Undisclosed charges, revenue deals and trading commissions are eroding the returns U.S. workers are counting on from $2.97 trillion in retirement savings.

By Darrell Preston Bloomberg Markets March 2008

For the 12 years Jerry Schneider has invested in the 401(k) retirement plan offered by his employer, Portland, Oregon-based engineering firm Elcon Associates Inc. he has battled to learn how much he pays in fees and then has tried to get Elcon to reduce them. Every time Schneider, 62, thought hed succeeded, he discovered more charges, he says. The latest blow came in September. Schneider found that undisclosed expenses for securities trades, administration and advisory services were driving the cost of Elcons plan to at least 3.5 percent of the amount he invested. He says he was furious because Elcon Vice President Kinh Pham had told workers in a February 2007 memo that Elcon had cut fees to 0.10 percent. Pham declined to comment for this article.

Were getting bamboozled, says Schneider, who hoped to save $1.5 million for retirement when he joined Elcons Seattle office in 1995. He now has about $450,000. To let people willy-nilly take out fees without knowing it is not what I want to do.

Since its introduction 30 years ago, the 401(k) has become the fastest-growing form of retirement savings plan for U.S. workers, who can no longer count on employer-provided pensions. Congress added Section 40l(k) to the U.S. tax code to establish the plans, which let employees invest in tax-sheltered savings accounts and then withdraw cash when they quit working.

From 1985 to 2006, the number of active 401(k) participants climbed fivefold to 50 million. Assets in the plans soared more than 19-fold to $2.97 trillion as of June 30, according to the Washington-based Investment Company Institute, an association for companies that offer mutual funds and other investment vehicles. What most of these workers dont know is that fees, rebates and revenue-sharing agreements among employers, 401(k) administrators and mutual funds—many of them buried in the fine print or not disclosed at all—are slowing the growth of their nest eggs. The U.S. Department of Labor lists 17 distinct 401(k) fees, including ones for record keeping, legal services and toll-free telephone numbers.

Hidden fees of 1 percent can reduce a workers 401(k) returns by about 15 percent over 30 years, says Stephen Butler, president and founder of Pension Dynamics Corp. in Pleasant Hill, California, a 30-year-old retirement plan consulting firm. These are expenses that investors never receive a bill for and they never write a check for and they have no say in when the plan is set up, Butler says. Its a loss to their accounts that happens with 100 percent certainty.

The most an investor should pay for a mutual fund-based 401(k) is 1 percent, says Gregory Kasten, a financial planner at Lexington, Kentucky-based Unified Trust Co. who advises wealthy individuals on $2 billion of investments. The average fee for stock mutual fund plans is 0.76 percent, according to the Investment Company Institute. If the fees in a plan are costing more than 1 full percentage point, the extra money sloshing around is profit, Butler says.

Schneider says he was shocked to learn that in addition to the 0.10 percent management fee on his Elcon account, he pays at least seven other charges to companies that provide 401(k) services. A 0.5 percent fee goes to the providers of the mutual funds in his plan. Then John Hancock Financial Services Inc. the Boston-based unit of Manulife Financial Corp. hired to administer the plan, takes 1.32 percent for those duties and a 0.75 percent advisory fee.

WITCHS BREW

On top of that, 401(k)s pay commissions to traders who buy and sell securities in a plans mutual funds. Schneider says hes charged 0.76 percent for these fees, which, like the others, come out of his returns. With trading commissions, a 401(k) may then pay a portion back to the mutual fund in so-called soft-dollar transactions. Such payments have gone for office rent, theater tickets, trips and fancy meals for money managers, U.S. Securities and Exchange Commission Chairman Christopher Cox said in a May 31, 2007, speech to the National Italian American Foundation in New York. This witchs brew of hidden fees, conflicts of interest and complexity in applications is at odds with investors best interests, Cox said.

