Hidden 401(k) Fees: The Great Retirement Plan Rip-Off

retirement lieYou've been advised to save for retirement using your company's 401(k) plan.

The benefits, after all, are significant:

  1. Contributions are made with pre-tax dollars, lowering your taxable income each year you contribute.
  2. The money you contribute, along with earnings, continues to grow tax-free until you begin to withdraw.
  3. Most plans include a matching contribution from your employer, handing you free money as an incentive to save.

Yet despite all these perks, a new study by Demos, a nonpartisan public policy research and advocacy organization, alleges that your 401(k) plan may be ripping you off in ways you don't even recognize.

What's worse, the typical 401(k) will steal an average of nearly $155,000 from each worker over a lifetime of saving.

'Secret' Fees Savers Don't Know They're Paying

The reason for this massive loss of wealth over a lifetime of saving comes down to fees. And those fees are usually expressed in a way that disguises the true cost.

Most investors who purchase mutual funds have heard of fees like the "expense ratio," which averages more than 1% annually. Funds in 401(k)s are not exempt from such fees, which cover the cost of record keeping and compliance, the fund manager's salary, and (sometimes) marketing fees.

While the expense ratio is publicly shared, there are other fees that, Demos found, "are nearly completely hidden from retirement savers." We're talking about "trading fees."

Trading fees are costs incurred when a mutual fund buys or sells an investment, in the form of commissions and bid/ask spreads (the difference between the price the fund actually buys or sells it for versus its market value). And they vary based on how actively a mutual fund is trading.

But good luck trying to figure out how much you're actually paying for trading fees.

Obscure Reporting at Its Finest

The biggest problem facing 401(k) sleuths is that "reporting fees as a percentage of assets actually disguises their true cost," according to the Demos report.

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Demos compares it to receiving a surcharge on a concert ticket purchase. Let's say you buy a ticket to a show. The ticket company bases its fee on the price of the ticket. So, for example, if the fee is 5%, you pay 5% of the price of the value of the good they're selling you.

Mutual funds, on the other hand, charge customers a fixed amount based on your account balance, not a percentage of the returns they earned on your money (which is the value they actually provided). It's akin to paying 5% of your bank account balance to the ticket seller in order to buy admission to the show.

In other words, mutual funds that employ this practice are paid even if they just hold onto your money. They don't have nearly as much incentive to actually earn returns on your money because they get paid no matter what.

You Only Think You're Paying 1.23% in Fees...

The study shares an example fund in which a $50,000 investment earned 4.65% net. Meaning after one year, the account was worth $52,325.

In reality, of course, the fund earned more on that initial $50,000. The stated expense ratio was 1.23%, so $615 in fees came out prior to that return. That means the fund actually made $2,930 gross, or 5.88% of the initial $50,000.

However, the study encourages us to look at this in another way -- by expressing fees as a percentage of the gross return. To do this, take the $615 in fees, and divide it by the gross return of $2,930. This equates to a startling 20.9% of its return in fees -- meaning an investor paid 20.9% for the value the fund added.

But this still doesn't take into consideration those obscure "trading fees" mentioned above. According to Demos, trading fees "often cost savers as much as or more than the explicit expense ratio," meaning this example fund probably had a "real expense ratio" of 2.46%.

Since trading fees come out of the gross returns, we can adjust the fund's gross (pre-fee) return to 7.11%. Meaning the fund actually earned $3,555 before fees. It gets worse.

... You're Actually Shelling Out More Than 30%

Combining the expense ratio and trading fees, this fund withdrew $1,230 in fees ($615 + $615). Dividing this by the gross return of $3,555, an investor in this fund paid a startling 34.6% in "true fees."

In other words, an investor paid a whopping $1,230 for $2,325 to be made on his money.

Add this up over a lifetime of saving and investing in a 401(k) plan and the average worker loses as much as $154,794, according to Demos. A higher-income household can expect to lose even more -- as much as $277,969.

The Big Retirement Myth: You'll Spend Less
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Hidden 401(k) Fees: The Great Retirement Plan Rip-Off

By Selena Maranjian, The Motley Fool

There's a persistent assumption going around about what happens after one retires: Pundits, financial planners and even retirees often claim that your spending shrinks after you leave the 9-to-5 world.

