Read an important update of this story here: International Teachers: Should You Invest in a Roth 401(k)?
Revised: January 4, 2017
At least three financial services representatives offer 401(k) platforms for American teachers overseas.
Such platforms offer the promise of tax-free gains.
Not all expatriate financial advisors believe that the strategy is legal. Some say it could bite participants in the butt. That’s beyond the scope of this assessment. For this article, I’ll assume that this tax platform (which doesn’t appear to be black and white) will work out for American expat teachers.
How About Investment Fees?
The financial services industry gets heavily criticized for charging high fees.
The Wall Street Journal wanted to find out what the average 401(k) costs. Including all administrative fees and fund charges, the typical small company’s 401(k) costs 1.27 percent per year. Companies whose investors have a combined $10 million to $100 million in their plan get charged an average of 0.82 percent.
The larger the firm, the lower the costs.
These figures include all fund costs and administrative costs.
Three of the firms/advisors that offer 401(k) plans to American international teachers include investment advisor Jon Levy (Integrated Financial Planning Services), Raymond James and The Investment Center (TIC Retirement Care).
Each charges fees that are above the industry average.
- How do they stack up?
- Which of the three offers the lowest cost platform?
- Does the tax-free status make the high fees worth it?
This white paper will try to answer these questions.
How Much Does The Average 401(k) Investor Pay In Fund Fees?
A 401(k)’s total plan fees include fund costs and administrative costs.
Let’s tackle fund fees first.
Note that orange line below. It represents expense ratio costs for typical U.S. mutual funds. In 2000, the average U.S. mutual fund charged 1.60 percent. By 2012, that average cost was down to 1.40 percent.
But costs vary a lot.
Investors could pay as little as 0.15 percent for expense ratio costs on a portfolio of index funds. Many employers and employees are starting to catch on. Check out the green bars below.
In 2000, the average 401(k) investor paid fund fees of 0.76 percent. By 2012, the average had dropped to 0.63 percent per year. Simply, investors and their employers are getting a lot smarter. They’ve been saying no to high fees, selecting lower cost options instead.
Source: Expenses and Fees Paid On Mutual Funds in 401(k) Plans, Investment Company Institute
Many companies, however, still charge a lot. Ian Ayres is an economist and lawyer at Yale Law School. In March 2015, he and Quinn Curtis (a professor at the University of Virginia School of Law) published, Beyond Diversification: The Pervasive Problem of Excessive Fees and “Dominated Funds” in 401(k) Plans in the Yale Law Journal.
They wrote, “A lengthy menu of varied funds all charging management fees of 1.5% [which is] well above the industry average, would not lead to good outcomes for the investors who must hold those funds.”
Below, I’ve listed total charges for three 401(k) platforms offered to American international teachers. The fees that I listed for Jon Levy’s plan came from the documents offered to the International School of Prague. Raymond James’ came from the documents offered to the American International School of Vienna. Costs for The Investment Center (TIC Retirement Care) came from email exchanges with program administrator, Lance Roberts, and documents that he was kind enough to send me.
I estimated annual expenses based on the average costs of the funds offered in each of the below platforms plus administrative charges.
Teachers who aren’t careful with their fund selections could end up paying more than the listed costs below.
Each of the 401(k) platforms below, for American international teachers, cost more than the average small company 401(k) in the United States.
International Teachers 401(k) Total Annual Charges
Including Fund Fees and Administrative Expenses
|
Jon Levy |
Raymond James |
The Investment Center (TIC Retirement Care) |
Average U.S. Small Company 401(k) Costs |
|
1.54%* |
1.61%** |
1.75%*** +$40 per year |
1.27% |
*This may be slightly higher if extra administrative costs are charged
** This includes possible administrative charge mentioned in the Raymond James prospectus: “If an additional amount is required to cover your plan’s administrative expenses, your employer expects that it will appear on your quarterly statement. Your employer expects that the total amount of plan-level expenses will not exceed up to 0.10% of your account balance per year.”
***Average fund fees are 0.30% per year; administrative charges are 1.45% per year
Jon Levy and Raymond James
Jon Levy and Raymond James offer the American Funds family of mutual funds for their 401(k) investment platform.