In another maneuver known as revenue sharing, mutual funds may rebate fees to 401(k) administrators. In this way, a company running the retirement plan uses employees own money to offset costs—often without the workers knowledge. Pat Beesley of Beecher City, Illinois, and 10 other employees of Memphis, Tennessee-based International Paper Co. sued their employer in September 2006, alleging such an arrangement. The complaint, filed in U.S. District Court in East St. Louis, Illinois, alleges that in addition to $1.2 million of disclosed fees that International Paper pays for its workers 401(k) plans, employees pay $3.6 million through undisclosed fees plus millions of dollars in revenue sharing. ParticiÔpants of the plans are forced to pay, from their retirement savings, excessive and unreasonable fees and expenses that are not incurred solely for their benefit, the lawsuit says. The suit is in the discovery phase with a trial scheduled for June.

International Paper, which denied the allegations in court documents, doesnt discuss specifics of ongoing litigation, spokeswoman Amy Sawyer says. In terms of our 401(k) savings plan generally, we provide a plan for employees that offers them a broad range of high-quality investment options, she says. We are committed to ensuring that these plans are competitive in terms of both their performance and fees.

Schneider says he has no way of knowing whether Elcon has soft-dollar or revenue-sharing agreements because the company refused to tell him about its contracts with plan administrator John Hancock. Melissa Berczuk, a spokeswoman for John Hancock, declined to comment for this article.

The way some of these fees are hidden is that theyre blended into the fabric of the fund so that theyre almost impossible to discover, says Matthew Hutcheson, a pension consultant in Portland. Hutcheson crunched numbers and reviewed the fine print in hundreds of pages of Elcons 401(k) documents to uncover fees not disclosed to employees.

Butler uses the example of a person who invests in the Fidelity Freedom 2020 Fund to show one way investors wind up paying more. If a person buys the fund from Fidelity, he pays a fee of 0.76 percent, Butler says, citing Morningstar Inc. which tracks fees and returns. An investor who buys the same fund through a 401(k) may pay 0.25 percentage point more via a so-called 12b-1 fee. This fee is designed to offset the 401(k)s marketing and other expenses.

The amount ceded to fees widens as investors lose the benefit of compounding returns during decades of working. An employee with $25,000 in his 401(k) and 35 years until retirement would see his savings reach $227,000 if the fee is 0.5 percent and he earns a 7 percent return, the Labor Department says. If the fee is 1.5 percent, the balance will be $163,000—28 percent less. Fees of that size provide a powerful head wind to sail against, Kasten says.

Cox lays some of the blame for lagging investor returns on undisclosed charges and diminished compounding. Financial services industries are able to skim off much more of the assets they handle than would be the case in a well-functioning market, he told the Mutual Fund Directors Forum conference in Washington in April. The difference materially burdens an investors annual expected return. And compounded over the retirement time horizon of even someone in his or her 50s, this can result in truly astronomical shortfalls.

LACK OF DISCLOSURE

Legislation introduced in the U.S. Senate last year would aid consumers in making better sense of their 401(k)s. Senators Tom Harkin, an Iowa Democrat, and Herb Kohl, a Wisconsin Democrat, co-sponsored a proposal to require that investors get more information on fees. The new law would disclose revenue sharing and other relationships between parties with financial interests in the retirement plans.

More and more Americans are relying on 401(k) plans to provide their retirement income, Kohl says. In spite of that, there are few requirements for fund managers to tell participants how much they are paying in fees.

What really bugs the senators is that 401(k) providers may strive to keep participants in the dark. The American Benefits Council, which represents sponsors of the plans and the companies that administer them, says its not a good idea to tell investors too much. If theyre overwhelmed by the amount of information they receive, there is the danger that some wont participate, says Jan Jacobson, legal counsel for retirement policy at the council. Daniel Peterson, who advises on 401(k)s, disagrees. When they put nutritional labels on food, did people stop eating? says Peterson, a managing director at Tualatin, Oregon-based G Fiduciary LLC, which provides 401(k)s for employers. No, they just started eating healthier.

