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Why Do Expensive 401(k) Plans Exist? And What Can You Do About It?

A reader writes in, asking:

“My daughter works for a company that provides relatively high cost investment options in her 401K plan. I’ve encouraged her to speak with senior management to encourage them to add low cost funds (such as Vanguard) so that every employee could realize these potential savings while employed there.

It seems only logical that management would want to have low cost funds available since they probably have 401K savings as well. What I don’t know and understand, is does a business or HR office benefit in various ways by only offering funds that are higher costs?”

There are two primary reasons why an employer might use a 401(k) plan with expensive funds.

First, the decision makers might simply be unaware of the importance of costs when it comes to investment performance. Perhaps they’re choosing funds based on past performance or based on the recommendation of a salesperson.

Second, the decision makers might have chosen to go with a plan that was inexpensive for the employer. In many cases, a plan is inexpensive for the employer precisely because it is expensive for the plan participants. That is, rather than making money by charging the employer, the plan provider charges administrative fees directly to the participants and/or offers funds that have substantial 12(b)-1 fees.

How to Get Less Expensive Funds in Your 401(k)

I’ve heard from many readers who have tried to get big changes made to their 401(k), such as switching from a provider with expensive actively managed funds to a provider such as Vanguard. Unfortunately, such attempts are usually (though not always) unsuccessful. There are several possible reasons why employers might be reluctant to comply with this request:

  • It sounds like a lot of work.
  • It may mean higher costs for the employer.
  • It appears risky. What if they anger a plan participant who likes the current investment options? Would they have to worry about a lawsuit?
  • It may mean having to “fire” a salesperson whom they’ve come to trust (and who, in some cases, may even be a family member or friend).

In addition, if the decision makers are using the current plan provider because they personally subscribe to an investment philosophy that involves using relatively expensive actively managed funds, you would have to convince them that they’ve been making poor decisions with their own money in order for them to see the wisdom of switching. That’s a big barrier to overcome.

Conversely, I’ve heard from several readers who have had success with a much simpler approach: Ask the employer to add one or two low-cost index funds. Phrase the request as a simple favor — a relatively easy way to make an employee happy. Something along the lines of, “I personally really like to use low-cost index funds. Would it be possible to add a stock index fund to the plan, such as Vanguard’s Total Stock Market Index Fund or Fidelity’s Spartan Total Market Index Fund?” Then follow-up as necessary.

With this approach:

  • You’re making a request that’s much easier (i.e., less work) to satisfy.
  • There would (likely) not be any additional costs for the employer.
  • There’s little risk of making any employees unhappy, because they wouldn’t be removing any investment options.
  • There is no need for a discussion in which you have to convince anybody of the merits of your investment philosophy (or the lack of merits of their philosophy).

Unfortunately, even this method isn’t foolproof. For example, in some cases, the plan provider will be unwilling to include lower-cost investment options. And in other cases, the salesperson representing the plan provider may talk management out of adding low-cost funds when asked about doing so.

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