Everybody knows you should be investing in your company's 401(k) plan, but here's something that almost nobody knows: Investing in a 401(k) could cost your three years' salary.
That's the surprising upshot of a new study by the financial folks at NerdWallet, whose InvestingNerd division just ran a study concluding that "9 out of 10 Americans (92.6%) dramatically underestimated the total 401(k) fees the average household will pay over the course of a lifetime."
According to NerdWallet, when posed the question "How much will the average American household with 2 working adults pay in 401(k) fees over the course of their lifetime?"
38.1 percent of respondents thought a 401(k) might cost them less than $10,000.
32.8 percent guessed somewhere between $10,000 and $50,000.
13.8 percent thought $50,000 to $100,000.
7.9 percent said $100,000 to $150,000.
And 4.1 percent tried "The Price Is Right" gambit, shooting the moon and guessing in excess of $200,000.
The correct answer is $150,000 to $200,000 -- but only 3.3 percent of respondents got it right.
The High Price of a Lifetime of Saving
NerdWallet underlies its findings with a report by public policy organization Demos from last summer, which added the further frightening fact that among folks investing in 401(k) plans, a full two-thirds had no idea they were paying anything at all for their 401(k) (which actually makes all of the folks who guessed wrong in NerdWallet's poll look pretty smart by comparison).
U.S. Census Bureau figures put the average household income in America today at just a hair over $50,000. Demos' report, however, shows that over the course of an investing lifetime, an average two-income family in the U.S. could spend as much as $155,000 paying the fees that managers charge for running the funds that make up your 401(k).
How does this happen? It's quite simple, really. When you invest in your company's 401(k), unless you keep the money in cash (and with cash yielding less than 1 percent today, good luck with that), what you're usually doing is buying various mutual funds that are held within your 401(k) account.
The 401(k) industry says expense ratios across all funds averaged about 0.78 percent in 2011. And according to Demos' calculations, deducting these fees year after year, every year, over the course of an investing lifetime, drags down the returns from investing in 401(k)s by the aforementioned $155,000.
That's a bit more than three years' salary for most Americans.
What It Means for You
This hardly seems fair. For years we've heard about the imminent demise of Social Security, with workers today paying money into the system -- and that money being immediately doled out to retirees today, rather than tucked away to pay back today's payers.
We all know that corporate pension plans are a thing of the past, as companies all across the country try by hook and by crook to do away with them. Witness Boeing's (BA) contentious negotiations with its labor unions last year. (By the way, Boeing won, and its workers are slowly shifting to 401(k)s.)
Yet now we learn from Demos and NerdWallet that doing what you're supposed to be doing -- investing steadily in your future by making regular deposits in your 401(k) -- could cost you three years' salary. Unfair!
So how do you cut this cost, and keep more of your money for yourself? Actually, that's not too hard.
Most funds are "actively managed" by managers who pick and choose stocks for their funds, and the fees for these services add up to about 0.93 percent on average -- again, year after year, every year. Putting your 401(k) money in passive "index" funds, which simply and automatically track the returns of major stock market indexes, can cost as little as 0.14 percent per fund -- less than one-fifth the average cost.
Sound like a better deal to you? In many cases, it can be. Click here to find out more.
Motley Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
Financial Terms You Need to Know
401(k) Fees Are Robbing You Blind
In a nutshell, net worth is what you get when you subtract liabilities from assets -- what you owe from what you own. Like many economic and financial terms, net worth can apply in a variety of situations.
If you're evaluating a company for your portfolio,you might glance at its balance sheet to get a handle on its net worth. Balance sheets break out assets (such as cash, inventory, and receivables) and liabilities (such as debt and accounts payable). Subtracting the latter from the former gives you net worth, which is also referred to in this context as shareholders' equity or book value.
Here's an example: As of the end of 2012, IBM's (IBM) assets totaled $119 billion, and its liabilities totaled $100 billion. Thus, its net worth, or shareholders' equity, was $19 billion.
You probably think you've got the term down pat: Inflation means prices rising over time. Well, yes, that's pretty much right. But there's much more to inflation, and it's much more relevant to your life than you might think. Inflation can go in the opposite direction, for example, and it can spiral out of control.
Inflation is about purchasing power. It's a way to measure the changing purchasing power of our currency by tracking changes in the prices of things we buy. The national banks of various countries try to keep inflation under control through their actions and policies (such as via the interest rates they set); many aim for an annual inflation rate of about 2 percent to 3 percent.
