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By Jason Stipp and John Rekenthaler | 07-30-2013 12:00 PM

401(k) Fees Need to Get Better

As 401(k)s become more of the centerpiece of the U.S. retirement system, the current average expenses for the plans are too high, says Morningstar's John Rekenthaler.

Jason Stipp: I'm Jason Stipp for Morningstar. Yale professor Ian Ayres is making waves in the 401(k) industry by threatening to expose what he's identified as high-cost 401(k) plans. So what might the study mean for the 401(k) industry? What should it mean? How should we interpret it? Here to offer some insights is Morningstar's John Rekenthaler.

John, thanks for being here.

John Rekenthaler: Sure, Jason.

Stipp: You've written about the study in a couple of columns in the last week. We're interested to take a step back at this point and talk about exactly what the study itself was looking at. We've heard a lot about the letters that he sent. But [let's talk about] what the study is looking at, what we can take away from it, and what might come next. There are two major things you're saying the study was looking at: costs and the menu of investments and how investors use them. How are you thinking about those two objectives of the study?

Rekenthaler: As we say, take a step back. This guy is a professor, so he assembles a database. He has a database of 12,000 401(k) plans, and he had very ambitious goal. His goal is to look and compare how people could have done with an ideal portfolio--his definition of ideal portfolio--and how far have they fallen short of the mark, and is this because of costs of funds, investor decisions on how they've put together funds, or the menu, the choice of funds that they were given. Do they have enough exposure to different classes in 401(k)? Were they given the chance to put together a complete portfolio by the menu, how much did the funds cost (because that cuts down returns), and did they assemble funds correctly? I really think only the cost piece they are able to truly do. Otherwise, it's rather technical to go through, but they have to make various assumptions. They don't know where the markets are going any more than anyone else does, and we don't know their efficient portfolio that the professor has put together in their paper is more efficient than your portfolio or my portfolio. So I'm not really going to address those issues, but they do have a great database of fees of costs of 12,000 plans, and I think that's valuable information and that's really what they're mining for the letter.

Stipp: The costs are the costs, right? The other assumptions that they're making for these other points about how well investors are using the funds--there's a lot of squishiness in there.

Rekenthaler: Very squishy.

Stipp: But they have the data on the fund costs and you said in your column this week that some of the conclusions look pretty reasonable about what the average cost of a 401(k) might be.

Rekenthaler: That's right. The data seemed to be pretty complete. It's important to know, and I think it's a fair criticism of 401(k) plans, that some of the jibing that comes at the professor and what his work is [about not having] all the costs in there, is because they're hidden in some fashion. That's not very complementary for the 401(k) industry to defend itself by saying we've got these hidden costs that actually don't show up there and you didn't capture all the costs. But setting that aside, the typical 401(k) plan in this database is about $13 million, so it's a pretty good sized plan compared with a mom-and-pop bagel shop that might have a 401(k) plan. But $13 million is not a gigantic plan compared with Ford and the major companies. It's 71 basis points or 0.71 or 7/10 of 1% for the average management fees or expense ratios for the funds in there.

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