I’ve included Jon Levy’s fund offerings below. They are similar to the funds offered by Raymond James to American teachers at the American International School of Vienna.
Note the figures on the far right of each fund.
Each percentage indicated (on the far right) represents the annual fund fees. Note that the American Funds AMCAP Fund costs 1.48 percent per year. The American Funds Global Growth Portfolio and the American Funds Growth Portfolio cost 1.65 percent and 1.59 percent respectively.
As you can see, they are well above the U.S. industry dollar-weighted average of 0.63 percent per year for 401(k) plan funds.
However, for Raymond James and Jon Levy’s 401(k) plans, fund fees include most of the administrative costs.
The funds that are offered by The Investment Center (TIC Retirement Care) are far lower. But the administrative costs are higher.
Below, you can see the fund selections for Jon Levy’s plan.
Again, it’s very similar to the funds offered by Raymond James to the American International School of Vienna. These fund offerings exceed the 401(k) small company industry average in total costs for U.S. based 401(k) plans.
Jon Levy Offered Funds
Source: American Funds, Capital Group, Share Class R-2
But Do High Fees Lead To Poor Performance?
I’ve looked at the performance for each of the above funds with 10-year track records. Ten years is a time period that’s worth examining. It includes the stock market crash of 2008/2009. On average, results for the above funds have underperformed their index fund counterparts.
But Haven’t American Funds Historically Performed Well?
The answer to the above question is yes.
But published performance comparisons, such as this one, don’t include sales commissions (5.75%) for the firm’s Class A funds. More important, they don’t include the high-cost R-2 Class of funds that are provided by the Jon Levy and Raymond James 401(k) platforms for international teachers.
American Funds pays financial advisors differently, depending on the fund classes offered. Probably the most common are the A class series. These are cheap. For example, take the American Funds AMCAP fund (A class). It carries a management expense ratio of just 0.67 percent per year. Its R2 class equivalent costs more than double. Its annual expense ratio is 1.48 percent per year.
It’s tough to tout the R-2 funds over the Class A funds. The Class A fund carries a front-end load fee (also known as a commission) of 5.75 percent. This looks like a hefty charge. But such commissions have far lower impacts on performance than an ongoing, higher expense ratio fee.
Not including commissions, the American Funds AMCAP A fund costs 0.67 percent per year. Its R-2 equivalent costs 1.48 percent per year. It’s the same fund. But based on costs, the R-2 fund costs 0.81 percent more each year.
Don’t let the 5.75 percent purchase commission fool you.
It’s better to pay a commission of 5.75 percent on every purchase and pay 0.67 percent per year in fund fees than it is to pay an extra 0.81 percent per year in expense ratio fees with no commission at all.
Assume the A class fund earns 8 percent per year over the next 30 years. Its equivalent R-2 class fund would earn 7.19 percent. Even if the A class investor paid a front-end commission of 5.75 percent on every purchase, they would come out ahead, thanks to the fund’s lower expense ratio.
If the investor added $10,000 annually for 30 years, the R-2 class investor would “pay”$105,304 more in fees as a result of the higher costs of the R2 funds.
$10,000 Invested Annually For 30 Years
|
|
R-2 Class |
A-Class |
|
Amount Invested Per Year |
$10,000 |
$10,000 |
|
After-Commission Annual Investment |
$10,000 |
$9,425 |
|
Annual Fund Return* |
7.19% |
8% |
|
End Value |
$1,047,805 |
$1,153,109 |
*The R-2 Class costs 0.81% more, hence the lower annual return
Below, I’ve listed the Jon Levy-recommended R-2 individual funds with 10-year track records and compared their performances with index funds representing an equivalent asset class. I excluded American Fund’s Small-Cap World Fund (it has no Vanguard equivalent and no combination of Vanguard sold funds replicates its holdings).
If one of the Jon Levy-offered funds didn’t have a 10-year track record, I didn’t include it for comparison.
I broke the funds down into 5 comparable categories. They included U.S. Equity, U.S. Growth, U.S. High Income Bonds, U.S. Broad Market Bonds and U.S. Intermediate Bonds. I also included a blended, sixth category, comparing the blended American Funds with some equal-weighted comparisons.
