Since the documentary The Retirement Gamble aired on PBS earlier this year, people are more aware of fees in 401k-type plans. In this article, I quantify the effect of a high-cost 401k plan. The result may be quite surprising to you.

First let’s look at a worker with a median income and a median savings rate. Suppose you earn \$50k a year and you contribute 6% of your salary to your 401k plan. Your employer matches another 3% of your salary. You plan to work there for five years, which is the median tenure at an employer these days.

Suppose your employer’s 401k plan has a very high cost. Your all-in expense ratio is 3%. How much worse off are you in this high-cost plan versus a very low-cost plan with an expense ratio of 0.1%?

I calculate the dollar impact as the additional money that must be contributed into the high-cost plan every year to make you whole as someone else in a low-cost plan. I do my calculation in today’s dollars, adjusting for inflation.

The answer: \$342 per year in today’s dollars. If the employer contributes additional \$342 per year for each of the five years you work for it, you will have the same amount of money in your 401k plan with an all-in cost of 3% versus a nearly perfect plan with an all-in cost of 0.1%.

When someone with a median income and a median savings rate is choosing between two employers, the difference between one employer with a high-cost 401k plan and another one with a low-cost 401k plan comes down to just \$342 a year. I’m sure other factors such as salary, career growth, job stress, commute time, cost and quality of health coverage, etc. etc. play a much bigger role.

Now we look at a higher-paid employee. Suppose you earn \$200k a year and you contribute the maximum to the 401k plan, \$17,500 in 2013. Your employer matches another 5% of your salary. You also plan to work there for five years. How much worse off are you in a high-cost plan with 3% cost versus a low-cost plan with a 0.1% cost?

The difference is much larger: \$2,090 per year in today’s dollars. It’s something, but still, when you are looking at a \$200k job, I’m sure other factors, again, career growth, salary, bonus, vacation time, job stress, commute time, company culture, etc. etc. are worth much more than \$2,090 a year. If I’m choosing between one job that pays \$200k a year and another that pays \$198k a year, I may very well pick the one that pays \$198k for those other reasons.

I’m all for lower cost in 401k plans. However, this exercise tells us we shouldn’t fret about it, especially when these days employees typically don’t stay at an employer for that long. As long as you remember to take the money out of a high-cost plan when you leave, the cost of a high-cost plan isn’t really that high. Whether the cost is 3% or 0.1%, contribute anyway. Don’t let the high cost scare you away.

The cost of a bad 401k plan goes sharply up if you are going to work for the same employer for 10, 20, or 30 years. If you are going to work there for a long time, there must be some good reasons; otherwise you would go somewhere else. Those good reasons make you stay. The bad 401k plan just becomes part of the tradeoff for those good reasons. No job is perfect. Remember the good reasons.

If you’d like to double-check my calculation or play with other scenarios, you can use my spreadsheet: how bad is a bad 401k.

[Photo credit: Flickr user deeplifequotes]

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1. KD says

Very timely article for me. The trustee of my 401k plan shared with us that the bundled cost of our plan was 1.03%. This put us in the first quartile which extends from 0.24% to 1.04% according to 401k averages book (http://www.401ksource.com) for the number of participants and asset size we have. I was infuriated so this calmed me down. I am still making my case for index funds in the plan that are low cost. We have index funds that cost arm and a leg and many actively managed funds. Thankfully, the S&P 500 index fund is somewhat cheap (0.24%). The total bond fund isn’t too bad either in tracking aggregate bond index but it is expensive (0.76%).

• Harry says

By all means advocate for a better plan. An employer can make every employee better off by hundreds of dollars every year without costing itself any more money if it just picks a more competitive vendor. I’m just saying if the people in charge don’t see the light, the cost to an employee at the personal level isn’t that high. Just treat it as a cost of employment, same as buying work clothes, commute time, dealing with an unpleasant boss, etc.

2. Alskar says

We’re going to have to agree to disagree on this one. While I agree with your basic premise, I take issue with some of your assumptions, particularly about matching.

Since the 2007 (when the stock market peaked) I have had three jobs. That is consistent with your assumptions. However, none of these three jobs paid ANY matching. So essentially the high fees in the 401(k) plan have been coming out of my pocket, directly reducing my retirement income. What makes me particularly angry is the fact that these three employers could have picked a plan that was less expensive for them and for me, but because of ignorance, laziness, and probably a bit of graft, they choose not to move to less expensive plans. I fail to see how that is consistent with their fiduciary responsibility to run the plan for the “sole benefit of the participants”. I don’t even see how this is good for the company. I see this as un-American in the extreme.

In a day and age when one can get Vanguard Admiral Class mutual funds in a plan with only an 8 bps custodial fee (as currently offered by Employee Fiduciary), I fail to see how plans with an average expense ratio of 1.03% (as described in the comment above) are even slightly acceptable. The fact that a plan with 1.03% average ER is in the first quartile is more of an indictment of the whole 401(k) system than comforting. Essentially what this means is that 1.03% ER is pretty great…that really should make us all sick to our stomachs. Instead, we all say “okay”. Speaking for myself, this really ISN’T OKAY! That is outrageous!

