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Fri., June 1, 2012 8:30am EDT (Reuters) — Retirement savers will get an eyeful when 401(k) account statements hit their mailboxes this summer.
A new format mandated by federal regulators will give investors a more transparent view of the fees they pay and a study released this week suggests many will be shocked by what they see.
Demos, a progressive think tank, argues that even in best-case scenarios, fees take an enormous bite from retirement nest eggs. The report kicked off immediate blow-back from the industry, which criticized its methodology.
The study looked at a median-earning couple that makes substantial, escalating 401(k) contributions over a 40-year period. The couple — each invested 50-50 in stock and bond index funds — accumulates a $510,000 portfolio over that period, but would end up paying a whopping $155,000 in fees, a number that is disputed by some critics.
While the fee disclosures mandated under new Department of Labor rules are a good start, Demos argues that transparency is not nearly enough. The report suggests a more radical step — scrapping the defined contribution system entirely and replacing it with a new plan focused on low-cost and guaranteed returns.
A recent AARP survey found that 71% of retirement savers do not think they pay any investment fees at all. And a report issued last month by the U.S. Government Accountability Office found broad misunderstanding and ignorance among plan sponsors about the fees charged by retirement plan providers. Yet, a survey last year for the Investment Company Institute by Deloitte Consulting found that employees pay 91% of all 401(k) fees, up from 78% two years earlier.
Robert Hiltonsmith, a Demos policy analyst who wrote the report, thinks the new statement format will help raise awareness, but argues that we need to re-think the entire approach to financing retirement.
"The fee disclosures certainly will get some people angry," says Hiltonsmith. "But the 401(k) system can't be fixed through transparency alone. The high cost and the risk of market exposure we're all shouldering just are not a smart way to do retirement for a majority of the country."
However, some in the retirement plan industry strongly dispute the methodology that yielded the fee data used for Demos' hypothetical couple. Although the study assumes the couple is invested in stock and bond index fund, it uses composite current weighted average expense ratios supplied by the Investment Company Institute for all stock and bond funds — 0.72% for bond funds and 0.95% for stock funds.
That overstates considerably the costs investors pay for low-cost index funds, according to the American Society of Pension Professionals & Actuaries.
Demos also estimated trading costs for the hypothetical investors, relying on a report from Brightscope that states these costs often equal or exceed stated expense ratios. Adding together expense ratios and trading costs, Demos pegged total stock fund costs at 190 basis points and bond fund costs at 122 basis points.
But Brightscope chief executive Mike Alfred disputes that methodology.
"When you look at transaction costs, it's driven by many different factors, but turnover is among the most important," he says. "The study exaggerates the turnover costs, because they are much lower than average for index funds."
Demos argues its hypothetical model actually under-estimates the fees that would have been levied against the portfolio over the 40-year period, since it applied today's lower costs as a flat rate, even though expense ratios were higher in the past. Hiltonsmith adds that "what we assume by using the weighted average is that the couple's stock fund is invested in something between an index fund and an actively-managed fund. That is what people are invested in market-wide."
Better to replace the system, Demos argues, with a structure more closely resembling traditional pensions, which have administrative costs 46% lower than the typical 401(k) plan, according the National Institute on Retirement Security.
Although tectonic change of that type is unlikely at the national level, several state proposals call for a pension-like option for private-sector workers by leveraging the efficiencies of public-sector defined benefit plans. The idea is to create a highly-automatic contribution system to a pension-like account utilizing a cash balance model. Participant benefits would be expressed as a virtual account balance and converted to monthly annuity payments at retirement.
"What we need is a low cost set-it-and forget-it option," Hiltonsmith says. "You get your 4% return, the balances don't go up and down like a yo-yo and at retirement you get all or part of it as an annuity."
© 2011 Thomson Reuters.