U.S. Equity Category
This category includes U.S. stock funds. It didn’t include specialty funds, such as those focused specifically on high growth stocks (think Apple, Netflix etc). As such, I compared the five American Funds listed by Jon Levy to two broad U.S. stock market index funds: Vanguard’s Total Stock Market Index (VTSMX) and Vanguard’s S&P 500 Index (VFINX).
Over the 10-year period ending September 30, 2016, the average returns of the Vanguard Index funds beat the American Funds R-2 Class U.S. Equity funds by an average of 1.09 percent per year. Compounded over 10 years, that’s an 11.45 percent total difference.
American Funds R-2 Fund Performances Offered by Jon Levy vs. Vanguard Index Funds
10 Year Period Ending September 30, 2016
Asset Class: U.S. Equity
|
Fund Name |
Expense Ratio |
10 Year Annual Performance |
|
1.48% |
7.14% |
|
|
1.35% |
6.21% |
|
|
1.37% |
5.74% |
|
|
1.36% |
5.36% |
|
|
1.36% |
5.36% (noted, same return as the above fund) |
|
|
0.16% |
7.41% |
|
|
0.16% |
6.69% |
|
|
American Funds Category Performance Average |
|
5.96% |
|
Vanguard Category Performance Average |
|
7.05% |
Source: Morningstar.com
U.S. Growth Stocks
The Jon Levy platform includes three R-2 Class American growth funds with 10-year track records. Such funds are stuffed with fast growing companies, in terms of business earnings. Over the 10-year period ending September 30, 2016, the three R-2 Class growth funds averaged a 6.17 percent annual return. This compares to the 8.17 percent earned by Vanguard’s Growth Index (VIGRX). Compounded over 10 years, that’s a 21.89 percent total difference.
American Funds R-2 Fund Performances Offered by Jon Levy vs. Vanguard Index Funds
10 Year Period Ending September 30, 2016
Asset Class: U.S. Growth
|
Fund Name |
Expense Ratio |
10-Year Annual Performance |
|
1.35% |
6.18% |
|
|
1.57% |
6.79% |
|
|
1.55% |
5.56% |
|
|
0.22% |
8.17% |
|
|
American Funds Category Average |
|
6.17% |
|
Vanguard Category Average |
|
8.17% |
Source: Morningstar.com
Bond Funds
If high fees don’t make sense for actively managed funds, that warning should double for bond market funds. Interest rates for bonds are low. The 10-year yield on U.S. government bonds was just 1.63 percent in October 2016.
October 2016 Yields On Government Bond
Source: U.S Department of the Treasury
These are the lowest bond yields that we’ve seen in years. That doesn’t mean investors shouldn’t buy bond funds. It does mean, however, if you’re paying more than 1 percent per year for a bond fund, you’ll have a tough time making money.
If the fund earns a 3 percent return before fees (which would be excellent, in a climate where yields are so low) then an investor paying expense fees of 1.5 percent would give up 50 percent of their proceeds to fees each year.
The American Funds R-2 class of actively managed bond funds offered by Jon Levy cost investors as much as 1.57 percent per year. Even during a higher interest rate climate (such as what we had during the past 10 years) a bond with such a high expense ratio would have a tough time making money–for those who invest in the fund.
Among the broad market bond funds offered by Jon Levy’s 401(k) plan (again, these are similar to those offered by Raymond James) the average 10-year return was 2.88 percent. Vanguard’s Total Bond Market Index (VBMFX) averaged 4.62 percent. Total pre-tax returns for the Vanguard Balanced Index was 18.2 percent higher over the 10-year period.
American Funds R-2 Fund Performances Offered by Jon Levy vs. Vanguard Index Funds
10 Year Period Ending September 30, 2016
Asset Class: U.S. Broad Market Bonds
|
Fund Name |
Expense Ratio |
10-Year Annual Performance |
|
1.34% |
2.64% |
|
|
1.38% |
3.11% |
|
|
0.16% |
4.62% |
|
|
American Funds Category Average |
|
2.88% |
|
Vanguard Category Average |
|
4.62% |
Source: Morningstar.com
High Income Bonds
High-income bonds are riskier. But they may offer the promise of better returns. That has certainly been the case during the past 10 years for both the American Funds R-2 class of bonds and for Vanguard’s equivalent.
