NEW YORK (MainStreet) — Extrapolating the fees of the mutual funds in your 401(k) or IRA can be exasperating since the lack of transparency makes it difficult to compare various funds.
The complex nature of how the expense ratios are calculated or why they are not explained in a simple fashion continues to confuse and frustrate investors.
The Department of Labor does not require expense ratios to be broken out in a simple line by line method, said Greg Carpenter, CEO of Employee Fiduciary, a 401(k) plan provider for small businesses in Mobile, Ala.
“If they did, plan participants could review the 401(k) fee disclosure and follow the money without needing a Ph.D. in economics or math,” he said. "More importantly, plan participants could make apples to apples comparisons as they decide how and where to invest their retirement savings."
The key figure investors should focus on is the investment expense ratio charged by mutual funds for the assets held in the plan, Carpenter said: “You need to know how much you’re paying in order to ask the next question - is a certain money manager worth a 2% annual draw on your fund earnings or would you be better served with a low-cost index fund?”
Investing would be more straightforward if retirement and brokerage firms were more transparent in disclosing their fees.
“We had hoped the fee disclosure rules would help investors understand and take even more ownership over their retirement planning,” he said. “So far the results have been totally negligible. We spend a fair amount of time educating our prospects and clients about our fees because we fully disclose our pricing unlike other providers who may have their fees hidden in the fund’s expense ratio.”
Fees, Dusted Under the Rug
While your statement may not show the fees, all investors are paying a variety of underlying fees every year on top of their management fee, said Sara Rajo-Miller, wealth manager for Miracle Mile Advisors in Los Angeles.
Identifying funds that offer transparency, low fees and a history of strong performance is critical.
“Lower cost alternatives such as ETFs and index funds have surfaced as the better option,” she said. “The fee differentials for mutual funds compared to ETFs are generally over 1%. Most actively managed funds underperform their benchmark.”
The more irritating and costly factor is the price that a client pays when he goes from one platform to another, said Patrick Morris, managing partner of HAGIN Investment Management in New York. Since not all platforms have the same product offering, if you currently own a blend of funds on Schwab and go to Fidelity, there is not a transition team that helps port the clients’ assets into funds that did not end up either double charging or overcharging the client in terms of fund share types.
“Yet my experience is that this service is not common,” he said. “In fact, the service is discouraged. The fee disclosures have been a nagging thing in the industry for a long time and the SEC is on it, but I have no idea what they are looking for.”
Most retirement plan participants still have no idea what the true costs are within their plan, said Chris Costello, co-founder of Blooom, an Overland Park, Kan. an online tool for people to manage their 401(k) plans.
“It is shameful and not their fault that most investors do not know,” he said.
Ignorance Is Not Bliss - Take Action
Poor fee transparency has led some investors to believe that they were not charged any fees within their 401(k) plan. If an employee was trying to evaluate two similar fund options within his plan and the fees were properly disclosed, that may be a good place for a plan participant to start due diligence since it is impossible to pick which fund will consistently do better based on past performance alone, said Costello.
While some investors may not believe that reducing the expenses by even 1% is noteworthy, the fees make up a large difference over 50 years, said Paul Jacobs, chief investment officer of Palisades Hudson Financial Group in Atlanta.
“Fees can compound and eat a significant chunk to your wealth,” he said.
One option is for investors to consider the lower cost index funds, especially if the actively managed funds lack a strong track record, he said. In some mutual funds, the expense ratio varies with the performance of the fund, which is an incentive to the money manager to deliver extra performance.
Examining the turnover percentage, which is how often the entire portfolio turns over its holdings by selling all of the current stocks and purchases new ones is another factor for investors to examine. A good turnover percentage is 100% or less, which means the portfolio manager is holding the stocks for one year or less.
“If the mutual fund is trading significantly, an investor could lose another 1% to 2% to trading costs,” Jacobs said. “This fee can be difficult to find. Depending on how they are turning over the portfolio, there could be high transaction costs. The costs outweigh the benefits of constantly trading.”
Following the cash drag or the amount of money in the fund that is in cash and not being invested is another important factor to monitor carefully, he said.
If your mutual fund is holding 20% in cash, that will drag down the fund’s returns and the investor will not see any upside to it, Jacobs said.
“The fund needs to hold some cash to meet redemptions, but we like the cash portion to be as low as possible such as 5% to 10%,” Jacobs said.
--Written by Ellen Chang for MainStreet