While the concept of inflation seems simple it's actually a bit more complicated. Read more on inflation here.
Most of us are familiar with the term, and have a basic grasp of it. It refers to how a project or decision might be evaluated, comparing its costs with its benefits. In many cases, it's a like a quantified pros-and-cons list.
Applying cost-benefit analyses in the business world and your own personal finances can be very effective, helping decision makers avoid just going with their gut or with very rough calculations.
Simply put, it's what you give up in order to do something. Imagine, for example, that you dream of becoming an engineer or a chef. If you opt to become a chef, you give up the experience of being an engineer and all that goes with it. That's an opportunity cost of becoming a chef.
Opportunity cost is also often defined, more specifically, as the highest-value opportunity forgone. So let's say you could have become a brain surgeon, earning $250,000 per year, instead of a chef earning $50,000. In that scenario, your opportunity cost, salary-wise, is $200,000. (Of course, you should also consider factors such as your enjoyment of your chosen profession.)
Most folks are familiar with the concept of supply and demand, but most of us also don't give it much thought, which is a mistake. That's because it applies to much more than just business.
First, to review. In basic economics, the law of supply and demand influences prices. If supply of an item is abundant, that will pressure the price downward, and vice versa. In practice, imagine that you're the only one in town selling shoehorns. Because consumers don't have any other places to buy the product, that gives you some pricing power. But if other stores in town start carrying shoehorns, you may have to drop your price to keep customers coming.
Read about the differences of supply and demand in the stock market and in our own lives here.
As the name suggests, sunk cost refers to money that has already been invested in something, money that can't be recovered. Too often, we factor that expense into our financial decision-making when we shouldn't.
Let's say you've spent $40 on a nonrefundable ticket to the theater for tomorrow night. And you're suddenly invited to play board games at a friend's house that same evening. You might think that you should go to the theater -- after all, you spent that $40 -- even though what you'd rather do is hang out with your friends and play games. The $40 is a sunk cost. It's spent, whether you go see the play or not, and the money doesn't know the difference. So you should do whatever you would rather do.
In the most basic sense, asset allocation is simply how one's assets are divided among different asset classes, such as cash, stocks, bonds, real estate, and so on -- even insurance investments, commodities, collectibles, and other categories count.
But the term also refers to an investment strategy -- one that can reduce risk through diversification.
Clearly, having all your money in any one asset class can be risky. In 2008, the S&P 500 plunged 37 percent. If you'd held all your assets in an S&P 500 index fund, your net worth would have taken a big hit that year.
Given the harrowing ride we've been on in recent years, you might think that holding cash is the best way to protect your assets from outside forces. Think again.
The concept of interest is familiar to most of us. We know that with many bank accounts, for example, we earn some interest -- though it's rather paltry these days.
But there are several kinds of interest that are calculated and represented quite differently than simple interest. Compound interest is -- pardon the pun -- one of the more interesting ones.
First, let's start with simple interest. Here's how it works: Let's say that you've parked $1,000 in an account somewhere, earning 10 percent per year in simple interest. In year one, you'll collect $100, bringing your total to $1,100. Great, eh? In year two, you get... $100. That brings your total to $1,200. In year three, you're at $1,300. You're probably catching on to the idea by now. You keep earning that interest rate off your initial principal.
Enter compound interest, which is far more exciting.
The meaning of the term varies depending on context. In the accounting world, for example, it refers to the change in a company's cash level over a specific period of time. If a company's cash level rises during that period, it's exhibiting positive cash flow. If it shrinks, negative cash flow.
When investors study companies to see if they might be good fits for their portfolios, they may assess "free cash flow." That reflects a company's cash flow from its operations after it pays all its expenses. Free cash flow can be viewed as the lifeblood of a company.
When it comes to financial matters, we all know what risk is -- the possibility of losing your hard-earned cash. And most of us understand that a return is what you make on an investment. What many people don't understand, though, is the relationship between the two.
The relationship between risk and return is often represented by a trade-off. In general, the more risk you take on, the greater your possible return. Think of lottery tickets, for example. They involve a very high risk (of losing your money) and the possibility of an extremely high reward (the giant check with lots of zeroes). Or penny stocks: They're also very risky and yet seem full of amazing potential.
At the other end of the spectrum are options such as a savings account at your bank, or buying government bonds. They're quite low-risk, but you're not going to make a mint on them, either -- at least not these days, with interest rates so low.