Investing based on fees is the wrong approach

In an article published on Fidelity’s website, there is a detailed description of the new regulations written by the Department of Labor back in February. 401K custodians are going to start including much more information about fees in up-and-coming statements mailed to clients.

More of the shocking statistics that I have mentioned before are published in this article:

  • A poll showed that 71% of 401K participants don’t think they pay any fees
  • Less than 5% of employees using workplace investment plans make a concerted effort to manage their 401K plans.
More info, more profit, right?

Reading the rest of article shows a clear focus on fees. It celebrates that these new regulations will bring fees to the forefront, because active investors may realize the costs of their choices and shift to alternative funds with lower costs. But it hesitates on the subject of passive investors, since they aren’t sure about them. (I think I know how people that don’t read statements will react to more unread information.)

The article fairly indicates that of course there is no such thing as a free lunch. Fees are par for the course. But the whole thing seems be a fallacy, because it implies that mutual funds in a 401K are the way to go. The name of the game is simply picking the best returns and with the lowest fees. We just don’t have enough information to make the right choices. A little more information, and our portfolios will do better.

Crosschecking with reality

Does that sound likely to you? It doesn’t to me, and here’s why: they don’t take into consideration systemic risk. What will happen when all the funds dip with the next big market correction? As usual, people will panic and sell their positions. Then when markets rally, they will buy what’s hot. That will lock in the historical sell-low/buy-high, rinse & repeat pattern of most investors. There is strong historical data showing this to be the case in the past, so we have no reason to doubt it won’t happen in the future. You don’t have to wait for the next installment of the Dalbar Report to reiterate what we already know.
If you are picking funds based on fees, you are just following the herd, but trying to pick a fund that isn’t QUITE as bad as the others. I recently read a chapter from a book where the person argued that if you choose index funds, you only pay 0.2% while everyone else is paying 2% average fund fees, giving you a 1.8% advantage. The author crowed over this, touting it as so simple, kids can understand it. I don’t think building your retirement wealth on 1.8% arbitrage is the answer. That is fear-based and kind of like trying to outrun the person next to you as you flee from an alligator.
Of course, this all tracks right into John Bogle and his strategy that lower cost funds tend to outperform other funds. Bogle developed the idea that indexed funds are more effective overall than actively managed funds. That statement may be 100% correct, but it isn’t enough advantage to build retirement wealth.

Indeed, it may allow you to save up TWICE THE AMOUNT that an actively managed fund can after years of saving, but it doesn’t answer the right question: Will this strategy be enough to truly retire and not end up working at Walmart?

Planning with the end in mind

Don’t forget that a wealth building plan needs to be able to handle life’s rocky bumps in the road that will definitely happen. We will hit various things that will force us to scale back or stop saving money at certain times. The plan also needs to factor in things like systemic risk, our desire to sell when things go bad, taxes, and inflation. I can definitely tell you at 1.8% isn’t going to count for much even if you only consider taxes and inflation. Throw in other risks, and it only gets worse.

If there is another strategy that will build enough retirement wealth despite the hard knocks we may face, then what difference does it make what the fees are? The end result is what we need to be looking into, not the costs along the way.

New study shows excessive 401(k) fees

A new study has come out titled “The Retirement Savings Drain: The Hidden & Excessive Costs Of 401(K)S” by Robert Hiltonsmith. The results are quite shocking. Or perhaps they SHOULD be shocking. I’ve already heard about this, and so I’m not surprised. But perhaps you haven’t? Some of the big ones:

  • 65% of 401(k) account holders aren’t even aware they are paying fees
  • 5 out of every 6 investors lack basic knowledge about the fees everyone with a 401(k) pays
  • fees are taken off the top, meaning reported rates-of-return are post-fee, hiding these costs
  • administering average pension funds costs 46% less than the cost of 401(k) plans
  • new regulatory tweaks that are coming, requiring better disclosure of fees, will have little effect on reducing the fees nor fix the issues associated with market risk and longevity risk
  • the individualized nature of the 401(k) doesn’t work and must be replaced with something else
Did you catch that last one? The author of the study has concluded that much of the issues that arise in 401(k)s is because of it’s individualized nature, and that tweaks and adjustments won’t fix it. The author figures that the new disclosure rules won’t fix 401(k)s, but instead expose them for the bad investment vehicle that they are.
I said shocking right? Well, I already learned this about six months ago. I have been working on my plan to leave my 401(k) behind. I have already stopped putting money into my corporate 401(k) and rerouted that money into an EIUL. In that article, you will find mention of the high fees embedded in 401(k)s. Combine that with the onerous rules that restrict your access to the money, and that pretty much sums up my disgust with them.

The study estimates that people will lose something like $155,000 on average over their working lives to excessive fees, enough to buy a house. What could you do with $155,000 of investment capital? Buy Berkshire Hathaway, or perhaps leverage it with investment property? Both of those options has a higher historical rate-of-return. Why don’t you hear about this from your financial advisor? Aren’t they supposed to be putting you first, according to the license they hold?

Towards the end of the study is a list of bullet points for what appears to be core principles in some sort of universal retirement plan. I think either the author or the institute that funded him believe we should all receive a universal, i.e. government orchestrated pension fund. I have my doubts on how effectively the government can manage something like that, considering their track record with managing social security. I could never support something like that unless we had the freedom to opt out and choose our own path. Or, they may be saying we need something better than what the IRC affords us from section 401(k), and these are the key points that must be met to have a true success. I just don’t remember the government having a big rate of success when it comes to money.
So what is the solution to all this? Don’t be a passive investor. Take active management of your plan. And HAVE a plan. Don’t just throw money at your 401(k), pick a handful of their funds, and then assume it will all work out. At the Wealth Building Society we focus on learning how to read this information, how to understand risk, and how to understand the mechanics of investing, so you can formulate your plan. One of the top reasons so many people are failing at retirement planning is because we have been told it’s easy and we don’t need to really be active. And also that there are plenty of experts out there to handle it for us.

I am not a licensed financial advisor nor an insurance agent, and cannot give out financial advice. This is strictly wealth building opinion and should be treated as such.