We get it; 401(k) fees are high and can do lasting damage to a balance over time, but thankfully, they’re coming down. While the hyper-focus on what participants pay may seem tiresome for 401(k) advisors that are doing what’s right for their clients, a scenario identified by NerdWallet illustrates why the topic is continually top-of-mind.
The consumer information and advice provider analyzed a variety of 401(k) savings scenarios, and in one case found that paying just 1 percent in fees could cost a millennial more than $590,000 in sacrificed returns over 40 years of saving.
The reason of course has what Vanguard founder John Bogle refers to as the “tyranny of compounding fees.” Just like the accelerating effect compound interest has on the growth of savings, the same thing happens — only in the opposite direction — when investment fees compound.
According to NerdWallet’s Dayana Yochim and Jonathan Todd, the impact of fees is twofold: An investor pays an ever-increasing amount in fees as account balances grow, because the fees are based on a percentage of assets. And fees also strike a blow to the portfolio’s returns. That’s because every dollar taken out to cover management costs is one less dollar left to invest in the portfolio to compound and grow. So in addition to paying potentially hundreds of thousands of dollars in avoidable fees, the research shows that an investor gives up many times that amount in lost portfolio returns over time.
The cost of hidden fees is one of the drivers behind the Labor Department’s new fee-disclosure rule, designed in part to give consumers better clarity about how much they’re paying in fees. But understanding the impact of fees—especially slight differences between similar products—is still up to consumers.
To examine the effect of fees on a millennial investor, NerdWallet looked at different investing scenarios for a 25-year-old who has $25,000 in a retirement account, adds $10,000 to the account every year, earns a 7 percent average annual return and plans to retire in 40 years.
- In one of the scenarios analyzed, paying just 1 percent in fees would cost a millennial more than $590,000 in sacrificed returns over 40 years of saving.
- A millennial with the option of investing in either of two commonly held funds can save nearly $215,000 in fees—and, through the magic of compounding, retire nearly $533,000 richer—by choosing the one with fees that are 0.93 percent lower.
- By assembling a low-cost exchange-traded fund, or ETF, portfolio on his own and rebalancing it once a year, a millennial can retire $345,000 richer than if he uses a target-date mutual fund.
- Outsourcing portfolio management to a robo-advisor could be a less work-intensive alternative to self-managing and less costly than a target-date mutual fund. In their scenario, using a robo-advisor would cost $232,000 in fees over 40 years, about half the $454,000 a target-date mutual fund would cost.