What Is the Recommended Maximum Expense Ratio for a 401(k)?

R says, Hey, Money Guy Team, my employer offers a variety of funds in their Fidelity 401(k) plan, and I was wondering what’s the highest gross expense ratio you’d be willing to have? My options range from 3% to 0.1%. We get this question all the time because you hear us talk all the time. We love index funds, we love low cost; it’s been a race to the bottom amongst a bunch of the big index fund providers. So a lot of people, because they know that and they believe that, start to get anxiety when they see anything that’s not a bottom-of-the-barrel expense ratio. So, is the correct answer that you don’t ever pay a higher expense ratio, or if you do, how do you know when and why, and does it make sense to? Well, I mean, it’s nuanced.

Let’s talk about different asset classes. Just as an example, large-cap – that’s all your top 500 companies in the United States, the S&P 500. I’m going to be pretty upset if I’m paying 1% for that because I know that there are index funds that charge me. Fidelity has a zero fund, but a lot of funds… it’s not hard to get 0.01, 0.02, which is still pretty close to free, yep. So, that’s right. You have to look at each asset class and think about what am I getting for this? Large-cap should be practically in the basement to zero. If you’re paying a high fee on that, I would start questioning that. Or is there a rate of return that’s exceeding what the benchmark is doing to justify this? The research from SPIVA shows that over the long term, 80-plus percent of managers don’t underperform. They underperform. So, that’s why we try to beat the market when you can be the market and just try to maximize the lowest cost option as possible.

Now, there are cases like we’re in this weird interest rate environment with bonds, and I like Bond index funds too. But I noticed we did our attribution analysis for our clients recently, and it was interesting to me that all the managers did better than smoked the indexes. That’s because that manager was obviously playing around with the inverted yield curve and the choice of different types of papers and other things that they were buying. We’re in a very inefficient marketplace with the crazy interest rates and all the other risks that are going on right now. So once again, I looked at the asset class, and I said, ‘Okay, how does this compare to the index?’ We’re in this moment of weirdness that it looks like the manager is actually overperforming, and to the point that it’s well beyond what the cost is that I’m going to be okay with paying a little bit extra on that. I think you have to look at that on every asset class that you’re doing. Definitely the big ones because you want to make sure that you got some diversification in there depending on your age, your risk profile, and your goals. That’s the way I look at it.

Ray, I’ll bring this back to you because you said you have a Fidelity 401(k). I’m surprised because you said you have a Fidelity 401(k), but your lowest cost is 0.3%. That was very surprising because usually when I see Fortune 500 Fidelity 401(k)s, they are practically free on the internal expenses. And they even offer the index Target Retirement fund, where those index Target Retirement funds with Fidelity are less than 10 basis points, like 0.08 or 0.07 depending on which one you’re looking at. So, there are options even there. But I would just say if I’m going to pay a fee, what am I getting, and how does that fit the asset class I’m investing in?

The other thing I would do is think about your total portfolio. When we do portfolio analysis, we look at the total portfolio internal operating expenses. You take your weightings times the internal expense and figure that out, or you have software that can help you do that. Just like Brian says, focus on the big things that matter and don’t get lost in the minutia. But I do think there’s probably a little bit of room where you could improve your plan. You said it great, Brian, make sure you know what you’re paying for and you’re getting value out of that. For more information, check out our free resources