This article discusses the major categories of 401(k) expenses and gives tips for evaluating them.
The first step for a plan sponsor is to know the total annual fees. The second step is to benchmark—to obtain information on the costs for similar plans (i.e., plans with similar assets and numbers of participants); the competitive marketplace does a good job of establishing reasonable prices.
However, even where the total expenses are reasonable, the costs for one of the categories may be too expensive. As a result, fiduciaries need to identify, quantify, and evaluate each major type of expense.
In my experience, the fees for 401(k) investments often fall within the range of reasonableness. However, when we see high investment expenses, they tend to be of two types. The first is that the expense ratio of one or more of the mutual funds is excessive. That can happen easily as a plan grows in size. For example, one share class may be appropriate for a small plan but, as the plan grows, a lower-priced share class may be right. Stated slightly differently, while small plans need to pay retail prices, large plans should pay "wholesale," or institutional, prices.
The second area involves so-called "wrap" fees. While wrap fees are not necessarily too expensive, they can be. I have seen cases where the total annual fees in a group annuity contract are 3% or more per year.
When plan fiduciaries are writing checks for the advice, the cost usually is reasonable. However, where the expenses are embedded in the investments, many plan sponsors do not know what they are paying, and they may pay too much. Further, as a plan grows, the costs should become increasingly smaller as a percent of the assets. That is because the services do not grow proportionately with the assets. Many advisers base their compensation on a percentage of plan assets, which is appropriate to a point, but which, thereafter, can be overly expensive. In those cases, lower fees and commissions can be negotiated directly with the adviser or through the use of less-expensive share classes.
These costs usually are fixed or can vary with the number of participants. However, providers are often recipients of payments—12b-1 fees and subtransfer agency fees—that are a percent of assets. Since part or all of the revenue is based on assets but costs are not, it is just a matter of time before a plan grows large enough that it is overpaying for these services.
Once a provider has recouped its operating costs plus a reasonable profit, any additional revenue-sharing should be restored to the plan (alternatively, lower-cost share classes, which pay less revenue-sharing, could be used). When the excess is restored, it is often done as a cash payment into the plan, which is sometimes called an "ERISA budget account" or an "expense recapture account." That money is available to pay other expenses of the plan or to be allocated to the participants. Either way, it improves the benefits for the participants.
Some recordkeepers create an ERISA account on their corporate ledger in lieu of putting the money into the plan. That raises two legal issues. First, is the money a "plan asset," which, under ERISA's fiduciary rules, must be placed in the trust? Second, must the money be allocated, under the qualification rules, to participants' accounts as of the last day of each plan year? Practitioners have conflicting views on these questions. As a result, fiduciaries should check with their ERISA attorneys.
Fiduciaries must identify, quantify, and evaluate expenses of their plans—both the total costs and the major categories of expenses. To evaluate those expenses prudently, fiduciaries need to benchmark the amounts against the costs for similar plans. As in all matters, if fiduciaries lack the expertise or the benchmark information to do the job properly, they should work with knowledgeable advisers.
Disclaimer Required by IRS Rules of Practice:
Any discussion of tax matters contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed under Federal tax laws.