4 sneaky investment fees to watch for

Everybody is looking for the next hot stock or mutual fund.

But we should be paying closer attention to the fees of the investments that we already own. For example, nine in 10 Americans underestimate the fees of their 401(k) plans. This means that many of us are paying too much for our investments and undermining our financial goals. 

To keep your investments on target, take notice of these four investment fees.

1. Front-End Load

A front-end load is a sales charge on purchases that effectively reduces your investment. This investment fee is a commission or sales charge applied at the time of your initial purchase of an investment, such as a mutual fund or insurance policy. Financial planners, investment advisors, and other types of investment intermediaries are the main beneficiaries of front-end loads.

Let's assume that you want to invest $5,000 into a mutual fund with a 5% front-end load. That would mean that $250 would go to middlemen and only $4,750 of your original investment actually lands in the mutual fund.

Some mutual fund managers claim that the front-end load is necessary to cover the extra services offered in a load fund. However, a study showed that mutual funds without front-end loads significantly outperformed those with front-end loads during the turbulent financial period of 2000 to 2002.

Still, some novice investors may still profit from the additional benefits that come from a load fund. Just make sure that you don't pay more than you have to.

• According to FINRA Conduct Rule 2830, a front-end load can't exceed 8.5% of your investment.
• If a mutual fund charges a front-end load of 8.5%, then it must offer a breakpoint schedule, rights of accumulation, and reinvestment of dividends and capital gains at net asset value.
• Most 401(k) plans allow you to waive the front-end load of a mutual fund.

2. "Breakpoint" Cost

There is no specific breakpoint cost. Think of this investment fee as the extra money that you're paying to your investment manager by failing to meet a required investment level to obtain a reduced fee. For example, if you were to invest just $2,000 you would pay a 6% sales charge to invest in A-shares of a mutual fund, but if you were to invest $50,000 you would pay a lower 4.75% sales charge for the same share.

While diversification is a useful tool to minimize investment risk, too much diversification within the same mutual fund may be increasing your investment expenses.

• The larger your investment, the lower your applicable fees. By having $100,000 in investable assets within the same mutual fund family, you can often get some breaks on investment fees.
• Immediate family members investing in the same mutual fund company can pool their individual accounts to qualify for lower costs.
• When you meet pre-determined total purchase thresholds, certain mutual funds provide rights of accumulation, which qualify you for a reduced sales charge for any additional purchases.
• Some mutual funds may allow you to still qualify for a breakpoint benefit when you sign a letter of intent to meet purchase thresholds within a mutually agreed time frame.

3. Operating Expense

Large companies have more leverage than small ones in driving down the operational costs of a 401(k) plan. That's why large companies are able to pick up the operating expense tab on behalf of their employees.

On the other hand, employees participating in the 401(k) of small businesses may be forking out the cash to cover that expense. To determine whether you're paying for your plan's operating expenses, you can check with the manager of your 401(k) plan. Another option is to find how much you're paying for your plan's operating expense by yourself:

1. Grab a copy of your plan's summary annual report;
2. Go to the "Basic financial statement" section;
3. Subtract the amount of benefits paid from the total plan expense;
4. Divide the amount from step #3 by the total value of the plan; and
5. Take the percentage from step #4 and multiply it by your total account balance.

If the amount that you're paying seems too high, you have a valid case for asking your employer to consider lower-cost options. When it comes to 401(k) plans, small business owners are receptive to reasonable requests from their employees. A survey found that 32% of small business owners consider requests to switch 401(k) providers, and 30% of those business owners choose lower-cost investment options within a plan.

4. Total Expense Ratio Above 1%

Everybody has to make a living, even investment managers. However, you need to be wary of any investment account that has a total expense ratio above 1%. They'd better be delivering some extraordinary profits year after year to warrant the cost!

Let's assume that you have a $10,000 starting balance, a 6% average annual rate of return for your investment account, and a holding period of 10 years. Here are several scenarios for your final balance after 10 years at different total expense ratios.

• Expense ratio of 0.30% = $17,408
• Expense ratio of 0.40% = $17,244
• Expense ratio of 0.50% = $17,081
• Expense ratio of 0.60% = $16,920
• Expense ratio of 0.70% = $16,760
• Expense ratio of 0.80% = $16,602

The lower the total expense ratio, the more money in your pocket. A useful rule of thumb is to keep the total expense ratio of an actively managed fund below 1%. There are several investment options out there, so look for the ones that meet your target rate of return at competitively priced expense ratios.

Remember that most investment managers make no guarantee for returns, but they surely are committed to picking up their fees. Only 20% to 35% of portfolio managers beat the benchmark for their category. With total expense ratios as low as 0.17% for some index funds, it's easy to see why more and more investors are shifting their dollars to passive funds.