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Encore
A blog about living in and planning for retirement

One More 401(k) Expense – Trading Costs

Alicia Munnell, the director of the Center for Retirement Research at Boston College, is a weekly contributor to “Encore.

As discussed in a recent post, the explicit fees of providing 401(k) plans fall into two categories – those associated with administration of the plan (record keeping, legal work, and accounting) and those associated with investment management. Neither employers nor employees have any real idea how large these fees are.

Fortunately, the Department of Labor will now require: 1) companies administering 401(k) plans to disclose to the sponsor all the costs associated with administering the plan; and 2) plan sponsors to provide participants with expense ratios for investments offered by the plan.

While the disclosure is a great step forward, the investment costs reported by plan sponsors are only a portion of the total costs absorbed by the participant. The numbers reported will be the explicit fees paid by 401(k) participants (expressed as an amount per $1,000 invested). But participants in 401(k) plans also pay the trading costs incurred by mutual funds. Prior studies of actively managed equity mutual funds find their trading costs are about as large as their explicit fees.

Mutual funds face two types of trading costs: commissions and price concessions. Funds report commissions in supplements to their annual reports. They do not report the price concessions they pay to trade securities.

The price concessions can be substantial because orders submitted by mutual funds tend to move prices. Because dealers commit to buying or selling stocks at their quoted prices, they are prone to being exploited by better informed traders, a risk they cover by setting low bid and high ask prices. The less visible opportunity cost of delayed or missed trades likely exceeds commissions.

Both components of trading cost are included in the effective prices a fund pays or receives for securities. That is, they reduce the value of the fund’s assets as trades occur.

Trading costs within 401(k) plans are important for at least two reasons. First, trading costs can be a substantial drag on performance, especially for very actively managed equity funds. After allowing for the sum of trading costs and other fees, studies find that most mature equity funds generally fail to match the performance of a market index fund.

Second, trading costs can transfer wealth among different types of investors within an investment fund. Investors share the trading costs in proportion to their investment in the fund. If all investors traded their shares in the fund equally frequently and in proportion to their balances, then this sharing of the fund’s trading costs would be equitable. But, when some of the fund’s investors trade more aggressively than others, the aggressive investors pay less than their fair share.

The point of this discussion is that 401(k) plans can involve very large costs. And very large fees dramatically erode retirement assets. If fees amount to 1 percent of assets each year over a 40-year work life, then fees reduce assets at retirement by about 25 percent. Participants can minimize their costs by sticking to index funds, which involve substantially lower fees and less trading than actively managed funds.

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    • #55I have money moved from 401k funds to secured money makret and bonds.Not in stocks for over a year.I kept new contributions in the stock fund .This is what I did before the bubble burst,so I did not get hit when the makret crashed.I recently moved $3ok into stock funds.I started when the S&P hit 1260 and kept moving funds into stock fund each time it was going down.

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    • DOL’s new 401(k) disclosure regulations will require investment options to disclose portfolio turnover rate, which helps identify which funds turn over their holdings more frequently, and therefore identify which will probably bear higher trading costs (which ultimately reduces performance). But buying index funds isn’t a guarantee that you will pay lower trading costs. If an index fund has a volatile investor base that results in cash flowing in and out of the fund, then the index fund could have just as high trading costs as a buy and hold active manager with a stable investor case since the index fund manager has to sell holdings to redeem investors and rebuy the same holdings when new investors buy into the fund. There is also an economic incentive to pay lower trading costs because it hurts the fund’s bottom line performance. Given these variables, trading costs is but one of many factors to evaluate, but shouldn’t be the primary focus of any one’s investment decision. And making the claim that index funds are always cheaper doesn’t take into account these other factors.

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About Encore

  • Encore examines the changing nature of retirement, from new rules and guidelines for financial security to the shifting identities and priorities of today’s retirees. The blog also explores news that affects retirement, from the Wall Street Journal Digital Network and around the web. Lead bloggers are reporter Catey Hill and senior editor Jeremy Olshan. Other contributors include The Wall Street Journal’s retirement columnists Glenn Ruffenach and Anne Tergesen; the Director for the Center for Retirement Research at Boston College, Alicia Munnell; and the Director of Research for Pinnacle Advisory Group, Michael Kitces, CFP.

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