are. Some insurance companies and stock brokerage houses are charging as much as 4% or 5% per year off the top for the plans they administer, which can significantly decrease the annual yield and value of your plan. (There are also fees and charges associated with maintaining IRA accounts, and generally there will be management or transaction fees associated with most products.)

Specific fees that are considered to be “hidden” are:
 Trading costs, commissions between fund managers and brokerage firms
 Soft dollar “excess commissions” paid to brokerages pursuant to Securities
 Exchange Commission (“SEC”) rule 28(e)
 Sub-shareholder (participant) servicing fees - called “sub-transfer agent fees”
 (“Sub-TA”)
 Account distribution (sales) based 12(b)-1 fees
 Account servicing based 12(b)-1 fees
 Unitized variable annuity wrap fees
 Variable annuity mortality costs
 “On-the-fly” pass through fees
 Retail versions of institutional funds (i.e. funds that could be purchased at a lower price but are not, due to fiduciary ignorance)

Unfortunately, managers at many companies have signed on with 401k sponsors and simply do not understand the fees involved.  Since the fees are not paid by the company, bu rather by you and the other participants, they have small motivation to look hard at the fees.  In fact, a study by Spectrem Group showed that most plan sponsors don’t know what they pay. 

So unless you ask and thoroughly read the prospectus and make sure onerous fees are not being levied against your account, it’s best to do an IRA rollover and not leave your funds in a high priced qualified plan.

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Years ago, I explained to a prospective client that my annual fee to manage her portfolio would be 1% of the portfolio.  She replied, “why would I pay that when I don’t pay anything for my mutual funds.”  Unfortunately, this public ignorance of what investors pay their retirement advisor is pervasive.  In fact, you’d be shocked to know that even executives at companies don’t know what they pay to have their 401k plan handled.  Spectrem Group surveyed plan sponsors and found that even half of the executives with plans of $50 million and more did not know how their representative was paid.

Don't Know Amount of Compensation Paid to Broker/Retirement Advsior by Size of Plan

Here’s how your retirement advisor is paid.

1. If you own mutual funds, the funds are likely load mutual funds which means you paid a fee when you invested (typically 4%) AND you pay an annual fee for management and distribution likely about 1.75% of the total.  Alternatively, you paid no upfront fee and pay an annual fee of 2.25% (including management and 12b-1). Note that these fees are fully disclosed in the prospectus but few people ever read it.  Not disclosed in the prospectus is the “slippage” cost which occurs when a mutual fund buys and sells large blocks of stocks.  This costs the average stock fund investor another 1.2% annually.

2. You may also own mutual funds in a fee-based account.  If these are “institutional class funds” such as DFA or Vanguard, your mutual fund management  costs are much lower.  There is no font end or back end load.  The mutual fund does have internal fees approximating .25% annually.  On top of this, your retirement advisor likely charges a fee for managing the mutual fund portfolio of 1% for a total annual cost of 1.25%. Slippage costs in these funds are minimal because institutional class funds do little trading.

3. Additionally, you may pay your advisor fees for planning on an hourly or project basis (e.g. for a retirement plan).  These fees may be from $100 to $250 an hour and are fully disclosed to you.  By law, a retirement advisor that gets paid fees directly by you (as opposed to situation #1 above where the fees are buried in the mutual fund share price) must disclose them clearly.

If you are confused, ask your retirement advisor to put the TOTAL costs of your investments in writing.  Ask him to enumerate:
1. the front end load or commission paid upon entry into the investment
2. the back end load or commission when selling the investment
3. the annual ongoing management fees and 12b-1 fees
4. advisory fees paid directly to the retirement advisor

If you don’t get a document you can clearly understand, change advisors and ask for this disclosure before investing.

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There are 3 ways that financial advisors or retirement advisors can charge in the US:

They can charge commissions based on transactions.  For example, when you buy or sell a stock or a bond.  The typical fees to a full service firm ,e.g. Merrill Lynch, where you value their research and recommendations, maybe 2% for a transaction.  So if you buy $10,000 of stock, your financial advisor fee is $200.  The same transactions can be made through any discount broker for $9.99 so you better feel that their advice is worth the commission paid to a full service broker.  At least when you buy an exchange listed stock, the financial advisor fee is transparent and printed on the confirmation.  (This is not true if you buy a stock in which your broker is also a dealer–the markup on your purchase is similar to a bond purchase described below).  By the way, your Merrill Lynch broker gets 35% of the commission he generates and Merill keeps the other 65%.  If your financial advisor is independent and does not work for a large firm but works with an independent broker dealer, then he keeps typically 90% of commission generated.

Not so if you purchase a load mutual fund or a bond.  In the case of a load mutual fund, the financial advisor fee is set by the fund and buried in the prospectus.  Typically, this fee will be 4% of the initial investment (i.e. $400 on a $10,000 transaction) or 1% annually.  if you don’t read the prospectus, you won’t see the financial advisor fee printed on the confirmation.  In the case of a bond, the fee is not disclosed.  Guidelines allow the brokerage firm to buy bonds, mark them up as much as 5% and then sell them to you for the 5% profit. The profit is not disclosed to you.  You may be shocked that this is the way financial advisor fees work on Wall Street.  Welcome to your education.

The second way that financial advisors assess fees is a non-transaction based system.  Foe example, they may manage your portfolio and charge you 1% annually of the portfolio value.  This system usually requires you have at least $100,000 portfolio and the financial advisor fee is $1,000 annually on such an account.  These advisors must have a registered investment advisor certificate (most financial advisors do not as they charge commissions) and with a registered investment advisor, the fee is fully disclosed in a separate management agreement and on your quarterly statement.  Your account is held at a discount brokerage firm that earns $9.99 each time there is a transaction in your account.  Your advisor gets no portion of that so he has no incentive to make trades.  His incentive, based on the structure of his financial advisor fee, is to keep you as a cliert for a long time (so he gets to collect the fee each year) and make your account grow (as that’s the only way he gets a raise).

A registered investment advisor may also charge fees for time.  For example, to do a a financial plan that may take 10 hours he charges $1,500.  Again, this is fully disclosed in the investment management agreement you must sign. Close to this would be a fee charged for a project.  Let’s say you own eight rental houses and want to know which homes are best to sell given the tax implications and cash flow.  The advisor can take on a project either for an hourly fee or project fee on which you both agree.

Last, some financial advisors charge incentive fees.  However, US regulations only allow wealthy investors to pay incentive fees because the government believes this is a risky way to invest.  The typical hedge fund, which requires a $1 million investment (and thus only deals with accredited or wealthy investors) will charge a financial advisor fee of 2% annually plus 20% of profit.  The belief is that this financial advisor fee structure incents the advisor to take larger risks because he gets a piece of the profit and thus the government allows such arrangements only when the investor is wealthy.

If you don’t know how you are being charged, ask.  Fees could be hidden and you may be shocked to learn how you pay your financial advisor and what you pay for retirement help.

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