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How To Avoid Trap Doors In Your 401(k) Plan

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There are more trap doors in 401(k) plans than a magician's stage. Only instead of allowing an illusionist to leave the stage, these devices make your retirement money disappear.

These illusions are hardly entertaining. While employers save billions by not offering real pension plans, they stick it to employees through badly managed and horrendously priced 401(k)s. Needlessly high expenses filch money from employees' retirement kitties.

Last year, Prof. Ian Ayres of the Yale Law School, sent out letters to several employers saying he was going to "out" their plans regarding high expenses. Ayres has followed up with a study, which is now a working paper entitled "Beyond Diversification: The Pervasive Problem of Excessive Fees and `Dominated Funds' in 401(k)s." He studied more than 3,000 funds with more than $120 billion in assets.

The premise of Ayres paper is simple: The fees in many funds are too high and they preclude meaningful saving. Here are the main points of his study and how to avoid some trap doors:

* Fees are so high that they outweigh the tax benefits of investing in the plan. This is perhaps the most startling conclusion of the Ayres study, co-authored by Quinn Curtis of the University of Virginia Law School.

Basically, high expenses eat up your tax break. As you know, although your withdrawals are taxable, your contributions are tax-exempt in conventional defined-contribution plans.

"In 16% of analyzed plans, we find that, for a young worker, the fees charged in excess of an index fund entirely consume the tax benefit of investing in a 401(k) plan," Ayres and Curtis found. 

You can somewhat offset that disparity by taking the employer match, which is free of fees before you invest it. Also look into how much you're being charged in the mutual funds within your plan.

* Plans can be crippled by an overpriced "dominated" fund. Nearly every plan gives you access to one or more stock funds. The actively managed funds can be quite expensive, costing more than 1 percent annually. That's exorbitant when you consider that you can find a passive index fund for less than 0.10 percent annually.

"We find that approximately 52% of plans have menus offering at least one dominated fund. In the plans that offer dominated funds, dominated funds hold 11.5% of plan assets and these dominated investments tend to be outperformed annually by their low-cost menu alternatives by more than 0.60 percent," the authors added. 

If your plan isn't dominated by low-cost index funds, ask your employer to make the switch. They have a legal responsibility to do so.

* Tell Your Employer to Dump Costly Funds. Many funds are "closet" index funds, meaning they mimic the market returns of an index fund, but do so at more than 10 times the cost. These should be the first ones to go.

How do you get your employer to act? Show them lower-cost alternatives from the FidelityiSharesSPDRSchwab or the Vanguard Group. There's currently a price war in exchange-traded index funds. Every major mutual fund house is competing for investor dollars, but you can't benefit from lower costs unless your employer takes action. (Disclosure: I hold my retirement funds in iShares, SPDR and Vanguard funds).

The best thing your employer can do is hire an independent fiduciary consultant who is not connected with a brokerage house, advisory firm or mutual fund complex. They can show them tangible savings -- money that can flow back into your retirement savings and not through a trap door.

John F. Wasik is the author of Keynes's Way to Wealth: Timeless Investment Lessons from the Great Economist and 13 other books.  An investor protection advocate, he speaks and writes regularly on investing, economics and personal finance.