Are You Paying Too Much in Fund Fees on Your 401(k)?

If you know absolutely nothing about investing, the single best thing you could do is invest in the lowest-cost fund choices. A study from Morningstar bears this out, finding that U.S. stock funds that were in the lowest-cost cohort were more three times more likely to beat their similarly invested peers than the highest-cost funds.

It's a simple truth that applies in bull markets and bear markets, but it's hard to know whether you're paying too much to own a fund, or getting a really good deal. Here is some hard data on mutual fund fees to use to compare your funds to similar investments.

Quantifying investing expenses

Mutual funds and exchange-traded funds are required to disclose just how much expenses eat into your returns. Funds publish a ratio known as an expense ratio, which tells you how much investors will pay each year in expenses relative to how much they invest.

If a fund carries an expense ratio of 0.50%, then an investor would pay about $0.50 per year for every $100 invested in the fund. Obviously, as the value of the fund increases, the fees increase, too, since they're assessed based on a percentage of the fund's value.

Whether a fund's expense ratio is high or low depends on the expenses on funds in its peer group. On average, stock funds cost more than bond funds, and actively managed funds cost more than index funds, so it's important to compare on a like-for-like basis.

Image source: Getty Images.

How does your fund compare?

The following table shows what investors paid on different types of funds, based on all the fees paid divided by all the money invested in each type of fund in 2016. The data is slightly old -- data for 2017 won't come out for a few more months -- but rest assured that fees don't change much from year to year.

Data source: Investment Company Institute.

There are very big differences between expense ratios for different types of funds. Actively managed stock funds, which employ costly analysts to pick investments, charge several times more than index funds, which simply invest in stocks or bonds that make up an index, like the S&P 500 for stocks, or the aggregate bond index for bonds.

Putting 401(k) fund fees in perspective

I'm not one to argue over small differences. Realistically, the difference between paying 0.2% a year on an index fund and 0.4% a year on an actively managed fund probably isn't worth worrying about, as the difference is pretty negligible. 

That said, there are many instances in which the differential in fund fees and expenses is substantial from fund to fund, even within the same plan. I've seen 401(k) plans where investors are automatically enrolled in target-date funds that cost 1% or more per year, when index funds are available for as little as 0.2% or even less. (Smaller employers are notorious for having poor selection in their retirement plans.)

It would take a really extraordinary run for a fund that costs 1% per year to outperform a similar mix of investments made through index funds at a cost of 0.2% per year. Every year, the index funds start off with a 0.8-percentage-point advantage. That's a really big difference.

Consider that a mix of 60% stocks and 40% bonds returned 8.7%, on average, between 1926 and 2016, according to Vanguard. If you paid 1% in fund fees for that asset mix, you would have given up nearly 12% of your annual returns to fund expenses. That makes a real difference over long investment timelines, and it can add up to real amounts of money, as much as a quarter-million dollars at retirement for even modest savers.

The best thing you can do in the new year is evaluate your 401(k) investments to see what you're paying to invest. Fund choices change frequently, and you may have better options now than the last time you looked.