Ogery Ledbetter learned the hard way what it means not to know enough about her 401(k). First, the 56-year-old Ford Motor Co. assembly line worker in Chicago says she lost $60,000 on the Ford stock that made up 20 percent of her account. Fords shares dropped to $6.06 a share on Jan. 11 from $29.50 on Aug. 9, 2000, when Bridgestone Corp. recalled as many as 14.4 million tires used on Explorer sport utilities and other vehicles. Last year, Ledbetter found she was paying $299 in annual costs she didnt know about for trading securities in her plans mutual funds. That added 41 percent to the $737 in fees she paid for management of the funds provided by Fidelity Investments, according to an analysis by financial advisers Hutcheson and Kaston. Jennifer Engle, a spokeswoman for Fidelity, the worlds biggest mutual fund company, says the firm doesnt comment on clients. We provide our plan sponsors full information about fees, she says. We believe our fees are very reasonable.

Now with $93,300 in 401(k) savings, Ledbetter says she wont be taking dreamed-of trips to Australia and Tahiti when she reaches her hoped-for retirement age of 62. She wont even be able to quit her job as planned. Im going to have to add another six or seven years to how long I work, Ledbetter says.

Ford spokesman Tim Hoyt says the types of fees labeled as hidden are transaction costs. They are difficult to quantify and cannot be avoided entirely, he said in a Nov. 30 statement. Every 401(k) plan incurs these types of fees.

While workers are losing out to 401(k) fees, retirement plans are a big—and growing—business for the companies that market and administer them. The number of U.S. residents over age 65 is expected to more than double by 2030 to more than 70 million, according to the U.S. Census Bureau.

Hewitt Associates Inc. Merrill Lynch & Co. T. Rowe Price Group Inc. Fidelity and dozens of other firms manage and collect fee revenue from 401(k)s. Fees for all U.S. retirement plans total as much as $89.1 billion a year, according to Hutcheson and Butler, who arrive at the estimate by taking 3 percent of the $2.97 trillion of 401(k) assets.

At T. Rowe Price, the eighth-largest U.S. asset manager, 44 percent of the $16.6 billion of new mutual fund investment in the first nine months of 2007 went to retirement funds, the companys third-quarter report says. The Baltimore-based firm says it earns an average fee of slightly more than 0.5 percent for managing its mutual funds, including those in 401(k)s.

Nationwide Financial Services Inc. based in Columbus, Ohio, generated earnings of $216.5 million from retirement plans in 2006, about 28 percent of its profit, according to its annual report. Principal Financial Group Inc. which derives most of its income from retirement products, had record third-quarter earnings of $312.9 million in 2007, up from $254.7 million a year earlier. The Des Moines, Iowa-based company had $306 billion under management as of Sept. 30.

Butler says 401(k) administrators may pick the mutual funds they offer customers based on potential revenue sharing. In this way, the companies can increase profits because the plan participant winds up footing the bill for administrative costs. Theyre automatically deducted from what would have been earnings, Butler said during testimony before Congress in March 2007.

Columbia Air Services Inc. which sells, leases and services small airplanes in Groton, Connecticut, sued Fidelity over alleged revenue sharing. The complaint, filed in U.S. District Court in Boston in July, claims that Fidelity took rebates from mutual funds chosen for the companys 401(k) plan, forcing employees to overpay for services. Fidelity should have cut its fees by the amount of the rebates, the lawsuit alleges. Fidelity has filed a motion to have the suit dismissed. Plaintiffs claims are fundamentally defective on many levels, Fidelity wrote in the motion. No trial has been scheduled. Nick Burlingham, Columbia Airs corporate attorney, declined to comment.

Hidden fees are a little bit like high blood pressure, says Jeff Acheson, director of retirement planning at Pittsburgh-based Schneider Downs & Co. You dont really feel it, and you dont necessarily see it, but itll eventually kill you.

