Fees for 401(k) plans cover services such as investment management and other financial advice, hiring and managing plan vendors, telephone or web-based customer service for plan participants, record-keeping and custodial or trustee services for plan assets. Generally, services are either bundled, where a plan sponsor hires one company to provide the full range of services directly or through subcontractors, or unbundled, where the sponsor uses a combination of service providers hired independently of each other.
These fees can influence the long-term performance of an employee savings plan. According to a November 2006 study published by the U.S. Government Accountability Office (GAO), even a small difference in 401(k) fees can significantly decrease an employee’s retirement savings over the course of a career.
“Assume an employee of 45 years of age with 20 years until retirement changes employers and leaves $20,000 in a 401(k) account,” writes report author Barbara Bovbjerg, director of Education, Workforce and Income Security Issues for the GAO. “If the average annual net return is 6.5 percent—a seven percent investment return minus a 0.5 percent charge for fees—the $20,000 will grow to about $70,500 at retirement. However, if fees are instead 1.5 percent annually, the average net return is reduced to 5.5 percent, and the $20,000 will grow to only about $58,400. The additional one percent annual charge for fees would reduce the account balance at retirement by about 17 percent.”
Many employers and plan participants are not aware of these charges or service providers’ undisclosed business arrangements that can negatively affect plan performance. In addition, fees can mask a potential conflict of interest—for example, where one service provider to a 401(k) plan pays a third-party provider for services, such as record-keeping, but does not disclose this compensation to the plan sponsor.
To compound the problem, not all companies review their 401(k) fees as often as they should. Transamerica Retirement Services, a retirement plan provider, reported in a 2005 survey that 17 percent of companies never evaluate their retirement benefits. Of those that do, small companies are less likely than large companies to conduct reviews at least once a year. At the same time, many employees don’t understand there is a cost for their 401(k) investment services. In a national survey conducted by AARP, more than 80 percent of 401(k) participants reported not knowing how much they pay in fees.
Managing 401(k) Fees
Since investment services account for the bulk of plan fees, many 401(k) plan sponsors are looking to institutional funds to help lower their plan expenses. Institutional mutual funds resemble funds available in the consumer market but are typically available only to 401(k) plans with assets above a certain threshold, such as $1 million. Similarly, indexed funds charge lower management fees than actively managed funds. These funds closely track a market performance indicator, such as the Standard & Poor’s 500, which largely eliminates expenditures associated with research, investment selection and buying and selling.
New federal initiatives that address 401(k) fees should help manage plan costs and improve understanding of a plan’s expense structure. The U.S. Department of Labor is proposing changes to the regulations that govern arrangements between plan sponsors and their service providers, with a focus on fee transparency. Under this proposal, plan administrators would be required to disclose indirect fees, including revenue-sharing payments, on the plan’s annual report. Plan service providers would also be required to provide a summary of all fees that plan assets cover or that participants pay directly.
Employers can also reduce 401(k) costs and liability concerns by taking an active role in plan management. Attorney Gregory Ash, a partner with Spencer Fane Britt & Browne and a specialist in employee benefits law and litigation avoidance, explains that class-action lawsuits are cropping up in response to 401(k) fees. In ten lawsuits filed recently, plan participants argued that even small reductions in the return of their 401(k) investments are devastating, and that the most certain means of protecting plan returns—and the factor most within employer control—is to reduce fees and expenses.
“The plaintiffs in these cases are arguing that the fee structures used by third-party administrators, recordkeepers, investment consultants and other 401(k) service providers are complex, excessive, undisclosed and illegal. They maintain that by adhering to those fee structures, plan fiduciaries are breaching their obligations to participants,” Ash says. “According to the plaintiffs, by failing to provide adequate information about plan expenses, the fiduciaries are responsible for any investment losses the participants may have suffered. This is likely to be just the first in a wave of similar suits which could have a tremendous effect on the 401(k) industry as a whole.”
Ash recommends these tactics to reduce your liability risk and promote a well-managed 401(k) fee structure:
- Calculate current plan costs and ask service providers to explain the expense- and revenue-sharing arrangements for each fund in the plan.
- Periodically review the performance of the investment funds the plan offers, including their expenses, to determine whether those funds continue to be appropriate.
- Aggressively negotiate your plan fees, including conducting formal or informal requests for proposals with existing or new providers, to ensure you provide the most competitive 401(k) offering.
- Offer a diverse selection of funds and investment options to ensure choice and flexibility for plan participants.
- Inform participants about the fees and expenses associated with the plan and thoroughly document the employee communication process.
“As American workers take increasing responsibility for the adequacy of their retirement savings through 401(k) plans, they need to be more aware of the fees that they pay,” says the GAO’s Bovbjerg. “Giving participants key information on fees for each of the plan’s investment options in a simple format—including fees, historical performance, and risk—will help participants make informed investment decisions within their 401(k) plan.” IBI
