How to Find (and Vanquish) Hidden Costs in Your 401(k)

I suspect that Americans spend more time clipping coupons and chasing sales than probing their 401(k)s and other retirement accounts for hidden expenses.

Although you can save a few dollars when something is on sale, trimming expenses from your 401(k) puts money into your pocket every year--and that can add up to thousands of dollars over a working lifetime. It's the one payback that keeps on working because of the compounding of returns.

Whether you're retired--and staying in your former employer's 401(k)--or still working, you need to be diligent to ensure you're getting the most investment dollars working for you. Any expenses you can cut back now will mean more money in your pocket later.

Here's what you can do:

Check your funds' expense ratios. This is always a good place to start, since it's the most visible tote board on how much you're paying--or overpaying. According to Morningstar, the average cost of a U.S. mutual fund is 0.71% annually (as of the end of 2013). The typical investor paid 0.67% for stock funds, 0.78% for balanced funds, and 0.60% for bond funds. 401(k) investors should demand better than average; you can find a core U.S. stock index fund that represents most of the U.S. market for as little as 0.04%. Conceivably, 401(k) plans, since they represent many investors, should be able to access lower-cost fund share classes for employees.

Go beyond the expense ratios into brokerage and other transaction costs. Discovering the all-in fees incurred when funds buy and sell securities is less simple. Brokerage commissions--the fees incurred when your fund makes trades--are not contained in fund expense ratios but can be found in a fund's statement of additional information (SAI). (See the "Filings" tab of a fund's data report on Morningstar.com.)

But in addition to tangible brokerage commissions, other indirect costs are incurred as a fund trades large blocks of securities and, in some cases, moves the price of those securities as it does so. Managers don't always get the best prices nor do they always time their trades ideally, and such costs may be higher for illiquid, small-company, or international stocks.

These trading impact costs end up getting passed along to you, but they can be devilishly difficult to calculate. Coupled with brokerage expenses, estimates for all-in transaction costs range from north of 30 basis points (0.30%) to as high as 144 basis points (1.44%). As you can see, these costs could potentially swamp the expense ratio of a fund, so they're worth keeping an eye on. 

Although actual trading impact costs can be tough to calculate precisely, you can get a ballpark sense for your exposure to them by checking a fund's "turnover ratio," which measures its trading activity. A higher ratio means more trading, which means higher transaction expenses for you the investor. You can find turnover data on the Portfolio tab (Holdings sub-tab) of a fund's data report on Morningstar.com, along with category average turnover data for comparison.

Such expenses will tend to drag less on funds that trade less, including most index funds, while they will be a bigger factor for active managers who trade frequently, especially in less liquid markets. 

Cash Drag. I'm always leery of active managers who keep a lot of money in cash, which earns close to nothing these days. After all, if a fund says it invests in stocks or bonds, that's what it should be doing. You can see a manager's cash position on the Portfolio tab (Summary sub-tab) of a fund's data report on Morningstar.com. A high cash position--anything over 5%--should be noted. Although some managers will argue they are keeping cash aside when they don't see opportunities, few of them can consistently time the market correctly. As such, a very high cash stake should give you pause unless you have confidence your fund manager is one of those few.

Soft Dollar Arrangements. Also called "revenue sharing," these deals between fund managers and administrators simply shift money from mutual fund operators to brokers and middlemen. As a result, you may be paying for brokerage commissions or other services that are overpriced. One study estimated that soft-dollar commissions may total some $1 billion annually. But since this is an opaque expense, the real number is unknown. For your purposes, you can ask your plan administrator if there's any revenue sharing involved in your 401(k). You should avoid fund companies that engage in this practice. Companies that pay soft dollars claim it benefits investors, although I've never seen academic evidence that it adds any value.

What You Can Do
I'll admit that this is never easy, but if you suspect you are overpaying either through direct or indirect expenses on the funds in your plan, you can approach your employer to ask for an independent fiduciary consultant to audit your plan.

How do you get the ball rolling? Organizing an employee committee is a good way to start. There is power in numbers. The key is to demand an independent review of the plan that also involves examining a number of new vendors. Since the competition for 401(k) plans is fierce, your employer should be able to find a better deal. 

When you get an audit--assuming your employer has heeded your call--review it carefully. Set up a timetable for review and re-bidding vendors. Ask if you can review the bids, and see how much you can save.

Make sure to vet every middleman expense. If there are 12(b)-1 expenses, revenue sharing/soft dollars, retail expenses, or wrap fees, how can they be eliminated?

You also may be able to reap big savings if your administrator can find a platform featuring ultra-low-cost exchange-traded funds. The bookkeeping is a little tricky on these plans, but they can save a bundle on expenses.

Some fixes may be easy to make, such as adding more low-cost and/or index funds to your lineup. Other changes are possible, such as switching to less-expensive share classes or obtaining institutional pricing on fund expenses.

Whatever you achieve is not only a victory for your own retirement, but it will help everyone in your 401(k) plan--including the executives empowered to do the right thing.

John F. Wasik is a freelance columnist for Morningstar.com and author of 14 books, including "Keynes's Way to Wealth: Timeless Lessons from the Great Economist." The views expressed in this article do not necessarily reflect the views of Morningstar.com.