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Hidden Fees Undermine Retirement Plans

Hidden Fees Undermine Retirement Plans

| November 30, 2018
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It is common sense to assume that fund fees and expenses affect investment performance, but few retirement plan participants realize their default investment options can carry a hidden price tag that would shock and even outrage cost-conscious investors.  

The Basics

There are three kinds of expenses associated with the total cost owning investments inside a retirement plan:

  1. Administrative fees charged by the company your employer has hired to provide your retirement account.
  2. Management fees paid to the company that manages the investment (mutual fund).
  3. Transaction costs incurred by a manager of a fund as it buys and sells various securities.

Management fees are documented as a fund's "expense ratio", and are readily published in prospectuses and by plan providers. Transaction costs come out of your money too, but are not reported as part of the published expense ratio because they are not categorized as a "management fee". Transaction costs include but are not limited to brokerage commissions, fees paid for investment research through "soft dollars", and costs associated with spreads (bid vs ask price of a security). The more a manager trades in the fund (turnover) the more transaction fees are presumably paid by the fund with your money.

Trading costs can more than double the published expense ratio (management fee) but are practically impossible for the average investor to identify or monitor. A fund's trading costs may be reasonably estimated by dividing its published trading costs by its total assets. For example, a billion dollar fund with 15 million in annual trading costs has an assumed trading cost of 1.5%. Add this to a published expense ratio of, say, 0.5% and you would get a true total annual cost of ownership of 2.0%. Surprised?

A fund's total assets and annual trading costs may be found in a "statement of additional information". The SAI is a lengthy supplement to the prospectus that is rarely delivered to the investor, but can be requested or is available online if you know where to look. There are also online resources that may help calculate trading costs of specific funds. 

If you do not want to finger through hundreds of pages of jargon then personalfund.com says trading costs may be roughly estimated by multiplying a fund's turnover ratio by 1.00%. Using this rule of thumb, we may assume a fund that turns over 100% of its investments each year will spend 1.00% of your money to sell and buy underlying investments. A fund with 200% turnover is presumed to cost you 2% a year. Turnover ratios for publicly traded funds often published by independent sources, and a quick web search can provide a number of different formulas for estimating trading costs using this statistic.  

Hidden Fees Within Fees

Increasingly popular target date funds and asset allocation funds make estimating the total annual cost of ownership practically impossible for the typical retirement plan participant. These funds are portfolios of more mutual funds commonly associated with your retirement plan provider. The published expense ratio of these "fund of funds" only represents the cost of managing the portfolio of funds itself, and does not include the cost of owning the underlying funds. A fund of funds, for example, may publish an attractive expense ratio of .50% or less, but contain underlying investment funds that maintain additional management fees and trading cost of 2% or more. In this scenario the true total cost of annual ownership could exceed 2.5% per year. Still surprised? It gets better...

Estimating the trading costs of a fund of funds using its turnover ratio is practically impossible for the average plan participant. A published turnover ratio of a fund of funds represents the trading between the underlying funds not the trading that occurs within the underlying funds themselves. Practically speaking, the layering of funds within a mutual fund effectively buries the true total cost of investment ownership. The unsuspecting plan participant may review published expense ratios believing a target date or asset allocation fund represent a great value without ever realizing the true total cost of ownership may be more than double the published expense.

In my experience, it is all but futile to expect a plan provider to disclose or help calculate trading costs. Service representatives can point you to the SAI, but are rarely versed on trading costs and will often insist the expense ratio represents your total cost of ownership... which is technically correct because trading costs are not part of the management fee. Wait.... it gets even better. 

Double Secret Fees

If investment expenses seem confusing the subject gets fare more complicated when your employer offers proprietary investments (e.g. California Savings Plus) that can not be independently researched. When your plan's investment options are not publicly traded you have to rely entirely upon the plan provider for disclosure. While providers obviously know exactly what their trading costs are, regulations do not require them to clearly publish these costs. A participant may ask their plan provider about trading costs, but in my experience the conversation will be limited to the published "expense ratio".  

Do Your Homework

You can learn more about hidden trading costs and the total cost of investment ownership with a quick online search. Reputable institutions like Forbes and the Wall Street Journal have published material on the subject. You can also ask your financial adviser to calculate your true total cost of investment ownership. If he/she does not factor trading costs into the equation then you might want to consider working with a different adviser.  

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