But once again, low fees beat high fees. Vanguard’s High Yield Corporate Bond Index averaged 6.60 percent per year. American Funds (R-2 Class) High Income Trust Fund averaged 4.73 percent per year.
The performance difference, between the two, was 1.87 percent per year. Over a 10-year period, that would be a pre-tax total difference of 19.3 percent.
American Funds R-2 Fund Performances Offered by Jon Levy vs. Vanguard Index Funds
10 Year Period Ending September 30, 2016
Asset Class: U.S. High Income Bonds
|
Fund Name |
Expense Ratio |
10-Year Annual Performance |
|
1.48% |
4.73% |
|
|
0.23% |
6.60% |
|
|
American Funds Category Average |
|
4.73% |
|
Vanguard Category Average |
|
6.60% |
Intermediate Bonds
The American Funds Intermediate Bond Fund (R-2 Class) didn’t perform any better. Its fees were also high. Its fund manager may have also made some mistakes. The one fund in the category with a 10-year track record averaged 1.81 percent per year. Vanguard’s Intermediate Term Bond Index fund averaged 5.84 percent per year.
Vanguard’s Intermediate Bond Index beat the American Fund Intermediate Bond fund by an average of 4.05 percent per year. Over a 10-year period, that’s a pre-tax advantage of 47 percent.
American Funds R-2 Fund Performances Offered by Jon Levy vs. Vanguard Index Funds
10 Year Period Ending September 30, 2016
Asset Class: Intermediate Bonds
|
Fund Name |
Expense Ratio |
10-Year Annual Performance |
|
1.40% |
1.81% |
|
|
0.16% |
5.84% |
|
|
American Funds Category Average |
|
1.81% |
|
Vanguard Category Average |
|
5.84% |
Some of the Jon Levy-listed R-2 Class of American Funds have no index fund equivalent.
But we can put indexes together to match their allocations.
American Funds R-2 Fund Performances Offered by Jon Levy vs. Vanguard Index Funds
10 Year Period Ending September 30, 2016
|
|
Mixed Allocations |
Expense Ratio |
10-Year Annual Performance |
|
14% U.S. Stocks 14% Bonds/Cash 72% Emerging Market Stocks |
1.78% |
3.70% |
|
|
Vanguard Index Fund Equivalents |
14% Vanguard U.S. Stock Index (VTSMX) 14% Vanguard Total Bond Market Index (VBMFX) 72% Vanguard Emerging Market Index (VEIEX) 74% |
|
5.39%* |
|
|
|||
|
42% U.S. stocks 37% International Stocks 21% Bonds/Cash/Other |
1.35% |
3.77% |
|
|
Vanguard Index Fund Equivalents |
42% Vanguard U.S. Stock Market Index (VTSMX) 37% Vanguard International Stock Market Index (VGTSX) 22% Vanguard Total Bond Market Index (VBMFX) |
|
5.49%* |
|
|
|||
|
53% U.S. Stocks 17% International Stocks 30% Bonds, Cash, Other |
1.36% |
4.78% |
|
|
Vanguard Index Fund Equivalents |
53% Vanguard U.S. Stock Market Index (VTSMX) 17% Vanguard International Stock Market Index (VGTSX) 30% Vanguard Total Bond Market Index (VBMFX) |
|
6.36%* |
|
|
|||
|
American Funds Category Average |
|
|
4.08% |
|
Vanguard Category Average |
|
|
5.75% |
Source: portfoliovisualizer.com
What’s The Average Annual Performance Difference Per Category?
Fees affect performance.
Based on the above six categories, here are the annual performances differences over the past ten years.