FINE PRINT

Acheson, who works in Columbus, advising companies on designing retirement plans, found half a percentage point in undisclosed fees from trading commissions in a 401(k) offered by National Sign Systems. National Sign eliminated the cost when it switched to Schneider Downs from Nationwide Financial Services, says Catherine McIntyre, benefits manager for Columbus-based National Sign. The savings translated into about $1 million over 20 years, she says. Schneider Downs offered us an opportunity to save money from an administration standpoint and for the participants to have more going into their accounts, McIntyre says.

Analyzing 401(k) plans to unearth hidden fees is daunting, Acheson says. One set of clues can be found in the annual returns 401(k) plans must file on Form 5500 with the Labor Department. This form requires information on some fees, although not all. Administrative costs, which arent noted on investors financial statements, must be listed in 5500 filings.

Reading a plans fine print may reveal other costs such as fees to buy in to or exit investments, charges for rebalancing investment allocations and the expense of getting daily computer access to account balances, among others.

To find the fees in his companys own 300-worker 401(k), Acheson reviewed more than 20 documents, including mutual fund prospectuses. Schneider Downs cut total fees half a percentage point to 0.75 percent from 1.25 percent, Acheson says. Theyre hidden in the legalese that you have to be able to interpret, he says. Its very challenging even for those that have some degree of background in the financial services business.

Total fees—disclosed and hidden—can hit 2 percent for companies with hundreds of workers and 3 percent for firms with fewer than 100, says Hutcheson, who has studied scores of plans. Thats double or triple the 1 percent maximum investors should pay. In extreme cases, fees can be much higher. Jerre Daniels-Hall, a Port Orchard, Washington, teacher alleges in a lawsuit that a 403(b) plan run by the National Education Association for the South Kitsap School District has fees totaling 12.17 percent for some employees.

A 403(b), similar to a 401(k), is available to workers in government and nonprofit corporations. Daniels-Hall says the fees include a 0.15 percent annual administrative charge, an annual contract fee of $30, a deferred sales charge that may total 7 percent and asset management fees that range from 0.78 percent to 2.57 percent, according to her complaint, which was filed in July in U.S. District Court in Tacoma, Washington. In addition, investors were socked with annual expense fees and as much as 1.55 percent for other charges, the lawsuit alleges.

The National Education Association offers a plan that gives members in any size school district anywhere in the country retirement savings options, says Lisa Sotir, general counsel for NEA Member Benefits Corp. Its hard to deliver a program like this with a low fee because there are commissions paid to agents, Sotir says. We dont condone high fees, but we want our members to choose the plan that is best for them.

Prospective retirees are beginning to agitate for better disclosure. At least five reform proposals are circulating in Washington. The Labor Department is considering three regulations. The first would require more details on form 5500 filings. A second would demand information on relationships between service providers and plan sponsors. The third would require more disclosures of fees for investors.

In July, U.S. Representative George Miller introduced the 401(k) Fair Disclosure for Retirement Security Act of 2007. The bill requires 401(k)s to reveal all fees investors pay. The Senate legislation by Kohl and Harkin asks the same.

None of these changes may do much good for Schneider. He says he started paying attention to his mutual fund returns in the 1970s, before he joined Elcon, noticing there had been no increase for five years. Fees slowed growth back then and have continued to stymie his efforts to save in his 401(k), he says.

Schneider says hed like to retire in September or October. He isnt sure that will happen. It depends on how everything works out, he says. Trying to figure out the fees is not a full-time job, but it could be.

Unless 401(k)s end stealth charges and demystify their fees, the more than 70 million Americans who will hit retirement age in 2030 may get less than they expected.

Darrell Preston covers municipal bonds and state and local government finance in Dallas. dpreston@bloomberg.net With reporting by Gary Matsumoto in New York.

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