In a 401(k) plan, a participant’s account balance will determine the amount of retirement income he/she receives. A low cost 401(k) plan may be slightly difficult to find, but the search will be well worth it: the small amounts you save each day now can amount to a significant improvement to the amount you retire with. While retirement plan participants may not see a fee charged on their quarterly 401(k) statement, they may be paying more for the underlying investments.
Several different types of fees may apply to your plan and generally fall into two main categories: plan administration costs and investment expenses.
Plan Administration Costs
The everyday operation of a 401(k) plan involves fees for basic administrative services that are necessary to run the plan, including, but not limited to, producing statements, providing customer service and a Web site, compliance testing, Form 5500 preparation and contribution processing. A 401(k) recordkeeper can charge for these services in several different ways, but the most common ways include:
Per-participant recordkeeping fee: Fixed dollar amount charged for each plan participant.
Asset-based fee: Percentage based on the assets in the plan.
Fixed per-plan fee: A flat dollar fee charged to the plan.
Investment Expenses
Typically, the largest component of all 401(k) plan fees is attributable to the investment management fees charged by mutual funds. According to a study by Deloitte and the Investment Company Institute, 74% of a plan’s cost is attributable to investment expenses1. These costs are usually displayed as an indirect charge on your account because they are deducted directly from investment returns. As a result, a funds net total return reflects performance after fees are deducted.
Management Fees
Management fees are ongoing charges for managing the assets of a mutual fund. They are generally stated as a percentage of assets invested in the fund. Management fees are paid out of the mutual fund assets to the fund’s investment adviser (or their affiliates) for managing the fund’s investment portfolio. Management fees may also be used to cover certain administrative fees paid to the investment adviser and can vary widely, depending on the investment adviser and the nature of the investment portfolio. All mutual fund investment options will have a management fee.
Distribution fees include fees paid for marketing and selling fund shares, such as compensating brokers for selling the fund’s shares, paying for advertising, printing and mailing of prospectuses to new investors and the printing and mailing of sales literature. The most common type is 12b-1 fees, which are generally between 0.25 – 0.75 percent of a fund’s average net assets (the maximum allowed for marketing and distribution expenses pursuant to applicable FINRA [Financial Industry Regulatory Authority] rules). Information on the 12b-1 fee is disclosed in a fund’s prospectus.
Furthermore, sub-TA (sub-Transfer Agency) or shareholder servicing fees can be paid by the fund company to a 401(k) recordkeeper for providing all the sub-accounting functions at the participant level, where there is only one account established at the fund company. In contrast to a management fee, not all mutual funds contain distribution and/or shareholder service fees; those that do will usually have higher overall expense ratios.
Other Mutual Fund Fees
Other fees charged by mutual funds include custodial, legal, accounting, transfer agent and other administrative expenses.
In addition to the types of fees previously described, an insurance company may offer products through a group annuity policy that essentially adds a variable annuity insurance fee known as a “wrapper” to the underlying mutual funds, resulting in an added cost. A variable annuity is a hybrid investment/insurance product that adds a mortality and expense fee that is charged on top of underlying mutual funds. As a result, it can be very costly to include variable annuities as part of your 401(k) plan.
There are several entities that may offer 401(k) plans marketed as “free” to plan sponsors, which include, but are not limited to, the following:
Mutual Fund Company
Mutual fund companies that offer 401(k) plans often do not charge explicit recordkeeping fees because their revenue is commonly generated from the management fees charged by their funds and other investment products. Essentially, they may offer 401(k) plan administration as a means to increase their funds’ assets under management. In many situations, a mutual fund company will outsource recordkeeping to a third-party provider that may be compensated by revenue sharing payments produced by the plan investments. Regardless of who provides recordkeeping services to a 401(k) plan, one potential pitfall to be aware of in a plan offered by a mutual fund company is that the mutual fund company may offer only a limited selection of funds and/or impose proprietary fund requirements, including share classes that might charge higher overall fees and expenses.
For clarification, revenue sharing is referred to as fees paid by mutual fund companies to service providers for performing recordkeeping functions, shareholder servicing and/or sub-transfer agency services to retirement plans.
Insurance Company
In the small plan market, an insurance company is likely to offer a product lineup of group fixed and variable annuity contracts. However, this can be very expensive for plan participants because variable annuities include an insurance wrapper in the form of a VAC (Variable Asset Charge) or an AMC (Administrative Maintenance Charge) that is an added layer of expense. A plan consisting of variable annuities will refer to the underlying investments as “sub-accounts” or “separate accounts” with reference to the mutual fund as an “underlying portfolio.”
Additionally, insurance companies may offer different classes of the same funds (e.g., Class 1, 2, 3, 4 and 5) to plans based on varying asset levels, with the most expensive class typically being sold to plans with the least amount of assets.
A TPA (third-party administrator) that provides recordkeeping services could offer a “free” plan by limiting the lineup of available funds to those that include a distribution and/or service fee. In other words, they are not providing an Open Architecture 401(k) platform. In this scenario, the TPA would likely make their profit by the retention of these payments from the fund companies. The effect of this arrangement is that the lowest expense ratio share classes are not necessarily available to plans. Additional fees may also be charged for services such as Form 5500 preparation or providing a plan document.
Long Term Impact to Participants
A low cost 401(k) plan generally results from a combination of low investment expenses and low plan administration fees. What matters most is the impact these fees can have on participant accounts. As a plan fiduciary, plan sponsors must act solely in the interest of participants and their beneficiaries with the exclusive purpose of providing benefits to them. Therefore, it is imperative that plan sponsors understand all fees that are being charged to plan participants. When a plan is marketed as “free,” it is likely that there are hidden investment costs that could potentially lower the retirement nest eggs of participants.
