THE SUPER SIMPLE 401k GUIDE (Part 1): Wall Street schemes, expense ratios, and avoiding 401k scams

Bogdan Zlatkov
13 min readFeb 3, 2020

On a cold and foggy night in Denver, Colorado, I got on a plane that would bring me more wealth than I could ever imagine.

I was 23 years old at the time, fresh out of college. I was working as a travel videographer and was flying back from my assignment in Denver.

I sat down in my cramped seat and got ready for the short 2 hour flight to San Francisco.

Next to me sat a clean-shaven, middle-aged man in a nice pair of gray slacks. He had his sleeves rolled up as he poured himself a gin and tonic from a miniature bottle he had secured from the waitress before takeoff.

“How did he get a drink before takeoff?” I thought as I glanced over.

“You want some,” he turned to me. “I’ve got extras.”

I took him up on the offer and we began to chat.

We soon arrived at the tried-and-true topic of “what do you do for a living?”

He said he was in the military because he wanted to give back, which I thought was strange considering how wealthy he looked.

Sensing my surprise, he added, “but I used to be a stock broker.”

O, I thought, it’s my lucky break! “Do you have any advice on how I should invest? I’ve saved up $2,400 so far and I want to try investing it.”

He smiled at the innocence of my remark. Then he pulled out a pen and began to draw on his cocktail napkin.

Over that 2-hour flight he explained how the stock market worked better than any textbook, blog post, or youtube video I had ever consumed.

He explained how his job as a broker wasn’t to make his clients money, it was just to get them to move their money. Every time they moved their money from one stock to another, he got a commission. If they gained money, he got a commission. If they lost money, he got a commission.

He described himself as a hype man for doctors, lawyers, and other rich people.

He would call them up suddenly and say, “hey we need to make some changes, these positions are going down the drain! We need to reallocate into this new portfolio, it’s skyrocketing!”

“You have to understand, these guys have made it. Most of them are retired and they’re bored out of their minds. This will probably be the most exciting thing they tell their wife this month,” he explained. “Or at least that’s how I justified it to myself at the time.”

As we began our final descent, he turned to me and said, “if you just keep your money in an index fund, you’ll do great. Put it there and don’t mess with it.”

“What’s an index fund?” I asked.

“Google it.”

Becoming 401k Literate

I didn’t follow his advice. After I got home I researched some stocks and invested in SolarCity (which filed for bankruptcy) and SunRun (which I bought too high and later sold for an $18 gain).

Fast forward to today and I am 30 years old and making nearly 4x the salary I did when I was 24 (but that’s a longer story).

I was saving my money diligently, but I knew that I wasn’t making the most of it. Every day in the back of my mind I knew I was losing 2–3% to inflation. If I saved $100,000 I would lose $19,000 every ten years to inflation.

So, one day I decided that I needed to become 401k literate. I dedicated 4 hours per day, every day, for 3 weeks to read anything and everything about 401ks (I’ll link to the most useful sources I found at the bottom of this post for you).

The shocking thing I found out was that the default 401k plan your provider chooses for you isn’t the best plan for you, it’s the best plan for them.

I won’t share everything I learned in this post, but I will distill the most essential things so that you can set up your 401k properly and then “don’t mess with it.”

If you aren’t interested in the “why and how” of choosing a good 401k, you can simply choose from the following low-cost recommendations for each provider.

Recommended 401K funds that follow the S&P500 Index:

Vanguard — Vanguard S&P 500 ETF (VOO)

Fidelity — Fidelity 500 Index Fund (FXAIX)

Schwab — Schwab S&P 500 Index Fund (SWPPX)

Valic — VALIC Company I Stock Index Fund (VSTIX)

T. Rowe Price — Equity Index 500 Fund (PREIX)

If you don’t see your provider listed above, send me a note in the comments section and I’ll find the correct fund for your provider.

If you want to know the why and how, here’s what we’ll cover in this series of articles (part 2) (part 3):

  1. How Wall Street makes money from your retirement
  2. Comparison: Actively traded vs passively traded funds
  3. How index funds work
  4. How to choose a good 401k fund (go directly to part 2)
  5. How to avoid the 2008 financial crisis

Disclaimer: I am not a certified financial adviser and this post is not an exhaustive list of everything about 401ks. I have consolidated the best practices I have learned from weeks of research that have helped me. In this post I use larger than average numbers ($50,000 vs $5,000) to better illustrate the effects of expense ratios, etc, but the principles remain the same. I have tried to simplify the information here for the financially challenged (like myself) so that the average person can make a more informed decision.

Why Wall Street Brokers are Rich: Expense Ratios

In one sentence: 401k funds that are managed by “fund managers” have higher expense ratios, but have historically performed worse than passively managed funds (index funds).

First, there are four important words you need to know:

Fund — A grouping of stocks.

Index Fund — A grouping of stocks based on a category. The most popular one being the S&P500, which is a grouping of the 500 largest companies in the United States.

Return — The amount of money a fund gained or lost. If a fund has a 10% return it means that it increased your money by 10%.

