Plan sponsors have long provided education on the magic of compound interest as a powerful force for retirement readiness. But most plan members—and even many plan sponsors—forget about the flip side of that coin: the long-term impact of compounding costs from investment fees.
In his article “The Other Side of the Compounding Coin: How Investment Costs Impact Retirement Security,” appearing in the September/October 2019 issue of Plans & Trusts magazine, Larry Bates says that employers and plan sponsors can take the following three steps to help their employees better protect their retirement savings.
1. Research, understand and reduce direct and indirect plan costs.
2. Offer lower cost options like index funds as part of a defined contribution (DC) investment menu.
3. Use financial education programs to inform employees about the impact of investment costs.
Common Misunderstandings
In some cases, the difference between 0.25% and 2.25% in annual fees could result in one participant keeping 93% of investment returns and another reaping only 48%, according to Bates, a consultant, speaker and author based in Toronto, Ontario.
Part of the issue stems from common misunderstandings around terms like 2.25% annual fees. To get a more accurate picture of investment costs, Bates suggests comparing investment fees versus gains, allowing for a wide range of time frames instead of focusing on the cost for just one year—and fully capturing the ever-growing compounding loss.
As an example, Bates writes about a $10,000 investment that generates an average annual compound return of 8% before fees over 30 years. The impact of 0.25% annual fees would mean that investors retain 93% of their total return after 30 years. Compare that with 2.25% annual fees and, at the end of that same 30-year period, the compounding costs of that extra 2.0% in fees each year for 30 years would mean investors retain only 48% of the total return. As Bates points out, the ultimate fee in this case would be 52%, not 2.25%.
To help plan members get the most out of their retirement savings, plan sponsors should consider the following steps.
1. Reduce Direct and Indirect Plan Costs
Obtain a detailed accounting of all direct and indirect plan costs, understand the long-term impact of those costs and find ways to reduce them, Bates writes.
Plans should research providers to avoid hidden or uncompetitive fees. One best practice is to benchmark the plan against plans of similar size to make sure the fees are appropriate and in line with industry standards. Employers that are starting a retirement plan or switching vendors may be able to include benchmarking reports within the vendor contract, Bates says.
Another option is to negotiate a fixed-rate recordkeeping fee based on the number of participants. Participant-based models can provide better transparency than asset-based models and avoid the fee increases that rise because of the value of plan assets rather than the value of services provided.
Bates suggests that plan sponsors review plan services each year and look for ways to reduce fees by simplifying or streamlining administrative processes, eliminating underutilized services, reducing mailing costs by delivering notices electronically, and increasing the usage of automation and self-service options for participants.
[Related Reading: Steps to Increase Retirement Plan Participation]
2. Offer Lower Cost Options
Plans also can offer lower cost investment alternatives, including index funds, on the DC plan product menu. Exchange-traded funds (ETFs) have greatly expanded in recent decades. With proper research and oversight, these funds can potentially help plan members receive the right mix of risks and returns, but with lower fees.
3. Provide Financial Education Programs
Bates also recommends that plans provide education on investment basics, including the impact of costs, to enable employees to make better informed decisions regarding their DC plans as well as other personal investments. This can help them while they remain plan members and when they ultimately transfer funds out of their DC plans.
Enhancing Retirement Security
Many workers rely heavily on DC plans for their retirement security. Their future financial well-being will be significantly impacted by market performance, individual investment choices and the costs they incur. The market may always be unpredictable, but employers that offer DC plans can do a great service to their plan members by helping them understand and reduce their investment costs.
Robbie Hartman, CEBS
Editor, Publications, for the International Foundation
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