Do Fund Options in 401(k) Plans Have Higher Expense Ratios?

Expense ratios tend to be higher in 401(k) accounts compared to individual brokerage accounts.

In today's world, the 401(k) plan stands as the most popular retirement savings vehicle for full-time employees. This plan allows workers to invest pre-tax income into various mutual funds, including stocks and bonds. Meanwhile, millions of Americans also invest directly in the stock market through self-directed brokerage accounts.

Interestingly, you can invest in the same mutual funds via both your 401(k) and brokerage account. However, the expense ratio—the annual fee charged to manage the fund—is often higher when held within a 401(k). This article unpacks the reasons behind this discrepancy and offers practical advice on managing these costs.

Key Insights

• Many individuals hold both an employer-sponsored 401(k) and a personal brokerage account. Expense ratios in the 401(k) are frequently higher than those in self-directed accounts.
• The additional fees stem from administrative and operational costs related to managing 401(k) plans, which vary by employer size—larger plans often benefit from lower fees.
• If your 401(k) fees exceed roughly 1%, it's wise to discuss cost reduction options with your employer.
• Alternatively, consider selecting lower-cost investment options within your 401(k) or supplementing your retirement savings through outside investments.

Understanding Expense Ratios in 401(k) Plans

At first glance, it may seem puzzling that the same mutual fund carries a higher expense ratio in a 401(k) than in a personal brokerage account. For example, Vanguard's VWUSX fund boasts a competitive 0.38% expense ratio. Yet, when held inside a 401(k), the effective expense ratio you pay can be noticeably higher than this figure.

This difference arises because 401(k) plans incur additional administrative fees on top of the fund's management fees. These fees cover services such as customer support, legal compliance, record keeping, and transaction processing. While some costs are absorbed by the employer, most are passed down to plan participants, resulting in a combined expense ratio that reflects both investment and administrative expenses.

As of 2022, actively managed mutual funds within 401(k) plans average about a 1% expense ratio. However, this varies significantly based on employer size and plan participation. Larger plans benefit from economies of scale, often offering lower fees, while smaller employers may have expense ratios exceeding 1%.

Though 1% may seem minimal, over time, even small differences in fees can dramatically impact your retirement savings. Research from the Pew Charitable Trusts highlights that fees not only reduce the amount saved but also diminish the compounding growth potential of your investments.

Important Note

Even slight variations in expense ratios can substantially affect your retirement portfolio's final value. Utilize online 401(k) calculators to assess how fees influence your long-term savings.

Strategies to Lower 401(k) Expense Ratios

Reducing your 401(k) expense ratio involves addressing fees from two primary sources: the investment funds themselves and your employer’s administrative costs.

Begin by reviewing your current expense ratio using your 401(k) statements and participant fee disclosures. Websites like BrightScope provide comparative ratings of corporate and government retirement plans to help benchmark your fees.

If your fees are notably higher than average, consider discussing this with your employer or plan administrator. Employers have a fiduciary duty to seek cost-effective plans for their employees.

Many plans include fees for independent investment advice, sometimes adding up to 1% to your costs, even if you don't actively use these services. You might eliminate this fee by opting out and conducting your own research or consulting a certified financial planner for a one-time fee instead of ongoing charges.

Focus on selecting low-cost investment options such as index funds, institutional funds, or target-date funds. If your plan lacks these, check if it offers a self-directed brokerage window for broader investment choices.

If reducing fees within your 401(k) isn't feasible, consider supplementing your retirement savings by investing outside the plan, such as through a self-directed IRA. Still, it's generally advisable to contribute enough to your 401(k) to capture any employer matching contributions.

What Is an Expense Ratio?

An expense ratio (ER), also called the management expense ratio (MER), represents the percentage of a fund’s assets used to cover operating and administrative expenses.

Average 401(k) Expense Ratios

Typically, you shouldn't pay more than a 1% expense ratio in a 401(k) plan. If your fees exceed this, it may be time to consult your plan administrator.

What Constitutes a Good 401(k) Expense Ratio?

For most 401(k) plans, a good expense ratio falls between 1.0% and 1.5%, with anything above 2% generally considered high. Lower expense ratios help maximize your investment returns.

Conclusion

Many workers juggle both a self-directed brokerage account and an employer-sponsored 401(k). It's common for 401(k) expense ratios to be higher due to administrative costs and plan management. Larger plans typically offer lower fees, while smaller employers may have higher costs.

If you find your 401(k) fees exceed about 1%, engage your employer about options to reduce expenses. Alternatively, select lower-cost funds or invest additional savings outside your 401(k) to optimize your retirement portfolio growth.

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