Sure, your house may be paid off by then, and you may be able to ditch the expenses of commuting and buying clothes for work. That's not the full picture, though.

In good and not-so-good ways, many people end up spending more than they expect during their golden years.

For lots of folks, retirement means finally getting around to doing things you've been putting off for years. And those things cost money.

You may finally do some traveling in Europe, for example, or explore the U.S. in an RV. Want to get serious about your love for curling? Joining a league costs some money. Looking forward to overhauling the garden or taking up woodworking? That'll cost you, too. Even just traveling to visit and spend time with the grandkids can add up -- in travel costs, dinners to treat the family, and gifts and ice creams for the young ones.

Of course, you don't have to bear these costs. You can let the children and grandchildren come to you and can spend more time in public libraries than on golf courses. But the early years of retirement, in particular, are when folks tend to have significant energy and lots of plans.

Unfortunately, many expenses in retirement are not so discretionary.

Health care, for example, can take a huge bite out of your nest egg. Fidelity Investments recently estimated that a 65-year-old couple retiring today can expect to pay, on average, about $230,000 on health care. That's just an average, so you might spend far less -- but you could also spend much more.

Medicare probably won't provide sufficient coverage, so you might need to buy supplemental insurance, which isn't usually cheap.

Meanwhile, though a lower income level will probably mean your income taxes will decrease, you'll still be on the hook for property taxes. And those will probably keep growing over time. If your annual property tax is $3,000 and it grows at 3% each year, it will hit $5,400 in 20 years.

Your home insurance costs will rise, too, along with your car insurance premiums, the cost of heating and cooling your home, groceries, and most other items.

And finally, whereas you might expect retirement to be a time when you're no longer raising children and supporting those dependents, you might still find yourself occasionally -- or routinely -- helping your loved ones out financially.

Still, the news isn't all bad. While you might spend more than you expected to once you retire, you probably won't keep it up. As we move into and then out of our 70s, people tend to slow down and be less active. Less travel, less eating out, and fewer hobbies can mean lower spending.

Throughout most of our retirement, we'll enjoy discounts on various expenses, too, such as movie tickets, meals, and even property taxes.

What to do

Don't let your retirement plan end up designed by assumptions you never questioned. Take some time to map out what your expenses may be in retirement, and to make sure you're saving, investing, and accumulating enough to support them.

If it looks like you're not quite where you should be, you have options. You can ramp up your saving and invest your money more effectively. (Yes, you can become a millionaire on a minimum-wage salary.) You might work a few more years before retiring, too, which can do wonders for your nest egg by boosting your Social Security benefits.

Another possibility is working part-time through part of your retirement, which can add income and possibly some useful benefits as well. It also keeps many retirees happier, giving them a social setting to belong to. Downsizing to a smaller home or moving to a less costly town or region can also make a difference.

Spend some time planning now, and you'll thank yourself later.

Learn more:

AOL DailyFinance Retirement News

The Motley Fool Retirement Nook

The Social Security Administration Retirement Planner

As Demos' study sums up, "Considering that a significant portion of these fees goes to paying the high salaries and expenses of the investment professionals managing these funds, asking struggling American households to pay these prices to save for retirement is more than patently unfair, it's immoral."

Unfortunately, the options for investors who want to avoid the fee frenzy are limited.

Stuck With a Rigged System?

One way around the fee issue is to take charge of your saving yourself, investing in a self-directed brokerage account through your company's 401(k) plan. Or you could make use of IRAs or taxable accounts.

The trade-off is that you lose some of the biggest perks of a 401(k) -- either a company match, or tax-free growth. After all, it's necessary to save for your own retirement. And a 401(k) is still the most tax-efficient way to save for retirement.

But the system is clearly broken. So until the 401(k) system gets fixed, it's a lose-lose situation for all too many investors.

This article was written by Motley Fool analyst Adam J. Wiederman. Click here for Adam's free report on how to ensure a wealthy retirement.

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