How to Reduce 401k Fees

401k fees are stealing our future.

401k fees will cost the average American couple almost $155,000 by the time they retire, according to research firm Demos. This loss will represent about 30% of this average couple's retirement account balance.

By taking a few easy steps now, we can reduce these excessive 401k fees and reclaim our future.

Assume you save $10,000 per year in your 401k retirement account for 40 years, and earn an average annual return of 7%. How much will 401k fees reduce your retirement nest egg?

A worker who makes $75,000 per year and saves 8% of that annually in his 401k would lose 11.6 years worth of savings over his career, according to HR-consulting firm Towers Watson. Since the median expense ratio of mutual funds in 401k accounts was 1.27% in 2010 according to Demos, this worker would lose more than 11.6 years worth of his savings!

Thus, one of the most effective ways to reduce 401k fees is to review the investment options in your 401k plan, and choose only options with low expense ratios. Look for low-cost index funds which simply track an index such as the Standard & Poor's 500. Also look at retirement date funds. The performance of low-cost index funds compares favorably with most actively-managed funds.

As an example of the effectiveness of choosing low-cost index funds for your 401k, the Towers Watson study found the hypothetical worker above would lose only 2.8 years worth of savings if he choose a target-date fund with a 0.2% expense ratio.

Some 401k plans (and 403b plans for public employees) offer complicated insurance products such as variable annuities. Variable annuities are usually not appropriate for 401k investments since one of their most valuable features--tax deferral--is redundant to the tax-deferred nature of 401k plans. Variable annuities also typically have high fees of 2% or even higher, which reduce long-run returns substantially.

Most people have never stopped to consider how much they are paying in 401k fees. Indeed, despite the fact that everyone pays 401k fees, an AARP survey conducted in 2011 found that a staggering 71% of participants believe that they are paying no 401k fees!

Before choosing any investment option in your 401k, review the plan materials to see if there are any sales charges such as loads or commissions. For example, some plans may charge a 3% up-front load for any contribution into a specific mutual fund. Most 401k plans offer enough no-load and no-commission options that there is no need to waste money by paying loads or commissions.

Also review the plan materials to see if you'll be charged any other fee(s) for buying an investment, such as 12b-1 or surrender fees. You can usually find good alternatives without these extra fees.

Individual Retirement Accounts (IRAs) typically provide many more investment choices than 401k plans, and many of these investment choices have lower fees.

Thus, consider rolling your 401k assets into an IRA whenever you switch employers. Also, consider contributing to an IRA instead of a 401k if the IRA's investment options are lower cost. Just be sure to contribute enough to the 401k to get any employer match, which will more than offset high fees.

There are many reasons to avoid borrowing from your 401k, including the need to repay the loan with after-tax dollars, the need to repay the loan within 60 days if you lose your job, and the loss of interest on the borrowed money. Another disadvantage is that you may need to pay an individual service fee for borrowing the money.

The Demos study also found trading costs in 401k plans average 1.2% per year, which is equivalent to the median expense ratio of 401k mutual funds. Thus, avoid trading excessively in your 401k. Even if you don't pay these trading costs directly, they will be passed along to the 401k members.

Studies also find most individual investors hurt their investment returns by buying stocks when prices are high and selling them when prices are low, which is the opposite of the desired buy-low and sell-high. Thus, a better option is to set up an automatic rebalancing plan for your 401k. Choose your desired allocations for your 401k portfolio (e.g., 60% stocks, 40% bonds), and then set up a plan to automatically rebalance your portfolio to this allocation at a periodic interval (e.g., annually).

If your employer's 401k plan offers only high-cost investment options, ask your HR people to review the plan and look for lower-cost options. The world of 401k plans is very complicated, and studies have found that even HR people are often unfamiliar with the fee structure of their own 401k plans.