A two-income American family with an average income that dutifully invests in a 401(k) plan using typical strategies will lose $155,000 – or about 30 percent of what they should have saved for retirement -- to Wall Street fees, according to a study by an economic justice advocacy organization.
The Demos study, released last month, is just the latest in a long string of research showing 401(k) plans are a better deal for Wall Street than for you. Many show that people lose about one-third of their retirement money to fees that they don't even know they're paying. The actual lifetime impact of fees is a matter of widespread debate, but it shouldn’t be. In one dramatic example, John Bogle, the inventor of index funds, demonstrated how fees can consume 80 percent of an investor's money through something he’d dubbed “the tyranny of compounding fees.” (Click on the link to see his proof.)
But some relief may be on the way. Regulations first set in motion in in 2007 (!) will finally kick in next week. Soon, 401(k) statements will include a fact box -- similar to the new info-boxes on credit card bills -- that lists the fee rates (“expense ratios’) associated with fund selections and shows in dollars how much the investor paid.
The disclosure box is a welcome change, but it's probably not going to make much of a difference, laments Robert Hiltonsmith, author of the Demos study.
"It will be underwhelming from a sticker shock point of view. It will not have the effect the doomsayers predict," Hiltonsmith said. The dollar amounts shown will reflect annual amounts, not the real harm from loss of compounding growth, he said. A 27-year-old with $10,000 invested in a mutual paying a 1 percent expense ratio will pay only about $100 in fees in a year, a number that will hardly inspire shopping around, Hiltonsmith figures.
But that benign-sounding 1 percent annual fee is the source of most 401(k) folly. Compounded, it can result in loss of one-third of retirement savings, or more.
Doing the math to determine real investing costs from fees is tricky. It involves a long series of assumptions on factors so individualized that no 401(k) projection model is easily generalized. Instead, the Demos study and others like it are merely "for instance ..." examples.
An obfuscator's dream
Wall Street protectors use this to their advantage. The Investment Company Institute, which is critical of the Demos study and others like it, uses its own calculations to claim the average investor pays only $248 annually in 401(k) fees and $20,000 during their lifetime. Even that conservative estimate should be alarming, when the average 401(k) balances is $75,000, according to Fidelity Investments, and those close to retirement (ages 55-64) have an average balance of $100,000.
It doesn’t have to be hard to see how recurring fees devour much of your 401(k) money. Here's a simple, if slightly imprecise, way to think about what happens when someone takes 1 percent of your money every year. If you had a dollar, and someone took one penny every year for 30 years, you'd only have 70 cents at the end. That's what investing in a 401(k) mutual fund does to your money. These fee losses are obscured by additional contributions you make, and by market ups and downs – complex 401(k) statements are an obfuscator's dream -- but there's no way around it: Fees are killing most investors' returns.
(If you are a stickler for math, more precise calculations will appear at the bottom of this column. They usually just muddy the conversation, however.)
How does Wall Street get away with this? Obscurity sure helps, but there is another element of human nature that the system was born to exploit and that most people seem incapable of avoiding: Behavioral economists call it "hyperbolic discounting." In short, Wall Street does a much better job of thinking about both time and money than you do.
Try this experiment, now oft repeated in the behaviorist world: If I offered you $50 today or $100 one year from now, which would you choose? Most take the $50 and run. Now, let's do the same exercise with a slight adjustment. If I offered you $50 five years from now, or $100 six years from now, which would you pick? Almost certainly the $100. But notice: if I asked you the same question in five years, you'd probably take the $50 again. That’s a funny way to think about money (the technical term is “dynamic inconsistency”).
The most obvious lesson from hyperbolic discounting is that people's choices are often focused on immediate gratification. But the other side of that coin, behaviorists tell us, is that people are too quick to discount rewards in the future and, to our point, to discount the impact of future financial pain. In other words, telling someone they might be missing $150,000 from their retirement account 30 years from now means almost nothing to them – they get angrier about a $35 overdraft fee taken last week from their bank account. Wall Street's genius is this: By stealing people's money from the future, they avoid consumers' wrath.
Perhaps it's possible to educate all Americans on the tyranny of compounding investment fees; and creating a fact box on consumers' quarterly statements that inspires them to shop around for lower-cost mutual funds is a step in that direction. But behavioral economists say that's highly unlikely to make much of a difference. Better to create a system that by default enters workers into low-cost, relatively safe investment vehicles and let them pick riskier, more expensive options if they wish, Hiltonsmith says.
“Even if there was more sticker shock, (workers) wouldn’t know what to,” he said. “The way things are now, we’re asking workers to take on a full-time job, to be financial experts.”
Anyone who thinks the current system is working is doing an awful lot of hyperbolic discounting when it comes to society’s future. Perhaps the most sobering fact in the Demos study, one that Hiltonsmith downplayed, is that his "perfect" investing couple had only $350,000 in their 401(k) at the end of 40 years. Does anyone think Mr. and Mrs. Perfect can live for 20 years on $350,000? And these two did everything right -- they invested between 5 percent and 9 percent of their income every year, starting at age 25. They never stopped making contributions -- which nearly everyone does during job changes or tough times -- and they never made a withdrawal, which roughly one-third of investors do. Still, they were left with just $175,000 each at age 65. Once and for all, that should expose the dirty little secret of 401(k) plans:
The math doesn't work.
Now, onto the math assumptions from above. For Demos’ model, Hiltonsmith created an imaginary couple who worked from 1966-2005. Each earned the median income for their gender during that time (a range from $50,000 to $70,000 total, annually) and socked away a slowly increasing amount of their income during that time, starting at 5 percent and ending at 9 percent. Half their money was invested in a stock fund, half in a bond fund. Average growth and average published stock and bond fund fees from 2010 were applied to their accounts, and average trading costs were also deducted. No employee match was considered in the calculation, given the wide variety of matching programs – and the fact that many firms suspended matching contributions during the recession. Of course, the couple is a pure abstraction -- there were no 401(k) accounts in the 1960s. But it takes this kind of modeling to create a hypothetical that covers an investor's entire work life, and their potential lifetime loss from fees.
As for my "one penny" calculation: Taking one penny every year from a dollar is not the same as taking 1 percent, but it's close. Because the initial dollar amount drops with each deduction, each 1 percent annual hit is slightly less. To wit, 1 percent of 99 cents is less than 1 percent of 100 cents. Do the math, and you'll find taking one percent of someone's money every year for 30 years is the equivalent of taking 26.03 percent. Still quite a lot of money for nothing.
What should you do with this information? Absent a better idea, put all your 401(k) money in an index fund, which will have fees that are 70 percent to 90 percent lower than standard mutual funds. And watch your next quarterly statement for those depressing fee boxes. Most employers have two months to comply with the rules that take effect July 1, so you won’t start seeing the fee information until your first statement after Aug. 10.