Annual Performance Comparisons For Six Investment Categories
|
|
American Funds R-2 Class |
Vanguard Index Funds |
Annual Lower Cost Advantage |
10 Year Pre-Tax Advantage For Lower Cost Funds |
|
U.S. Equity |
5.96% |
7.05% |
+1.04% |
+11.45% |
|
U.S. Growth |
6.17% |
8.17% |
+2.0% |
+21.89% |
|
Broad Bonds |
2.88% |
4.62% |
+1.74% |
+18.2% |
|
High Income Bonds |
4.73% |
6.60% |
+1.87% |
+19.3% |
|
Intermediate Bonds |
1.81% |
5.84% |
+4.03% |
+47% |
|
Mixed Allocations |
4.08% |
5.75% |
+1.67% |
+17.2% |
Does The Tax Free Status Make The High Fees Worth It?
Mark Zoril is a U.S. based investment advisor who has set up plenty of 403(b), 401(k), 401(a), Simple IRA, Simple 401(k), SEP IRA’s and multi-employer plans for both ERISA and non-ERISA groups.
I asked him whether it could be worth paying high fees for tax-free status. I showed him the example of the platform fees I’ve examined for this article. He says, “The investor that goes outside of the plan and uses very low-cost index funds and/or ETF’s should come out ahead – and it could be substantial – compared to the investor that uses the investments in a plan that is burdened with fees year in and year out in the name of ‘guidance’ and ‘advice’.
I wanted to see if that could be true. I assumed a long term capital gains tax of 15 percent for a taxable portfolio of low cost index funds. If a taxable portfolio of index funds could come out 15 percent ahead of a higher cost, tax free portfolio, the investor in the taxable portfolio would be better off.
ETFs (or index funds) in taxable portfolios are very efficient. They do attract taxes on dividends. But because an index fund has low (almost no) taxable turnover, an index fund investor can defer capital gains taxes almost entirely until the moment it’s sold. At this point, it would attract, in this hypothetical example, a 15 percent long term capital gains tax.
Morningstar gives us an estimate of how taxes paid on dividends and short term capital gains (which are unavaoidable in a taxable account) would affect an index fund’s performance.
Vanguard’s Total Stock Market Index
Pre-Tax and Post Tax Returns
Vanguard’s Total Stock Market Index (VTSMX) has averaged 9.26 percent before taxes since its inception. Morningstar estimates that its after-tax return would have been 8.66 percent. This assumes dividend taxes and some capital gains taxes (which would have been minor) based on the sale of some of the stocks within the fund if those stocks were dropped from the composition of the index.
The American Funds R-2 Class of actively managed funds underperformed their Vanguard counterparts in the six categories assessed by an average of 2.05 percent per year. If we remove the outlier category (Intermediate Bonds, where the difference was 4.03 percent per year) we give a 1.66 percent average annual advantage to the low-cost index funds.
Let’s assume that the R-2 Class of Americans Funds continue to underperform by 1.66 percent per year. Note that this is almost directly aligned with the extra fees they charge. It supports what the Economic Nobel Prize winner, William F. Sharpe, published in his paper The Arithmetic of Active Management.
Let’s also assume that Vanguard’s after-tax performance deducts 0.60 percent per year from its annual return and that the portfolio of index funds attracts a 15 percent capital gains tax when sold.
Hypothetical 9.26 Percent Pre-Tax Return*
|
|
Taxable Vanguard Account |
Tax Free American Funds R2 Class |
|
|
Minus Underperformance Based on Extra Fees |
0% |
-1.66% |
|
|
Minus dividend tax/capital gain drag** |
-0.6% |
0% |
|
|
Annual Return, post dividend tax (not including long term capital gains taxes) |
8.66% |
7.6% |
|
|
|
|
|
Overall Difference |
|
$10,000 Invested Annually Would Grow To: |
|
|
|
|
Over 15 years |
$310,637 |
$283,219 |
9.6% |
|
Over 20 years |
$535,137 |
$471,115 |
13.5% |
|
Over 25 years |
$875,204 |
$742,122 |
17.9% |
|
Over 30 years |
$1,390,329 |
$1,135,000 |
22.49% |
|
Over 35 years |
$2,170,679 |
$1,696,770 |
27.93% |
*This is the pre-tax (post fee) return of Vanguard Total Stock Market Index since inception. It isn’t meant to forecast future returns. But it’s used as a mathematical base for this assessment.
**Note that an ETF is more efficient than a typical index fund in a taxable account because it doesn’t attract any short term capital gains taxes if the investor doesn’t sell it
Teachers can’t withdraw their 401(k) funds without an IRS penalty unless they’re at least 59 ½ years of age.