Actively traded fund — Actively traded funds are managed by a “portfolio manager” who tries to pick stocks in order to get higher returns than the stock market.

Passively traded fund — Passively traded funds are not managed by a person. Instead they are set to automatically buy and sell a group of stocks, this group of stocks are called “index funds.”

When I was first researching my 401k and I learned about actively traded and passively traded funds, I immediately thought, “I definitely want to have someone managing my money, following the stock market blindly seems way more risky.”

The question then was: who should I have manage my money?

Once I started researching which person I should give my money to, I discovered a troubling pattern.

The people who manage these funds obviously need to get paid somehow.

So who pays them?

The answer is that you do. We all do.

If these “portfolio managers” made the salary of a teacher or firefighter, we probably wouldn’t have a problem and this post would be over.

But they don’t.

Portfolio Managers don’t work alone, they have teams of dozens of financial analysts helping them.

They make millions of dollars per year by siphoning off a little bit of money from every client.

This leads to a higher “expense ratio” and it’s the difference between you retiring with thousands instead of millions.

Expense ratio — measures how much of a fund’s assets are used for operating expenses. The largest component of operating expenses is the fee paid to a fund’s portfolio manager. Other costs include accounting, taxes, legal, and advertising expenses.

Say you have your 401k in an actively traded fund at Fidelity. You’re sitting at home with some friends watching the Superbowl and a Fidelity commercial comes on.

“Wow,” you think, “Fidelity’s commercial was so funny! They did a great job!”

In 2019, that 30-second commercial cost an average $5 million dollars. That money was inadvertently taken out of your retirement and it didn’t benefit you at all.

The person that it does benefit is the “portfolio manager,” who will get more clients and a big bonus this year. In fact, that portfolio manager’s bonus will probably be larger than our entire retirement.

“Portfolio managers expect to earn an average of $1.59 million in total 2018 compensation, including $1.36 million in bonuses, options, and commissions.”
Institutional Investor

“Well,” I thought to myself, “I’m sure the reason they get paid so much is because they earn way more for us by picking the right stocks.”

This, as it turns out, is rarely true…

The Omaha man who bet $318,250

In 2007, the richest man in the world, Warren Buffett, made a bet with a few of his colleagues.

He bet them that they wouldn’t be able to build an actively managed fund that would outperform the S&P 500. The S&P500 is a passively managed fund that simply includes the 500 largest companies in the U.S.

They took his bet with a few caveats:

  1. They could use as many actively managed funds as they wanted in order to try different combinations of stocks
  2. They had to track the bet over a 10 year period so that the gains averaged out and weren’t just a single bad year.

Warren Buffet took the bet.

They hired an independent 3rd-party firm, named Protege Partners, to manage the bet and let the dice roll.

In 2017, 10 years later, he wrote about the results of the bet in his annual letter to investors. Here is Buffett:

American investors pay staggering sums annually to advisors, often incurring several layers of consequential costs. In the aggregate, do these investors get their money’s worth?

Protégé Partners, my counterparty to the bet, picked five “funds-of-funds” that it expected to overperform the S&P 500. That was not a small sample. Those five funds-of-funds owned interests in more than 200 hedge funds.

Essentially, Protégé, an advisory firm that knew its way around Wall Street, selected five investment experts who, in turn, employed several hundred other investment experts, each managing his or her own hedge fund. This assemblage was an elite crew, loaded with brains, adrenaline and confidence.

The managers possessed a further advantage: They could — and did — rearrange their portfolios of hedge funds during the ten years, investing with new “stars” while exiting their positions in hedge funds whose managers had lost their touch.

Every actor on Protégé’s side was highly incentivized: Both the fund-of-funds managers and the hedge-fund managers they selected significantly shared in gains, even those achieved simply because the market generally moves upwards.

Those performance incentives, it should be emphasized, were frosting on a huge and tasty cake: Even if the funds lost money for their investors during the decade, their managers could grow very rich. That would occur because fixed fees averaging a staggering 2.5% of assets were paid every year by investors, with part of these fees going to the managers at the five funds-of-funds and the balance going to the 200-plus managers of the underlying hedge funds.

Here are the final numbers (compare each fund to the “S&P Index Fund” on the right:

You’ll notice that the managers did do a good job in 2008 when the economy crashed. They lost less money than the S&P500. But over the 10 years that followed they couldn’t outperform the S&P500.

This is true in this 10 year period and in nearly every 10 year period you choose to sample.

^That’s a game-changing finding^

While the people who put their retirement money in these funds lost hundreds of thousands (sometimes millions) of dollars, the people who ran the funds actually made tons of money.

“A higher-income worker, making approximately $90,000 per year, will lose upward of $277,000 in fees in his/her lifetime.”

As Buffett summarized it perfectly:

Performance comes, performance goes. Fees never falter.

We, the average guy & gal, can learn a lot from the bets of billionaires, namely: Never put your money in an actively traded fund.

Note: Actively traded funds can outperform index funds, but rarely over the long term. The best actively traded funds have minimum investment requirements that far exceed the average person’s wealth. Since we’re specifically looking to secure a solid retirement here, we want great long term results, not just a short-term gain.

