The 401(k) landscape is notorious for hidden fees and disparate pricing strategies. According to the Congressional Research Service, it is common for plans to have fees of 2% or higher. The actuarial and consulting firm Milliman found that a 1% higher fee could result in 26% lower returns to a participant over a 40-year time horizon. This has led to an increase in class action lawsuits and complaints against 401(k) providers and plan sponsors for breaching their fiduciary duty by charging excessive fees or allowing them to be charged.
It’s important for plan sponsors to know the fees associated with their plan so they can determine whether each fee is reasonable. Here is a breakdown of common fees to be on the lookout for. (For more, see: 401(k) Lawsuits: How Employers Plan to Protect Themselves.)
The largest fees that plan sponsors will encounter are those associated with the underlying investments themselves. All mutual funds have expense ratios, or the percentage of assets deducted each year to cover the cost of managing the fund. These costs can include items such as administrative and operating costs, investment management fees, and 12b-1 fees. Investment fees make up 70% to 80% of total plan costs, but they are the easiest fees for plan sponsors to manage because of their clear disclosure. By choosing passively-managed funds as opposed to actively-managed ones, you can keep your plan’s investment fees lower.
Funds that are not actively managed, such as index funds, will carry a lower expense ratio than funds that are being actively monitored by a fund manager. Passive funds will seldom have 12b-1 fees that are charged to cover the cost of marketing the fund.
Plan Administrative Fees
Like the underlying funds, there are costs associated with managing a 401(k) plan itself. Record keeping, accounting, trustee services, customer support and investment advice, if provided, all fall under plan administrative fees. These costs can be deducted directly from plan assets or investment returns or they can be covered by the plan administrator. If your plan has individual accounts under management, you can charge a flat fee to each participant or offer a sliding scale by deducting fees on a pro rata basis.
Optional Service Fees
Some 401(k) plans may offer optional services for an additional charge. These fees would be charged on an individual basis to those participants who choose to use these additional service.
Most of the fees listed above are made clear in the plan and fund service agreements. For example, a mutual fund’s expense ratio is openly disclosed in its prospectus and shareholder reports. When plan sponsors and advisors may be blindsided is when these fees are shared or bundled.
According to ERISA laws 401(k) plan sponsors, while advisors, have a fiduciary duty to ensure the fee structure of their plans is “reasonable.” What exactly constitutes “reasonable” under the law is not specified. But one thing is clear: plan sponsors cannot know if the fees associated with their plan are reasonable unless they first understand what those fees are. (For more from this author, see: What the New Fiduciary Rule Means for 401(k)s.)
This article is adapted from Tyler Harrison's white paper “Building An Efficient Plan: An Overview of the Evolving 401(k) Landscape." You can download the full version here.