The 401(k) is a big chunk of America’s retirement nest egg. Among Fidelity account holders, the average 401(k) balance was $91,100 at the end of the second quarter this year.
It’s favored for retirement saving for a few reasons: It allows for tax-deferred growth, it’s funded by paycheck deferrals and many companies offer to match a percentage of employee contributions.
But all 401(k) plans are not created equal, and there are some universal downsides to these accounts. Here are five things you need to know about your 401(k).
1. Administrative fees could be costing you big bucks.
401(k) plans are an expensive offering from the employer’s perspective: There are costs associated with providing the plan, for everything from paperwork to accounting and legal fees.
These administrative costs, combined with investment expenses, can total 1 percent or more and add up to nearly $140,000 over the lifetime of a worker whose salary starts around $30,000 at age 25, according to analysis by the Center for American Progress, a public policy research organization.
Some employers swallow administrative costs on behalf of the employee, but others pass them along, either dividing those costs equally between plan participants or charging a percentage of assets (which means employees with larger account balances pay more).
A 2013 study by NerdWallet found that 9 in 10 employees underestimate their 401(k) fees. To avoid that, here are a few tips to better understand your 401(k) plan fees.
2. Your investment selection is puny.
According to the nonprofit Plan Sponsor Council of America, 401(k)s offer an average of 19 fund choices, a small selection compared to what you’d be able to access in an individual account like an IRA.
“Generally, what you find is more of these passive index funds that charge less, and then there are these little landmines — actively managed higher-fee funds — mixed in,” says David Hunter, a certified financial planner with Horizons Wealth Management in the Carolinas.
Actively managed funds are landmines because they can be more expensive for investors: They are managed by professionals, and investors in the fund pay for that service as part of the expense ratio, the annual fee charged by the fund. The asset-weighted expense ratio of active funds in 2014 was 0.79 percent, according to Morningstar, compared to 0.20 percent for passive funds.
“Investors want to be aware of these fees and, to the extent they can, tilt [their] investment portfolio toward lower-cost funds,” says Walter Updegrave, editor of the website Real Deal Retirement. “If investors choose those, that can make a big difference in how their nest egg grows over time.”
On $100,000 invested over 35 years at a 7 percent return, the difference between a 0.79 percent fee and a 0.20 percent fee could add up to more than $175,000.
3. Target-date funds can have a dark side.
Many 401(k)s auto-enroll participants these days; that is, your investments are automatically chosen for you. If you don’t make investment selections, the default option is typically a target-date fund, a kind of mutual fund that is tied to a retirement year and rebalances to take less risk as that year draws near. But many target-date funds are actively managed and carry higher expense ratios. Even if you’re auto-enrolled in your plan, you want to take a look at your investment options.
“If you’re being auto-enrolled into a target-date fund, look at what the expense level is and whether you may be able to come up with a similar asset mix out of index funds and do better on expenses,” Updegrave says.
Keep in mind, however, that target-date funds do the work of rebalancing for you, which is part of the reason you may pay a premium. If you invest in index funds, you’ll need to keep an eye on your allocation and rebalance as necessary.
4. Employer contributions can vanish if you leave your job.
An employer match is one of the biggest reasons to contribute to a 401(k): It’s free money that makes potentially higher fees worth it. But that’s only if you stay in your job long enough to keep it.
The Plan Sponsor Council of America annual survey reports only about 39 percent of plans provide immediate vesting of employer contributions. In other companies, employer matching funds vest by a certain percentage each year, or as a whole after three, four or even five years. That means if you leave before you are vested, you may be giving up some or all of those matching dollars.
5. Your auto-enrollment contribution isn’t enough.
Plans that auto-enroll participants generally do so at a contribution rate of 3 percent or 4 percent, which isn’t enough to make for a financially secure retirement.
“You want to save 10 percent, and ideally 15 percent,” Updegrave says. “You can include an employer match in those figures, but 3 percent or 4 percent is not going to be nearly enough for most people’s retirement needs.”
On a $50,000 salary, contributing 3 percent per year over 35 years will leave you with a retirement savings of only a little over $300,000 — and that’s with a 7 percent return and salary increases of 3 percent per year and no employer match.
You should contribute at least enough to capture all matching dollars, but aim to inch up your contribution each year until you’re saving 10 percent to 15 percent of your salary.
Arielle O’Shea of NerdWallet contributed to this article.
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