My money is my money to spend on my retirement not for some Gucci shoe-wearing, Mercedes convertible driving, stuffed shirt from Marin to use to buy a ski cabin in Vail. I resent paying high fees for retirement accounts and I have left employers that refused to find cheaper 401(k) plans.

Rather than passively accepting high fees, I think we all should be outraged. A few more high profile lawsuits like the one against Edison International, Tussey v. ABB and Fidelity’s class-action lawsuit in addition to more media coverage like the Front Line show you referenced might motivate employers to make better choices.

Nothing is going to change unless we all as a society insist on change. Acceptance may be good for one’s equanimity, but it will not change a thing.

3. DonB says

You can pretend it doesn’t make much difference, but it’s a just a lie. By your own calculation, if I invest \$3000 per year but my fees are high, I need to kick in an extra \$342 (or my employer does). In other words, I have to kick in 7.6% more money every month to cover a couple of percent in fees.

And that was because you used a time frame of only 5 years. If I work for 10 years that number jumps to more like 17% more money every month. God forbid I stay in chump investments like this for a 30 year career, because I need to invest 70% more money every month.

You pretend that it doesn’t make much difference. It only doesn’t make much difference if the time period is short. If you don’t get yourself out of a stupid investment as soon as possible, then the difference is no longer small.

• Harry says

A match, or lack thereof, and fees (in the negative column) are part of one’s total compensation, together with salary, bonus, career advancement, health plan, vacation, hours worked, commute time, cafeteria food, and a list of other things. Zeroing in on 401k fees while ignoring those other parts of the total compensation misses the forest.

It’s a whole package. Give me a good salary, a good bonus, a pension (!), a good match, good opportunities to build skills and advance, less job stress, I will gladly take 3% 401k fees. I will take it for 30 years if I get those good things for 30 years.

4. DonB says

“Itâ€™s a whole package. Give me a good salary, a good bonus, a pension (!), a good match, good opportunities to build skills and advance, less job stress, I will gladly take 3% 401k fees. I will take it for 30 years if I get those good things for 30 years.”

If you keep contributing \$3000 each year and earn an 8% return on your money, by the 11th year, the fees eliminate your match entirely. By the 22nd year, not only is your match gone, but so is your \$3000 contribution too. Fees eat them both together.

By the 30th year you have accumulated \$280,450 with the fees you propose. Without those fees, you’d have nearly \$460,000.

It’s a little better if you assume that you get a 3% raise each year. In that case fees don’t eliminate your match until the 12th year, and it’ll be about the 28th year before the fees are eating both your contribution and match together. But there’s no question: your math is short-term thinking. It’s only a good deal for a few years at best.

• Harry says

You are still not looking at the forest. The match, and the \$3,000 I contribute, come from my employer to begin with. I don’t mind losing them at all, even for 30 years, if I’m compensated in other ways by a good salary, a good bonus, a pension (!), good opportunities to build skills and advance, less job stress, etc. etc. If I’m working there for 30 years, it means those things in the positive column outweigh the fees in the negative column.

I would think those who work for the same employer for 30 years tend to have a pension. If I have a pension I will not complain about 401k fees, but if the employer pays a poor salary, no bonus, has no opportunity to grow, lots of stress, I won’t stay just for the pension. I actually left a job that had a pension before the pension vested. Again, look at the whole package.

5. DonB says

“You are still not looking at the forest.”

I’m going to respectfully disagree. You’re changing directions mid argument. Your first calculation was that a good match makes up for a lousy fee structure. But that’s really only true in the short term, and that’s why it feels like smoke and mirrors to me. After 25 years of being in bad investments (because of the fees), those matches will all be gone; they might as well have never existed. You could do better without the match and better fees.

It is of course true that there may be other things that make a job attractive. A pension is great. A higher salary, or better benefits is great. I don’t disagree. But I don’t want a person to read your article and that calculation and think for one minute that it’s okay that their plan charges 3% (because they’re getting a match and it makes up for it).

People do stupid things. They sign up for bad funds, and they let them ride even when they change jobs instead of cashing out into a sensible IRA. So here’s a perspective. Consider just that first \$3000 contribution, made that first year of work. Let it grow at any rate you like and consider 3% fees with a match vs. 0.1% fees and no match. After 15 years, you might as well not have had the match; beyond 15 years it’s even worse.

The only proper way to look at high fees is that it makes any match more pathetic, not that a good match makes up for a bad fee structure. Fees are like a (big) discount rate that applies to your match.

• Harry says

A good match is among a long list of things that I said that will make me accept a 3% fee for 30 years. You somehow plucked it out as if I said it will do the job by itself. What is a good match anyway? A match at 3% of salary is just mediocre, not good (Vanguard report, page 14). Regardless whether the match makes up for it or not, there’s no reason to pair only the match against the high fees. That’s mental accounting. I will take it one step further: I will take no match and 3% fees for 30 years if I get those other good things. Look at the whole package. That’s the point of the article, in the second-to-last paragraph, and in my replies to comments.

