It is no secret, and a study by the National Association of Retirement Plan Participants has proven, that retirement plan participants have no idea what fees they are paying. Moreover, some are not even aware of their existence. As a part of their fiduciary responsibility, plan sponsors are required to provide participants with an annual notice about the fees they are paying. Unfortunately, this doesn’t help much as indirect fees which are deducted from fund return still remain hidden and are very easily overlooked.
To help plan participants make better investment decisions and point out the importance of fees and the detrimental effect they can have on their account, many plan sponsors conduct educational sessions. The paradox of this situation, however, is that often plan sponsors are the ones who need to be educated first. Why? Because the whole “fee situation” is very imbroglio.
As a part of their fiduciary responsibility, plan sponsors need to understand and evaluate the fees paid by the plan. However, lack of fees and compensation transparency by the service providers as well as no clear guidance from the Department of Labor, makes it hard on plan sponsors to fulfill this duty. How can you, as a fiduciary, be sure that the expenses the plan and participants pay are reasonable and competitive, if you can’t understand the payment mechanism and what’s hidden behind the fees?
That is why it is so critical to know everything about your retirement plan’s fees. You need to know what fees are out there, who exactly is being paid, what they are being paid for, and who is going to pay for the services.
Categories of Fees
There are three main categories of 401(k) fees:
Administration fees
These are the expenses associated with basic administrative services such as third-party administration, recordkeeping, accounting, trustee and legal services, investment advice, asset custody, software, and education sessions for plan participants. In other words, administrative services fees are expenses needed for the day-to-day operation of the plan.
Investment fees
These are the fees related to managing plan investments. Investment fees are usually borne by plan participants and are deducted from their accounts, which makes them hard to spot. Plan sponsors need to pay very close attention to investment fees as they are the least transparent. For example, mutual funds available to plan participants in the investment menu can have sales charges (also known as loads). In the case of a front-end load fund, plan participants pay an upfront fee for investing in a fund whereas a back-end load charge is paid when shares of the fund are sold. In any case, these charges reduce participants returns.
In addition to management fees and sales charges, mutual funds can charge 12b-1 fees. These fees are the annual commissions paid by a mutual fund to brokers and investment advisory firms for promoting and placing the customer with the fund. Simply put, 12b-1 fees are the marketing costs of mutual funds that are paid by investors (plan participants) out of fund assets. Needless to say, these fees negatively impact participant’s returns in the long run.
If variable annuities are available to plan participants, insurance companies may have surrender and transfer charges as well as insurance-related and administration charges.
Individual service fees
These are the fees for additional features available to plan participants, such as taking a loan from the plan, withdrawal or distribution fees, financial planning advice or managed account services.
Who Pays the Fees
Depending on the category of the fee, plan expenses can be paid either by a plan sponsor, by participants, or by both through plan investments. If the expenses are paid directly by the plan sponsor or participants via deduction from the account balances, these fees are called direct fees. Direct fees are the most transparent form of compensation to 401(k) providers as they have to be disclosed in the annual fee notice.
Usually there are no questions when it comes to investment and individual service fees as both are paid by participants. For instance, why would you, as a plan sponsor, pay for a participant’s desire to take out a loan?
The “who pays what” situation gets a little more complicated when it comes to administrative fees, specifically for recordkeeping services which are by far the biggest expense. The most transparent and participant friendly method is for the plan sponsor to pay all of the fees directly. However, maintaining a 401(k) plan is already a very expensive endeavor. Therefore, driven by a pure business desire to keep costs low, plan sponsors allocate some of the plan expenses to participants. As a result, recordkeeping fees are often paid indirectly. Indirect fees are deducted from funds returns and they are not disclosed in the annual fee notice.
There are three popular plan expense allocation methods: “revenue sharing,” fee “leveling,” and a flat dollar amount.
Under a “revenue sharing” method, recordkeeping fees are pre-built into the expense ratios of the plan investments. Mutual funds then make payments directly to third-party administrators (TPAs) to compensate them for their recordkeeping services. Though it looks rational, revenue sharing has been under a large amount of scrutiny recently. The problem with revenue sharing is that TPAs were compensated based on a percentage of plan assets, when in fact they only need a fixed amount for their services (i.e. a flat dollar amount). In a rising market environment, many TPAs receive revenue sharing payments that exceed their actual costs (“excess revenue sharing”).