That means the higher cost, tax free account might benefit teachers above 38 years of age.
Younger investors who are making a decision whether to invest in a high-cost, tax free 401(k) might be better off in a low cost taxable portfolio of index funds. They have more time for their money to grow. They also have more time for fees to erode their investment growth potential. High fees, over long periods of time, may hurt them more than taxes.
Have a look, once again, at the table below. Note the column on the right.
|
$10,000 Invested Annually Would Grow To: |
Low Cost Taxable |
High Cost, Tax-Free |
Pre-Tax Advantage For The Lower Cost Taxable Account |
Post Dividend And Post Long-Term Capital Gains Tax Advantage/Deficit For The Lower Cost Taxable Account |
|
Over 15 years |
$310,637 |
$283,219 |
9.6% |
-6.4% |
|
Over 20 years |
$535,137 |
$471,115 |
13.5% |
-1.5% |
|
Over 25 years |
$875,204 |
$742,122 |
17.9% |
+2.9% |
|
Over 30 years |
$1,390,329 |
$1,135,000 |
22.49% |
+7.49% |
|
Over 35 years |
$2,170,679 |
$1,696,770 |
27.93% |
+13.93% |
A 30 year old teacher would have to keep her money in the 401(k) for 29 ½ years. For such a teacher, a taxable, low cost portfolio of ETFs (exchange traded index funds) could come out roughly 7.49 percent ahead of a higher cost, tax free platform.
A 45 year old investor, however, could redeem (or roll over) their high-cost 401(k) after just 14.5 years in the plan. Such an investor may come 6.4 percent ahead with the tax-free platform, despite its higher costs. That said, they must remember to get into a lower cost portfolio at 59.5 years of age. If they don’t, over time their portfolio’s high fees will likely negate the initial tax savings.
How Could A 401(k) For International Teachers Benefit Every Teacher?
Providers would have to lower fees. Once again, here’s the comparative fee table. The three 401(k) providers offering their services to international teachers charge fees that are well above the U.S. national average for small company 401(k) plans.
International Teachers 401(k) Annual Charges Compared To Small U.S. Company Average
|
Jon Levy |
Raymond James |
The Investment Center (TIC Retirement Care) |
Average Small Company 410(k) Costs |
|
1.54%* |
1.61%** |
1.75%*** +$40 per year |
1.27%**** |
*This may be slightly higher if extra administrative costs are charged
** This includes possible administrative charge mentioned in the Raymond James prospectus: “If an additional amount is required to cover your plan’s administrative expenses, your employer expects that it will appear on your quarterly statement. Your employer expects that the total amount of plan-level expenses will not exceed up to 0.10% of your account balance per year.”
***Average fund fees are 0.30% per year; administrative charges are 1.45% per year
****Source: The Wall Street Journal
What Can School Administrators Do?
Bargain on behalf of your teachers. If a school’s 401(k) plan costs American international teachers 1 percent per year (including administrative and fund charges) it could be a good deal for everyone. Bargain with the investment provider. If schools set this precedent, fees will fall.
If your school offers to match a teacher’s contributions into a 401(k) scheme, don’t punish a teacher who wants to invest elsewhere. If that teacher is young, she may be better off investing in a lower cost, taxable portfolio. Don’t punish financial literacy. Such teachers deserve matching contributions too.
Make sure your financial service provider signs an important document. It should state that the advisory firm will take financial responsibility for any individual tax penalties that may come as a result of this tax-free platform. If the firm is confident that the platform is legal, they will sign that document. If they skip around the issue, it might spell future trouble.
On January 4th, 2017, I asked Raymond James’s lawyers if Raymond James would back teachers if they ran afoul of the IRS as a result of investing in their firm’s Roth 401(k) for international teachers. Their law representative at Kaufman & Canoles P.C. wrote:
“We are simply providing our professional opinions but of course cannot and are not providing any guarantees.”
If your school offers such a plan, and you feel comfortable with it, here are some fund suggestions. How To Select The Best Funds For Your 401(k).
Spend wisely. Save as much as you can. Retire well.
Cheers, Andrew
