Retirement Portfolio Cancer: The Destructive Effect Of Expenses On Building Retirement Savings

by: Bruce Miller


Retirement plan expenses reported as a percent of account value seem small and incidental.

Compounded over one's working career, small percentages grow into large percentages.

Total expenses include not only the nominal charges, but must also include the loss of earnings on those nominal dollars.

There are advantages and disadvantages to using a pure income approach to generating a lifetime of reliable and growing income over retirement years. One of the distinct advantages is expenses - or perhaps I should say the lack of expenses.

I just received my 2016 summary brokerage account statement, which showed a grand total of six stock trades (12 transactions) totaling $94.20 in portfolio expenses. Assuming this was only on a portfolio of stocks, this expense would figure out to a portfolio expense ratio of about .006% or .00006. Now, in fairness, I do have four dividend ETFs - SCHD, XLU, VIG and SPY - which will increase my income portfolio expense ratio through their own expense ratios. But without doing the math, I think it reasonable to assume that even with these expenses weighted into the entire portfolio, would still result in an ultra-low expense.

Last week, I got a call from a close family friend who is preparing for retirement and, just out of curiosity, asked how to calculate the expenses he and his wife are paying each year on their 401(k) and 403(b) account savings. Always glad to take on a planning and quantitative challenge, I sharpened up my pencil and jumped in. What I finally figured out shouldn't really come as a surprise, but I was truly surprised, particularly with her 403(b) expenses (she is a teacher set to retire next year after 33 years with her school district).

During one's accumulation years, employees will often be restricted to the investments offered by the employer-sponsored plan and so don't have the broad selection options of those of us in retirement working out of our taxable accounts or IRAs. And the investment goals during accumulation will differ from the income goal of those investing purely for long reliable income. But expenses are expenses and will come right out of the investments' total return or income production, and so like any other household expenses, they should be managed. But how much should one expect to pay in expenses during a working career, and what effect will this have on the working year's savings total at the first year of retirement? That is the question I've studied and will show here.

Set Up

I began by getting low, average and high expense ratios for 401(k) plans from the annually published "401(k) Averages Book" by 401(k) Source, which provides a wide array of 401(k) plan ratios designed to provide plan sponsors and employers with comparative cost information needed to determine if their plan costs are at, above or below average. The Employee Retirement Income Security Act, or ERISA, requires employers to provide a detailed of plan expenses to employees to include investment-related expenses, administration expenses and individual expenses. However, this disclosure of fund expenses is not required of 403(b) or 457(b) plans offered by governments or non-profit employers.

  1. Individual costs will be specific to the account owner and include such costs as loan or in-service (hardship) withdrawal costs, transfer costs, divorce decree transfer costs and other episodic and non-recurring costs, so I did not assume any individual costs in this review.
  2. Investment expenses must include reported fund expenses, transaction costs, trust management, sales loads, surrender charges and other expenses related to investment management that must be paid from the employee's account.
  3. Administrative costs include legal costs, record-keeping, filing fees, the cost of the Third Party Administrator or the cost of labor and overhead paid by the retirement plan if the employer provides their own administration. Sometimes, the employer will fund some of the administrative plan costs while other employers will pay nothing, hence the employee will carry higher expenses when bearing all costs of administering the plan.

From the latest 16th edition of the "401(k) Averages Book," I obtained the bottom quartile average expense ratio, the top quartile average expense ratio and the mean percent expense ratio. These values came from the employer database used by 401(k) source. For the 403(b) average expenses, I used listed Fees and Expenses associated with Variable Annuities and used the averages shown.

As can be seen, the separation between the quartile averages is not linear. That is, low-cost plans are considerably lower in cost than higher-cost plans are higher in cost from the mean expense ratio. Another striking observation is the markedly higher cost of the "average" 403(b) plan funded primarily with variable annuities. This almost certainly has to do with 403(b) and 457(b) plans not being subject to the disclosure requirements of ERISA plans. Most such plans offering fixed and variable annuity products are administered by insurance companies with little oversight from the non-profit organizations, school districts and government employers sponsoring the plans

It is also noteworthy that expense ratios will also be affected by the size of the plan and the number of participants. The above averages from "401(k) Averages Book" assume 100 participant employees with an average account balance of $50,000.