A solution to this problem is the use of a reimbursement account, also known as a revenue credit account. Under a contractual agreement between the plan sponsor and the TPA, the TPA charges a flat rate for its services (“required revenue”) and reimburses the excess revenue back to a reimbursement account. The funds in the reimbursement account can then be used by the plan to pay for other plan expenses such as participant education, nondiscrimination testing, audits, advisers, legal fees, etc. In many cases, the plan may even return the excess back to plan participants.
In a fee “leveling” method, each plan investment option has the recordkeeper required revenue applied to them. If the expense ratio of a specific investment fund exceeds the required revenue, the recordkeeper returns the difference back to participants. However, if the expense ratio is less than the required revenue, the recordkeeper then adds a “wrap” fee to each participant’s account that holds the investment fund in order to compensate for the shortfall.
Finally, in a flat dollar amount method, the recordkeeper charges each participant a flat dollar amount and deducts this amount usually on a quarterly basis.
Each method has its own pros and cons. Fee leveling and flat dollar amount methods are simple to understand and the most transparent. Each participant pays either a fixed percentage or dollar amount for the recordkeeping services. However, with a fee leveling method, participants with larger account balances pay a greater amount of fees than those with smaller balances. For example, let’s imagine that the required revenue is 0.20%. A participant with an account balance of $100,000 will pay $200 per year, whereas a participant with an account balance of $20,000 will pay $40 for essentially the same amount of services.
To avoid this disproportion, some plan sponsors prefer a flat dollar amount model. But, this model has the opposite effect of a fee leveling model. A participant with a smaller account balance pays a larger portion of its balance towards the recordkeeping services than a participant with a bigger balance. For instance, with a $100 annual recordkeeping fee, a participant with a $20,000 balance would be paying a 0.50% of the account balance whereas a participant with a $100,000 would be paying 0.10%
As of now, many plan sponsors still rely on revenue sharing. But, of course, revenue sharing isn’t flawless. The issues with this method arise not only because of its hidden fee structure, but also due investments in the plan menu that have little or no revenue sharing. In this case, some participants that are invested in high revenue sharing funds may be subsidizing those who are invested in low revenue sharing funds.
Considering increased litigation around plan fees, the importance of fees transparency, and overall tendency towards lower investment fees incurred by participants, it is hard to say how long revenue sharing will prevail. It could very well be that in the near future, plan sponsors will migrate to a per participant allocation model.
Whatever allocation method you choose, make sure you understand the pros and cons of each method and know your plan demographics. Remember, a fee allocation decision is a fiduciary decision with all the consequences that come with it.
How Plan Sponsors Can Help Participants?
401(k) fees are a very sensitive topic for both plan sponsors and plan participants. Even though we mentioned that plan participants are still very far off from getting the full fee picture, more and more are starting to see and understand the negative effect of high fees on their retirement savings and raise questions. As a plan sponsor, it is in your best interest to make sure that the fees that the plan and participants pay are reasonable. Not only will it help you fulfill your fiduciary duty, but it will also minimize future litigation.
So, what can you do to make your 401(k) even more attractive and help them save more to retire financially secure? Below is a list of actions that you may consider taking right now.
Provide easy to understand disclosures and educate them.
Do not use load mutual funds.
Think twice before including mutual funds that charge 12b-1 fees. Imposing the fund company marketing and advertising on your participants is not that sensible.
Avoid actively managed funds in the menu. They are move expensive and rarely perform better than their passive counterparts.
Consider unbundled service agreements with providers and pay directly for some of the expenses that relate to plan administration.
Make sure you offer participants the lowest cost class of shares. Hint: don't just make judgement based on the lowest expense ratio. Look if the plan gets any excessive revenue back after all the expenses have been paid back.
Exclude plan loans. I know that it is easier said than done and may cause some backlash from participants, but you are not obligated to make loans available. Allowing participants to tap into their nest egg rarely leads to anything good as many participants don't repay the loans. By excluding loans you are not only minimizing plan expenses charged to participants, but also protecting participants from impulsive and not well thought out decisions.
In conclusion, develop a fee policy which will outline who pays for the fees, how these fees are allocated, and the exact fee monitoring criteria. Then, rigorously follow it.