According to a Dalbar Financial Services study that tracks investor returns, from 1989 to 2008 the S&P 500 yielded 8.35% annually. But the average investor only earned 1.87% over the same period. This fact deserves restatement. The average investor received less than a quarter of the general market return and did not even keep pace with inflation.

The study suggests that average investors would enjoy better outcomes if they simply invested in bank certificates of deposit (CDs) rather than trying their hand at more aggressive investing. We certainly do not endorse abandoning the equity markets. Seeing so many people forgo their retirement dreams, however, is very discouraging.

We call the difference between the market return and typical investor returns the “termite gap.” Termites eat away at the very foundation of your retirement plans. They hide in layers of financial intermediaries that all take a bite out of your portfolio. And the most dangerous termites lie within your emotions.

Fees are the strongest predictor of a fund’s performance. John Bogle, founder of Vanguard Funds, commonly shares a simple and compelling mathematical equation that highlights the importance of managing fees. If the performance of all of the market participants make up the average return (A), then after fees (B), investors underperform the market by the amount of those fees (A – B = C). Thus the higher the fees, the higher the underperformance. And when you find out you have termite damage, the first thing you need to do is call the exterminator.

The obvious solution for average investors is to find proven investments with the lowest administrative fees. However, they are left in a very difficult situation. Most do not have the time or expertise to uncover these hidden costs. In a market with so many 401(k) options, we would expect highly competitive pricing. Instead, investors and plan sponsors of small to medium market cap companies display very little price sensitivity when making 401(k) investment decisions. The Government Accountability Office (GAO) found that 80% of 401(k) participants are unaware they are paying any fees.

Many mutual funds with annual operating fees more than 1% will likely underperform and should be avoided. Request a copy of each fund’s prospectus and use a magnifying glass to uncover these first three hidden termites. Look for subjects like “wrap fees,” “subtransfer agency fees” and “mortality and expense fees” (M&E). M&E fees are an extra insurance charge in annuity contracts. You may have heard that combining your investments with your insurance is a bad idea. Inside a retirement plan, it is a terrible idea.

The fourth hidden termite is 12(b)1 fees. These fees actually pay for a fund’s advertising, which is strange. Consider the consumer outcry if grocery stores started charging an extra line-item fee to cover their advertising.

In addition to the standard investment management expenses, mutual fund companies have agreed to pay retirement plan providers so they can be included on a short list of available funds within a 401(k).

If we were describing the mafia, we would call these arrangements “kickbacks.” Retirement plan providers have convinced the public they are merely “revenue-sharing” agreements. However, this is not the sharing you learned about in kindergarten. Mutual fund companies create a new “class” of shares, often called “retirement shares” in standard plans or “insurance class” inside of annuities. These new shares are created with higher fees than the standard fund to pay for these types of fee arrangements: the fifth termite.

Unless you are lucky enough to participate in a large corporate 401(k) plan, you typically will not find more than a small handful of no-load Vanguard funds or index funds in these accounts. You will find a large list of funds that try to justify their high expenses by raising their risk levels through active management. The cost of portfolio turnover is the sixth termite affecting expenses. Higher portfolio turnover increases the transaction costs of buying and selling the individual securities in a mutual fund or other investment account. These transaction costs are not separately identified but are netted with the investment return.

Management fees in the 401(k) industry run about 1.6% for the average equity fund. Add in portfolio turnover costs and the impact of sales charges, and another 1.4% of cost has been added. That brings the 1.6% management fee or expense ratio up to 3% a year for a typical 401(k) plan.

High fees do not need to be put on a 401(k) plan. We’ve designed dream 401(k) choices for our small business owners with less than half those amounts. Incentives always exist for the industry to hide these fees. So being an informed investor is critical.

The seventh and final termite is found within. Common sense tells us to buy low and sell high. The evidence of mutual fund flows suggests that many investors pull their money out of the markets when it is falling and reinvest it back as it is rising. Behavioral finance identifies and addresses these self-destructive actions. But solutions are lacking. Target date funds and managed accounts have helped guide 401(k) participants away from the folly of focusing too closely on individual fund returns. Unfortunately, the termite damage remains.

Imagine a world without financial termites. A person who makes $60,000 a year and invests in the company’s 3% matching retirement plan would have $434,947 in 30 years at market returns (8.35%). If this same investor, subject to the termite gap, receives only average investor returns (1.87%), the portfolio would be worth $143,108, nearly $300,000 less than expected.

Average employees cannot make changes to their 401(k) provider. So here are a few words of advice. We usually recommend that people invest up to their match and no higher. Maximize other low-cost investment opportunities, including a Roth IRA, before saving unmatched money in a typical 401(k) plan. If you have left a job or are retired, roll your money over to an IRA that offers low-cost investment options unencumbered by excess fees. If you are currently employed, diversify your investments among index funds and, if necessary, actively managed funds with lower expense ratios.

If you are a business owner or HR director, seek a revenue-neutral investment advisor. In other words, find someone who does not accept revenue-sharing payments or commissions from mutual fund companies. When any mutual fund rebates these revenue-sharing payments, a revenue-neutral advisor will pass these payments back to the plan to offset fees. These investment advisors are more likely to choose low-cost index funds rather than high-cost actively traded funds. The best advisors are fiduciaries. Registered Investment Advisor fiduciaries must disclose fees in writing, invoice the plan sponsor or plan for those stated fees and credit any revenue-sharing fees back to the 401(k) retirement trust. The goal for all employees and plan sponsors should be to capture as much of the market gains as possible.

Photo by Megan Marotta