Many advisors and financial institutions would love to manage your 401(k) account after you terminate employment. Of course, they'll charge you for this service, so you need to ask yourself if you'll be receiving good value for the fees you'll be paying.
Many advisors charge a percentage of your assets under management, with 1 percent per year being typical. Usually, this charge is on top of any investment expenses that come with mutual funds and/or the transaction costs of trading individual securities. One percent seems like such a small number -- it can't really make much of a difference, right? Wrong!
Let's look at an example that demonstrates how much money you'll be shelling out if you pay a 1 percent fee on your assets.
Suppose you just retired and have $500,000 in your 401(k) account (this is often the minimum for many advisors to accept your business). Now, let's suppose your advisor charges 1 percent per year and invests in low-cost mutual funds with fees of 0.25 percent per year (that's 25 basis points in investing jargon). Your all-in costs in this situation are 1.25 percent per year, or 125 basis points.
Let's also suppose that you worked for a large employer that offers low-cost mutual funds in its 401(k) plan and that you could have simply left your accounts with your former employer. In this case, we'll assume your employer's funds also cost 0.25 percent per year, so your all-in cost for this option would be 25 basis points.
Even if your 401(k) plan didn't offer such low-cost funds, you can find funds with comparable costs or lower at such companies as Fidelity, Schwab and Vanguard, which offer index funds with charges in the neighborhood of 10 basis points.
Now let's make one more assumption: that your investments earn 5 percent per year before expenses. Let's see how much money you'll have accumulated after 10 years under these two scenarios, assuming you didn't make any withdrawals:
- With the investment advisor, your net earnings rate is 3.75 percent per year (5 percent minus 1.25 percent). In this case, after 10 years, your $500,000 would be worth $722,522.
- If you left your money in your employer's plan, your net earnings rate would be 4.75 percent (5 percent minus 0.25 percent). In this case, your $500,000 would be worth $795,262 in 10 years. That's $72,740 more compared to working with your investment advisor.
Financial advisors may quickly point out that this example is unfair because they can add value by increasing your rate of return if you invest with them. The trouble with this argument is that a ton of evidence shows that most active managers don't outperform their benchmark indexes over time. So, it's really a stretch to claim they can beat a low-cost index fund in a large employer's 401(k) plan after all costs have been considered.
But financial advisors can add value in other ways. For instance, they can help you determine the appropriate amount of risk to take with your investments, they can help reduce the taxes that you'll pay, they can help you cut debt, assist with budgeting, work with you in selecting a retirement income strategy and be there to calm your fears when markets are melting down. These are just a few examples -- there are many more.
But could you buy such help for less than $70,000 over the course of 10 years? And do you need to pay them every single year for these services?
Let's suppose you hire a financial advisor who charges $300 per hour (probably at the high end of the rates). Let's also suppose you need to spend 10 hours per year with him to review your situation. You'd pay $3,000 per year, or $30,000 over 10 years.
To rack up $70,000 in charges over 10 years, you'd need to consume 233 hours of their time -- not likely unless you have a very complex situation, in which case you might very well be receiving good value for that money.
The math in the above example gets worse if:
- your advisor charges more than 100 basis points
- your advisor uses funds that charge more than 25 basis points
- you're invested for more than 10 years
- you have more than $500,000 in savings
- you're lucky enough to participate in a 401(k) plan that charges less than 25 basis points, or smart enough to find such funds on your own.
Here's just one example of the last point: The Federal Thrift Savings Plan (TSP) for government employees offers investments with average costs of 2.9 basis points. For most government workers, it would make no sense to transfer money out of the TSP -- it's one of the best deals around.
On the other hand, I've seen 401(k) plans of smaller employers that come with charges of 150 basis points or more. In this case, for most people it would be nuts to leave their money in the plan.
Even if you have much less than $500,000 in savings, you can still save thousands of dollars by reducing the fees you pay for your investments. In the above example, if you had $100,000 in savings instead of $500,000, you could save $14,548 over 10 years by paying 25 basis points instead of 125 basis points.
So, what can you do if you decide to keep your money in your employer's plan but also need financial advice? You have a few options.
You can find financial advisors who charge by the hour, such as those who work with the Garrett Planning Network. Also, many 401(k) plans now offer professional advice using services like Financial Engines, typically at costs that are half those of retail advisors.
The bottom line is, a few percentage points of expenses can make a big difference over time. Before deciding what to do with your money, you'll want to determine the costs of the funds in your 401(k) plan and compare them to the costs of any financial advisor or institution you're considering investing with. It shouldn't be so hard to do because all 401(k) plans are now required to disclose the fees of their funds.
It's good American common sense to ask how much you'll be paying for services rendered and to make sure you're getting the best value for your hard-earned dollars.