If you’re still doubtful, I have one last example for you:

Once some people started catching on to what high expense ratios actually meant, they began to move their money away from these actively traded funds.

This was bad for the fund managers, so they needed a new solution, they needed to figure out a loophole.

They decided that instead of getting their fees in the form of “operating expenses,” which they would have to report in the expense ratio, they would create 3 new fees they wouldn’t have to disclose.

Costs not included in operating expenses are loads, contingent deferred sales charges (CDSC), and redemption fees, which are paid directly by investors.”

These all sound very complicated, but once I dug into them, I realized that all three are very simple sales fees.

Loads — A sales commission you pay to the fund manager in order to buy the fund.

Contingent deferred sales charges (CDSC) — A sales commission you pay to the fund manager when you sell your shares of the fund early.

Redemption fee — A sales commission you pay to the fund manager when you exit the fund (when you retire).

Fund managers aren’t legally required to share these fees in their expense ratio and so they bury them in all the legal paperwork that none of us read.

Imagine in the case of the redemption fee, you invest in what you think is a low expense ratio fund and hold onto it for your whole life.

Now you’re 65 and your 401k has a healthy 1.3 million dollars in it. Looks like it’s time to cash out, go to a beach, and rub coconut oil on your belly, right?

“Sure, no problem sir,” the associate says, “we’ll just need you to pay the $120,000 redemption fee and we’ll get you on your way.”

“That’s ridiculous! I’m not paying that!” you exclaim with potent indignation.

But the associate doesn’t need to argue with you. “Sorry sir, it’s right here in the contract you signed with us (when you were 24 years old). Don’t worry, we’ll just withdraw it from your total balance and you’ll still have over a million dollars.”

This isn’t the worst thing that could happen. But, if you had taken just a few minutes to read this blog post back then, you could have cashed out that extra $120,000 and been cruising in your brand new Jaguar down highway 1 on your way to that 5-star resort…

Redemption fee or Jaguar?

If you’d like to see what moving your money from a high expense ratio fund to a low expense ratio fund could do for your retirement, you can use this 401k calculator and plug in your own numbers:

To get an idea of how the expense ratio affects your final retirement follow these steps:

  1. Plug in all your current numbers. If you don’t currently have a 401k or aren’t sure, just put $40,000 as your current balance and $0 as your monthly contributions.
  2. Input 9% as the estimated annual return (this is the average of the S&P500 index).
  3. Write down the number it spits out under “Future Value.”
  4. Now change the estimated annual return to 8% (this means just 1% is taken out by the “fund manager’s” expense ratio).
  5. Look at your new “Future Value” and compare it to the previous one.
  6. Take a deep breath and read on to see how to fix this…

That’s it for part 1. If all you do today is move your 401k from a high expense ratio actively managed fund to a low expense ratio passively managed fund, you’ll be better off than 90% of Americans out there.

In Part 2 we’ll go over:

  • How much money you should put in your 401k
  • How employer matching works
  • How to choose between stocks vs bonds
  • How to withdraw money from your 401k early if you need it

Go to Part 2: Index Funds, Blockbuster vs Netflix, and Choosing your 401K

If you found this article helpful I would super appreciate it if you shared it with a friend or hit the clap button so that more people can find it.

Useful sources I’ve used to learn about finances:

How to Get the Most out of your 401k — Investopedia
(This site is incredibly useful, but beware it might overwhelm you with all the jargon and lingo)

401k Calculator — Financial Mentor

Inflation Calculator — In 2013 Dollars

Compound Interest Calculator — NerdWallet

Expense Ratios Explained — Investopedia

Berkshire Hathaway Letters “The Bet” — Warren Buffett

Investing Without People — Oak Tree Capital

There They Go Again — Oak Tree Capital

5 Best Fidelity Stock Funds to Buy for the Long-Term — Kiplinger

Picking Warren Buffett’s Brain: Notes from a Novice — Tim Ferriss

The Psychology of Automation: Building a Bullet Proof Finance System — Ramit Sethi

The James Altucher Cheat Sheet to Investing — James Altucher

Money Master the Game — Tony Robbins
(very dense book, I recommend the podcast episode below instead)

Podcasts:

How to invest with clear thinking: Howard Marks— Tim Ferriss Show

The Steve Jobs of Investing: Ray Dalio — Tim Ferriss Show

Money Master the Game: Tony Robbins — Tim Ferriss Show

What I Learned Losing a Million Dollars: Brandon Moynihan — Tim Ferriss Show

Exploring the World of Investing: Peter Mallouk — Tim Ferriss Show

What do you need to retire: David Bach — James Altucher Show

Billionaire investor on market cycles: Howard Marks — James Altucher Show

Trading against your instincts: Roy Niederhoffer — James Altucher Show

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Bogdan Zlatkov

Telly award-winning Content Strategist, Video Wizard, World Wanderer, Writer, worked at Emmy award-winning production studio, beat Mark Zuckerberg at hockey.