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Preparing for retirement in the United States today requires individuals to pay growing attention to financial markets and the cost of investing. More and more people save for their retirement through so-called defined contribution plans, of which 401(k) plans are the most popular variety. Employees and sometimes their employers contribute a portion of employees’ earnings to these plans, with income in retirement dependent upon the plan’s investment returns during employees’ careers. Employees, however, must pay fees to the administrators and fund managers of these plans from their annual investment income, which over time can cut sharply into their eventual retirement savings.
Fees charged on 401(k) plans can often appear to be deceptively low, ranging from less than one percent of assets under management to more than two percent of assets, depending on the size of the defined contribution plan and on the level of services offered to employees. Although these fees as a percent of assets may appear small, over the course of a full working career, typical fees in 401(k) plans can reduce employee savings by 20 percent to 30 percent, as the table below makes clear. Calculated another way, employees would need to postpone retirement for up to three years to compensate for the lost investment income to 401(k) fees over a course of a full career.
People are often not fully aware of the fees that they are charged and of the potential impact of these fees on their retirement income security. The disclosure of 401(k) fees is increasingly the subject of review by the U.S. Department of Labor, which polices private employer pension plans and state authorities, who watch over state pension plans. So far, these actions have not translated into more comprehensive and more easily understandable fee disclosure. How that should be done is one key focus of this paper.
Even with better disclosure, however, some workers would always face higher fees than others. The reason: Size matters for the level of fees. Small-business employees and low-wage workers tend to face substantially higher 401(k) fees than those who work for larger companies or predominantly higher paying companies. The costs of managing a 401(k) plan are typically fixed. Pooling more money in a larger defined contribution, or DC plan, can reduce the fees relative to the size of the savings in that plan. That’s why smaller plans pay higher fees relative to the savings in each employee’s account.
A more promising approach for small employers and their employees is for the U.S. government to set up a large, but very basic 401(k) plan so that these businesses and their workers can take advantage of these economies of scale, too. Our nation’s small business community could then also offer their employees a low-cost option to save for retirement.
How would such a system work? The easiest solution would allow private sector employees to join existing 401(k) programs run by state governments and the federal government for their own employees. The underlying model here is the Thrift Savings Plan, or TSP, which offers federal employees a limited range of investment options and services in exchange for low fees. Of course, employers who want to offer a DC plan with more choices and more service options, such as 24-hour call centers, could still purchase these plans in the private market.
The bottom line: If all Americans are given the opportunity to save for their retirement free of excessive 401(k) fees, everybody—employers and employees—can more effectively do their part to provide for a secure middle-class retirement as a reward for a lifetime of hard work. Achieving this goal should be a shared responsibility. Public policy can do its part to foster the common good of a secure middle-class retirement.
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