6. Roger @ The Chicago Financial Planner says

Interesting post and I want to say up front that my perspective is both as a financial planner for individual clients and as an advisor to several 401(k) plans.

First I’ve never seen a plan with costs as high as 3% or as low as 0.10%. As an example one of the plans I advise has an all-in cost of 0.57% (excluding my fees which the company pays) with a mix of active and passive choices. This includes fund expenses and administration.

I would agree, however, that the quality of the 401(k) plan itself should not be a determining factor in choosing an employer or deciding whether or not to take a new position. I would agree that no matter how bad or high cost the plan is that is generally makes sense to contribute at least enough to get the full company match.

The Retirement Gamble was a good show in that it helped to put the focus on many of the flaws with retirement plans, but it was also quite biased and failed to shed light on 401(k) savings success stories (I count a number of these as clients) and the really good plans out there. Bad journalism in my opinion.

• Alskar says

@Roger

I am probably one of the “401(k) savings success stories” to which you refer. I have saved about 8x my annual salary and I’m 53. However, that was done with the benefit of 401(k) matching during a period when the equity market did extremely well. I have not had any 401(k) matching since 2006, so the high-fees I’m currently paying (~1% of AuM) are coming straight out of my contribution. You wrote, “I would agree that no matter how bad or high cost the plan is that is generally makes sense to contribute at least enough to get the full company match”. In my experience, 401(k) matching has disappeared from smaller companies entirely. So why would I pay 0.57% of AuM in a 401(k)?

I have seen a 401(k) plan with 3% fees and despite what you say, it ABSOLUTELY affected my willingness to work for that company. I turned down their offer and went to a different company that had lower salary, lower 401(k) fees, and more vacation. A company with a 401(k) plan that has 3% fees is at the very least hostile, and my view criminal…literally. I think executives of that company should be in jail for failure to perform their fiduciary duty to their employees.

401(k) record keeping costs about \$25 per employee per year. All “revenue sharing” should be returned to the employee. Custodial fees of 8 bps of AuM are readily available. Vanguard Admiral Class mutual funds are available from several 401(k) providers including Employee Fiduciary. If the company feels like they need an advisor to keep them from going to jail, they should pay for that representation themselves, as I don’t want it or need it. So in my mind an all-in cost of 20 bps (0.20%) is not only desirable but achievable. That less than one half of the plan you use as an example.

Here’s my solution: Change the tax code so the limits on IRA’s and 401(k) plans are identical and to allow people that are eligible to contribute to a 401(k) to contribute to their IRA instead. I can then “opt out” of any 401(k) plan and contribute instead to my IRA in a pre-tax manner with the same limits. My IRA has a weighted average of 18 bps of AuM. Can’t beat that in any 401(k) plan I know of.

Employers should not be in the retirement business. Their fiduciary duty to their shareholders is in conflict with their fiduciary duty to their employees to run the 401(k) plan solely for the benefit of the employees.

• winthorpe says

0.10% is possible.

I work for a large-cap company with a \$55 billion market cap and tens of thousands of employees.

The index fund options in our plan broadly cover just about all investable global assets and have ERs 0.05% to 0.16%.

The weighted average ER of my personal 401k portfolio is 0.11% (+ a \$30 annual administrative fee, which adds another 0.01% to my cost)

7. Alskar says

@Harry,

I think we’re all seeing the forest, you just have different priorities. To pick the trivial case: If I could work at a place where I had 6 weeks of vacation a year, a low-stress job, and pleasant co-workers, I wouldn’t need to save for retirement because I’d be so happy that I would just work until I died.

Personally, I would take a HUGE pay cut in order to have at least 4 weeks of time off a year (paid or unpaid). If that pay cut came in the form of a 401(k) with large fees, I would probably just save money in taxable accounts instead of participating in an expensive 401(k) plan. If this hypothetical employer paid matching and had high fees, I would probably choose to participate in the 401(k) plan just as you describe.

Study after study shows employees want more time off and are willing to take a pay cut to get more time off, but in my experience employers are reducing paid-time-off (PTO) not increasing it. Give me salary cut and more time off and I’m there! Two weeks of vacation isn’t enough for me.

8. Choy says

I don’t believe this post offers any real value other than to help someone justify their own bad feelings about a bad 401k.

What would be valuable is if you analyzed whether it was still worth it for an employee with a bad 401k to contribute to that 401k or invest their money elsewhere. It’s complicated when you think of the different variables. How high are the fees? Is there a match? What tax bracket is the person in? How long does the employee plan to stay with this company? I would appreciate seeing an analysis that showed break points for when a person should consider investing outside of a bad 401k.

9. S. B. says

I think the reason people are jumping all over this is because of the post title. The title in isolation seems to imply that bad 401(k) plans are nothing to get excited about, or perhaps even that a bad 401(k) plan isn’t much different than a good 401(k) plan.

The content of the post and the comment replies indicate something much different. The main idea seems to be that your 401(k) plan is only one part of your total compensation package. I can agree with that. If the total compensation of a particular job is very high, provides excellent benefits, and so forth, it might not matter whether it even offered a 401(k) plan. So I agree with the post, but maybe a clearer title would be better.