One More 401(k) Expense – Trading Costs

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 (recordkeeping, 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.