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Individual retirement accounts, or IRAs, are the dominant retirement account in America today. Nearly 4 in 10 Americans have one, and, as of last year, these accounts held $13.5 trillion in total assets, according to Alicia Munnell, director of the Center for Retirement Research at Boston College.
But those would-be retirees are losing billions of dollars to high IRA fees when they roll their 401(k) accounts into similar IRA accounts — even if they choose the same underlying investment, according to a Pew analysis released last week.
Those relatively small differences in fees can snowball into big losses over time, Pew found. That’s particularly damaging because retirees typically live on fixed incomes, which means a reduction in a worker’s potential retirement savings can have a long-lasting impact on their standard of living when in retirement.
“In the aggregate, the amount of retirement savings lost in such rollovers potentially reaches tens of billions of dollars,” the report found.
Risks of a rollover
The bulk of IRA investments stem from workers leaving jobs and shifting assets from their prior 401(k) plans.
When someone leaves a job with a 401(k) plan, they have several options:
- Keep their funds in their employer’s old plan, if the employer allows it
- Move their old 401(k) to their new employer’s plan, if one exists
- Roll it over into an IRA
Many people like IRAs because of the convenience of tracking all their retirement savings in one place and the ability to choose from a number of investment options. But marketing from financial institutions also heavily favors IRAs, a government watchdog found in 2013.
Institutions steer workers into IRAs without understanding their specific circumstances, while workers may not understand that they’re being sold a product, the Government Accountability Office found.
That’s bad news for investors, who can get stuck with much higher fees from an IRA — even when the underlying investment product is the same, Pew found.
The difference comes from what’s known as share classes. Shares in mutual funds come in different flavors, known as classes, depending on whether they’re aimed at individual investors or institutional investors.
Even though all classes of shares are invested in the same basket of investments — stocks, bonds, real estate and other investments — different classes may offer different features or services or have different underlying expenses for marketing, administration and other costs.
Institutional shares — a class of mutual fund shares that are only available for sale to institutions only — typically require a large minimum investment, sometimes $100,000 or more, making them available only to employers pooling individual contributions from many people, or to very wealthy individuals. Because institutional investors have a lot more money to throw around, these share classes have the lowest fees.
Retail shares, on the other hand, are aimed at individuals and have low, or no, minimums. But retail share classes often charge much higher management fees than investor classes — a loss that compounds over time.
What’s more, many investors may not understand they’re being charged higher fees. “Fee disclosures [for these accounts] are written in a technical manner that is difficult for the average consumer to understand,” according to Pew. And, like the “terms and conditions” of many an online account, those disclosures often go unread.
A difference in class
But fee differences can be significant, Pew found.
Stock-based investment funds typically have expenses that are 37% higher for retail than institutional investors, Pew found, while median expenses for bond-based funds are typically 56% higher.
Hybrid funds, which invest in both stocks and bonds, have the lowest difference in expenses. However, with the typical hybrid fund charging expenses that are 31% higher for retail investors, the upcharge is still significant.
And because fees reduce the amount of retirement savings that can compound and grow over time, they can add up to tens of thousands of dollars in lost retirement savings.
“At first glance, the differences appear small, but they can substantially affect savings over time,” Pew says.
In one example Pew offers, a worker retires at 65 with a substantial 401(k) balance of $250,000, and rolls it over into the same investment fund in an IRA. Due to the higher fees in the IRA, she would have $20,513 less in income after 25 years.
A mid-career worker who moves that same $250,000 balance from a low-cost 401(k) to a high-cost IRA could lose substantially more, ending up with an account balance $137,630 lower after 25 years.
“Because the higher fees erode subsequent gains, the magnitude of the reduction in savings is even more substantial than the magnitude of the fee increase,” Pew notes.
For an early-career worker who moves $30,000 from a 401(k) into an IRA, higher IRA costs after 40 years would result in a balance that is $64,000 lower than it otherwise would have been.
To slow the erosion of workers’ retirement savings, Pew recommends that employers help departing workers with 401(k) rollovers, either by allowing them to keep their 401(k)s where they are or helping them resist marketing from high-fee financial products.