What You Can Do About a Lousy 401(k)

PHOTO: one in four Americans prefer cash

It's a tough world out there for people hoping to retire. An employer-sponsored plan such as a 401(k) is a huge help, but bad plans can make it harder for people to retire than it should be. Some of the bells and whistles, such as a match from the employer, are extremely nice to have. Free money from a generous employer is great. But that may not be enough to make up for a plan with lousy investment options.

Most of the problems in bad 401(k) plans stem from high fees and poor investment choices.

Fees are Everywhere

Workers who sign up for their employer-sponsored plan may have no idea what kinds of fees they're being charged. Last year, the Department of Labor instituted a rule that requires plan sponsors -- employers -- to disclose the fees charged to plan participants. Even so, this did not appear to enlighten workers about what they're paying in fees, since half of them had no idea how much they paid in 2012 -- the same percentage as the previous year, according to a study by LIMRA, an insurance consultant.

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Average fees and expenses paid by plan participants in 2012 totaled 1.46 percent for small plans with 50 participants and less than $2.5 million in assets. For large plans with 1,000 participants and $50 million in assets, average fees were 1.03 percent, according to the most recent version of the 401(k) Averages Book and the Society for Human Resource Management.

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The bulk of fees comes from the expenses related to investments. Fund companies bundle fees differently, depending on share class. One class of shares may have no built-in sales charge, but another share class may add that charge. Institutional share classes generally don't have 12b-1 fees built into the cost. These are "distribution fees" that pay for advertising and marketing costs of funds. Overall expenses will hinge on the investment choices made by the participant, but the share classes offered by the plan make a big difference.

Typically, the share class is identified in the name of fund, for instance, Columbia Mid Cap Index A indicates that class A shares are on tap for that plan. Class A shares typically charge a sales charge, also called a front-end load. The cost of the funds can be found in the prospectus or on the fee statement.

The R Share Class

While A, B and C share classes are generally sold to individuals who work with commission-based advisers, R shares are often found in retirement plans. Though R shares have no load or sales commission, they may have other expenses built in. Investors want to see higher numbers attached to the R, for example R4 shares rather than R1, according to Donald Jones, a director at Fiduciary Doctors in Phoenix, Ariz. "If it's an R1, R2 or R3, you can bet there is a lot of hidden expense built into that fund," he says.

The difference in cost between R1 and R4 share classes can be nearly a full percentage point, according to Jones. That may not sound like a lot, but it adds up year after year and can make a huge difference in how much you end up accumulating for retirement.

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"I call it the rule of 1 percent -- if you take a difference of 1 percent lost through an improper share class and you multiply that over 35 years, participants have approximately $200,000 less at retirement," says Craig Morningstar, chief operating officer at Dynamic Wealth Advisors in Scottsdale, Ariz.

As an example, if you save $10,000 a year and earn a 6 percent return on average, you'll end up with $1,114,348 after 35 years. But if you only earn 5 percent net of fees, your nest egg will be worth $903,203 -- a difference of $211,145.

Spread across an entire plan, that represents a lot of money lining the pockets of investment professionals rather than the retirement accounts of workers.

Why would an employer pick share classes that are obviously to the detriment of their workers? In many cases, they wouldn't; they simply don't know how the financial industry works. "The plan sponsor is not the one choosing the share class.… Usually, the adviser or plan provider is helping select those," says Jones.

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Bad Investments

Unfortunately, plan sponsors may be nudged in the direction of adding investments that could benefit the investment provider more than plan participants.

"The revenue sharing they can build in is the most important to them," says Morningstar.

Revenue sharing occurs when plan providers get payments from investment fund companies for selecting particular mutual funds for 401(k) plans. Plan sponsors are often unaware that these conflicts of interest exist. "Many sponsors, particularly of smaller plans, do not understand whether or not providers to the plan are fiduciaries, nor are they aware that the provider's compensation may vary based on the investment options selected. Such conflicts could lead to higher costs for the plan, which are typically borne by participants," according to a 2011 report from the Government Accountability Office.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

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