To do a comparative analysis will require making reasonable assumptions that are as "middle-of-the-road" as I can get. For these values, I use Department of Labor current reported averages along with my years of working as a financial planner in the financial planning industry. From this, I am using the following assumptions:

Working years groups: 30 years and 40 years

Average annual gross (before expenses) rate of return: 7.5%

Average annual wage growth: 3.3%

Beginning year salary: $46,000

Annual Percent of Salary contribution: 8% (includes employee and employer contributions)

All plan contributions, assignment of investment gains and subtraction of expenses is done at the end of each year.

These are imperfect assumptions and will certainly vary between employers and over the working years of the employee. But the objective here is comparative, not nominal accuracy. All five expense categories are held to the same assumptions other than the expense ratios.

Total (all-Inclusive) plan expenses over working years

In this study, I will be looking at not only the nominal annual charges to the employee's account, but I will also include the future earnings foregone from those expense dollars. So the total (or full) expense will include:

  1. The actual stated fund expenses that are subtracted from the employee's account at the end of each year, and
  2. The earnings that are lost over the employee's working years from the expenses subtracted out each year. For example, for each $100 of expenses subtracted out in, say, year five will reduce the 40-year total account value by $1,257 in lost earnings.

Tax, as an expense, is a non-factor, as these retirement plans are tax-deferred and so will not be subject to taxation until withdrawals from the plan are made.

The below pie charts expenses include both 1 & 2 as total expenses.

Zero Expense Results:

The following is the breakdown of final savings-year portfolio value between contributions and earnings, as there are no expenses in this first group.

Unlike a retirement income portfolio where income is the primary investment goal, it is highly unlikely one can invest within an employer-sponsored retirement plan with zero expenses each year unless, I suppose, the employer agreed to underwrite all direct and indirect expenses. But this is only used here for comparative purposes. Under these assumptions, after 40 working years of 8% of salary per year contributions, 75% of the future value will be from earnings and only ~25% from contributions. The importance of earnings cannot be overstated. Also, it is strikingly noteworthy that accumulating for 10 additional years between year 30 and year 40 increases the final plan value by a factor of 2.3X!! The old axiom of start early is clearly exemplified here. And the power of compounding is indeed a free lunch.

Low Expense Results

This graphic shows that at a career average plan, expense ratio of .22% (.0022) per year results in a relatively small career total expense charge to the plan.

This kind of plan will most likely have employer subsidies to cover some plan expenses and will almost certainly use exclusively low-cost ETFs or even a trust to pool investments in larger plans so as to take advantage of economies of scale. Most employees would be happy to have this level of career low-cost savings at their first retirement year.

Average Expense Results

An average of 1.32% expense ratio on the employee's retirement plan over their working years, with the assumptions given, would produce the following breakdown of contributions, earnings and total expenses.

This chart shows that for an "average" 401(k) plan, over one quarter of the total plan's expense-free value will be lost to total expenses over 40 work years. This is more than most employees realize is being given up from their savings plans.

High Expense Results

Now things start to look ugly.....

Here, with expenses running 1.81% in the "high expense" category, over one third of the "high expense" portfolio is lost as compared to the zero expense portfolio over the 40 work years. Most employees will consider this excessive, particularly when there are much less costly alternatives available to the employer.

Variable Annuity funded 403(b) or 457(b) retirement plans

But the big kahuna of plan expenses comes from those plans with fewer regulations and historically not much oversight. The 403(b) and 457(b) plans offered by non-profit organizations and government employers are often administered by insurance companies whose "advisors" recommend (some might say "push") variable annuities. Some of these investment options may indeed be reasonably priced, while others will carry excessive fees greater than this average.

Here, nearly 60% of the 0% expense portfolio is lost to expenses, based on a total average account expense rate of 3.85%. By anyone's tape measure, this is egregious.

The following is a summary of all five expense ratio account values at the end of a 30- and 40-year work history, using the initial assumptions.


There are three takeaway lessons from this fee-focused study of long-term retirement savings accounts and the fee load they carry:

  1. Expenses not only matter, they REALLY MATTER, and the lower the expense ratio for an employee with many working years before them and a given asset allocation/risk profile, the better.
  2. Starting to save 10 years after beginning work is too late. The sooner, the better. Auto-enrollment plans offered today by many employer-sponsored 401(k) plans are more than a good idea for those entering the workforce, and should be vigorously encouraged.
  3. It feels good to be a true income investor with very close to a 0% expense ratio on retirement savings, where the cancerous effect of compounding expenses, regardless of the length of retirement, is pretty much a non-factor!

And as always, for anyone wishing to have the Excel Spread Sheet I used to derive these graphs and data tables, send me a PM with your e-mail and I'll be happy to send it along to you.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.